Hi Frank - The article was interesting, but lacked resolution in some ways.
"A 2006 report co-sponsored by the Federal Reserve Bank of New York and the National Academy of Sciences concluded that even defining systemic risk was beyond the scope of any existing economic theory. Actually managing such a thing would be harder still, if only because the number of contingencies that a systemic risk model must anticipate grows exponentially with the connectivity of the system."
Economic theory is hardly science. Such theory as exists consists of often divergent approaches to explaining a mix of transactions interdependently influenced by information, geopolitics, national agendas, ideology, weather, scarcity, abundance, information and more, while market dynamics generate separate forces that interplay with all of the preceding, such that cause and effect may become interchangeable, depending on the level at which they are working. Economic theories and quantifications are based on assumptions that are themselves inexact statements of unmeasurable realities.
We've probably done a better job of understanding weather than economics. It's fair to say that in the broadest, most general sense economics is understood - but how, when and why impacts are felt is often explained away by the vagaries of "the market".
[It could be argued that the supposed omniscience of the market ("the market is always right") is merely a nonsensical attribution of god-like power to a mechanism that quite often is wrong for extended periods of time before it adjusts to reality. As such, the saying is a strong indicator that mere mortals know not what they have created]
Back to the bolded statement: ... defining systemic risk was beyond the scope of any existing economic theory
C'mon now - it may be beyond economists, but it's not beyond ordinary people. Actually, the author has almost defined systemic risk in the first paragraph... "a single power line in western Oregon brushed a tree and shorted out, triggering a massive cascade of power outages that spread across the western United States.'
There: systemic risk is event cascades, out of control. The solutions are well-known:
[A] Isolation: localize the event
[B] Limit: slow the propagation
[C] Recognition: don't "design in" systemic risk
[D] Plan for the worst case, the so-called "Black Swan" event
To avoid getting all academic, let's look at some very common and well-known prescriptions for systemic risk:
[1] Saving for a rainy day (reserves)
[2] Insurance (stop-loss)
[3] Running "what if?" scenarios and gaming systems through the range of event probabilities
[4] Defining acceptable risk/reward and cost/benefit in macro and micro environments (are you introducing a profitable change that weakens system integrity?)
[5] Over-engineering
[6] Regulation, control, and education.
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The near-failure of the banking system is an interesting problem, being a repeat of its predecessor in '29.
In engineering terms, the banking system is inherently unstable. That is, because of the fractional reserve system, banks can never fulfill their obligations should all customers decide they want their money at any given time. What's more, given certain preconditions, they're likely to stop working entirely. It's somewhat like overbooking on airlines, or telecomms reliance on predictable patterns of usage - except in those cases, failures precipitate unacceptable performance, not complete system meltdown.
Even more important, failure of the banking system may be caused not by an actual event, but a by perception or even pervasive fear. So the trigger may not be actual, physical or real, but merely psychological.
We have bank depositor insurance, which obeys some of the common-sense rules established above.
But here's the thing: it wasn't external macroeconomic events that triggered this crisis - though they were bad enough. It was the pervasive and poorly understood implementation of financial "innovations" by the practitioners themselves. Simultaneously, it was recognition by banks everywhere that they had participated in the transmission and replication of these "innovations" and were themselves "infected". See [4] above.
This was their orgy. They all had financial STD, and they all knew it.
If these people had been engineering graduates, we'd have buildings and bridges collapsing, roofs caving in, dams bursting - and to top it off - engineers awarding themselves astronomical compensation, while making profits from bets on these events via Alternative Risk Transfer, using leveraged carry trade money.
Message 25588027
It doesn't take an expert to find the problems here; they're numerous and pervasive. The keystone is the oft-repeated emphasis on the word "confidence" and recognition of the fact that our banking system with its fractional reserve system is inherently unstable. At some point, we lost the idea that guardians of our system were paid to maintain system integrity - not generate obscene profits, motivated by rock-star compensation and incentives.
Their job is to keep the system safe, first. Instead, they did the opposite, thus undermining the global economy and banking system to the tune of tens, perhaps hundreds of trillions of dollars.
Ordinary people are disgusted, and rightly so. This has been a perversion of system design and intent by the very people entrusted with its safekeeping. If they were engineers, they'd be drummed out of the profession.
Jim |
