Insights from ecologists show ways of preventing economic disaster

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  • Posted on April 18, 2011

    Global financial system, mirrored the complex but less disease-resistant ecosystems such as the Amazon rainforests, leading to its rapid decline from 2008. Photograph Getty Images

    In the eight centuries from 1000-1800 AD the world’s fish stocks and species numbers were stable and healthy. In the subsequent 200 years, 40% of the species in coastal waters collapsed, showing falls in their population by 90% or more.

    There was a pattern to this story of decline. There was a much-less marked attrition in coastal regions with richly diverse marine ecosystems than in regions exhibiting low levels of diversity.

    What does this have to do with economics? Quite a lot, as it happens. In recent years, as the limitations of the rigidly mathematical approach to economics have been exposed, there has been interest in what the dismal science can learn from biologists, ecologists, geneticists, physicists and psychologists.

    Two years ago, Andrew Haldane, the Bank of England’s executive director for financial stability, published a paper in which he used global fish stocks, the spread of epidemics, and the destruction of the rain forests to explain why the system collapsed so dramatically. The March edition of Central Banking contains a fascinating piece by its editor, Claire Jones, on how the work of the scientist Robert May on the stability and complexity in ecosystems supports the case for deep structural reform of finance.

    This is, of course, a topical issue in the light both of the preliminary report by the UK government’s independent commission on banking (ICB) and the setting up of a financial policy committee (FPC) at the Bank of England to keep tabs on what the City is up to. Both the ICB and the FPC seek to strike a balance between preventing another financial crisis and ensuring that the growth prospects of the economy are not impaired by over-zealous regulation.

    As Paul Tucker, the Bank’s deputy governor put it in a speech in New York last week: “The government has proposed that the FPC be subject to a constraint that it should not act to preserve stability at the cost of significantly impairing the capacity of the financial sector to contribute to medium-to-long term economic growth. What this means in practice is that when faced with an immediate or incipient threat to stability, we must try to find a solution that avoids damage to long-term growth. That discipline is welcome by the Bank.”

    But perhaps it shouldn’t be. A light-touch approach could make the financial system less safe and increase the chances of a second financial crisis. It needs to be remembered that as a result of the first blow-up the UK economy is operating 10% of GDP below where it would be had the pre-crisis trend of growth continued.

    Haldane’s analysis certainly suggests that leaving the status quo largely untouched is risky. Judging reforms by whether one or more big UK bank might relocate in the US, Switzerland, Dubai or Singapore misses the point entirely. Seen from an ecological viewpoint it is a bit like asking whether half a point off Brazil’s GDP for the next 10 years is more important than protecting the Amazon rain forest.

    Précis of the argument goes like this. In the decade or more leading up to the crisis, the financial sector became bigger, more complex and more homogeneous. Mutual institutions became banks, commercial banks dabbled in investment banking, and investment banks set up in-house hedge funds . What had been a diverse financial ecosystem became a monoculture.

    “In consequence, the financial system became, like plants, animals and oceans before it, less disease-resistant”, Haldane noted. “When environmental factors changed for the worse, the homogeneity of the financial ecosystem increased materially its probability of collapse.”

    Those running the system did not think for one minute this was going to happen. They thought that the system was strong and durable because risk had been spread. They were also reassured by the way global finance had withstood the Asian crisis of 1997, shrugged off the dotcom collapse of 2001 and had continued to expand despite rising oil prices and wars in Iraq and Afghanistan. The rationale was that complexity equalled stability, which was what biologists believed about ecosystems until the 1970s. Then, research showed that some simple ecosystems, such as the Savannahs were robust while more complex systems such as rain forests were vulnerable. For a while, this vulnerability lay hidden, with the system able to absorb a considerable amount of strain without appearing to suffer. But eventually, a tipping point was reached: the moment when fractionally more over-fishing caused irreparable damage to the stocks of cod on the Grand Banks.

    Seen from this perspective, it becomes easier to explain why seemingly minor problems triggered a systemic crisis in global finance. Few could understand why the bankruptcy of Lehman Brothers in September 2008 could lead within a month to a situation where no bank in the world appeared safe, but that was because none of those responsible for the system – the bankers, the politicians and the regulators – understood that complexity plus homogeneity spelt danger.

    Haldane noted in his paper that “in just about every non-financial discipline – from ecologists to engineers, from geneticists to geologists – this evolution would have set alarm bells ringing. Based on their experience, complexity plus homogeneity did not spell stability: it spelt fragility.” In an echo of the loss of fish stocks after 1800, by early 2009, 23 of the biggest European and American banks had lost 90% of their market value.

    All this is highly relevant to the debate about how to fix the financial system. Up until now, the focus has been on curbs on pay and on ensuring that banks have bigger capital buffers to limit their leverage and their exposure to risk. Neither is likely to do the trick. The root of the problem before the crisis was that bankers did not know the risks they were taking. If, in the years ahead, they still do not appreciate those risks, they will try to find ways to sidestep new capital constraints, no matter how much they are paid.

    The task of the FPC is to ensure that the City is aware of those risks. Better information would help to reduce the risks of another crisis, particularly if information was shared across borders. Haldane cites the example of the World Health Organisation, which set up a Global Outbreak Alert and Response Network in 2000 to provide a co-ordinated global response to fighting epidemics such as bird flu and SARS.

    But more transparency won’t be enough on its own, because what the financial system needs is more diversity and more simplicity. That means a richer ecosystem: mutuals, commercial banks, investment banks, state-owned banks, banks dedicated to funding environmental industries. It also means greater simplicity to ensure that shocks do not lead to system collapse. That is why it is a mistake to accept, at the first sign of resistance from finance sector, that there can be no Glass-Stegall-style separation of retail and investment banking. We need to be clear what an insufficiently robust response to the crisis means. It means allowing the City and Wall Street to hoover up all the fish and chop down all the trees.

    Andrew Haldane; Rethinking the Financial System

    Claire Jones; Preventing System Failure; Central Banking Volume 21, Number 1;

    The Guardian | Londres/AC

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