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Can ecological models explain global financial markets–and make them more stable?

The views expressed are those of the author and are not necessarily those of Scientific American.

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stock traders in global financial marketplaceBananas, cacao and bee-pollinated crops are all threatened with collapse in part because of their monoculture management. When a biological or social system is full of uniform individuals—be they bean plants or banks—one shared weakness can spell disaster for the whole lot. Even when a new beneficial trait or tool enters the picture, if all organisms adopt it, as many financial institutions did with credit default swaps and other risky trades that led to the financial meltdown of 2007-08, a tenuous balance can be quickly upset, argued an economist and an ecologist in a new essay.

"Excessive homogeneity within a financial system—all the banks doing the same thing—can minimize risk for each individual bank, but maximize the probability of the entire system collapsing," Bank of England’s Andrew Haldane and Oxford University’s Zoology Department’s Robert May wrote in their new paper, which will be published in the January 20 issue of Nature (Scientific American is part of Nature Publishing Group). Thus even as banks themselves were pursuing internal diversity by adopting new financial tools, across the board "banks’ balance sheets and risk management systems became increasingly homogenous," they wrote. And that similarity led to a vulnerable system.

A thoroughly interconnected food—or financial—web might provide the illusion of security, as "high connectivity distributes, and thereby attenuates risk." But as the authors pointed out, when a shock does hit the system, it will affect more institutions.

One way to combat this issue is to establish more self-contained "nodes" as has been employed in forest management and even computer networks, so that if one element takes a hit, it doesn’t take down the entire system. 

And rather than regulating with the aim of individual institution stability, Haldane and May noted, attention should be tuned to the overall system’s risk. Like the spread of an infectious disease, financial troubles can be launched by so-called "super-spreaders," such as Lehman Brothers. By "focusing preventive action on ‘super-spreaders’ within the network to limit the potential for system-wide spread," regulators might be able to avoid the contagious hemorrhaging that occurred with the 2008 Lehman Brothers collapse.

Not everyone is convinced the ecological model is ready to be incorporated into policy-making decisions. Haldane and May asserted—and reasserted—that the dynamics they present are "deliberately oversimplified" and that "there are, of course, major differences between ecosystems and financial systems" (including preference of speed over long-term fitness and the interference of governments). Nevertheless, "rigorous statistical validation of any toy model or analogy is essential before policies are suggested," asserted University of Miami physicist Neil Johnson in an essay published in the same issue of Nature. By way of comparison, he asked: "Would you fly in a paper plane that had been scaled up to the size of a 747?"

But other non-biologists are ready to entertain the ecological model. University of Kiel economics professor Thomas Lux noted in another essay in the same issue of Nature that it is "essential" to "take stock of the accumulated knowledge on network structures when studying systemic risk in the banking sector."

Whether or not experts agree that biology is a useful lens through which to study financial markets, Haldane and May suggested that financial regulation is already "following in the footsteps of ecology, which has increasingly drawn on a system-wide perspective when promoting and managing ecosystem resilience."

Image courtesy of iStockphoto/ene

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  1. 1. killing Mother 7:14 pm 01/19/2011

    The capitalist free market economic model is at its very essence flawed because it attempts to defy the laws of nature. In the artificial economy, resources are harvested, usually in excess of what is actually needed. Then, those resources are converted to goods, and at the end of their life, thrown away. Nature neither over-indulges nor makes garbage. Organisms that do not limit their consumption are quickly done away with. We think we have fooled the system, but Mother Nature will undoubtedly have the last laugh.

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  2. 2. jtizzi 8:03 pm 01/19/2011

    I think this is missing the point. A lot of stuff has been done on this, my favorite is Mutual Aid: A Factor of Evolution by Kropotkin. We need to not figure out how to make these unsustainable institutions more durable but instead ask more fundamental questions about our society.

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  3. 3. jtdwyer 1:03 am 01/20/2011

    Perhaps a better question would be: can economic models predict humanity’s effects on the ecology? Since humanity now overburdens the planet, the answer should be obvious!

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  4. 4. bucketofsquid 10:09 am 01/21/2011

    You seem to know nothing about ecosystems. Nature produces excess of everything constantly. My crab apple tree produces abundant fruit and the animals only eat a tiny portion. The rest ends up making my yard a squishy mine field of rotten applettes. In nature animals try to eat when hungry. They also tend to eat when not hungry so as to store fat for later when they are less successful hunting or foraging.

    The capitalist economy mirrors nature better than any other. The lower level people are the herbivors and the higher levels are the predators. See a wolf rip a bunny apart and eat it while it hasn’t yet died and you will see a parallel of a bank foreclosing on someone that lost their job and can’t make mortgage payments. Nature is ugly and brutal and so is unregulated capitalism.

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  5. 5. bucketofsquid 10:14 am 01/21/2011

    Every day I ponder which scenario I would prefer;
    A gradual decrease in population that will take decades or a catastrophic population collapse that would resolve a lot of issues quickly. The first is a lot less brutal but strikes me as unlikely. The second seems much more plausible but I dislike the idea of such suffering and loss.

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  6. 6. jtdwyer 11:02 am 01/21/2011

    I don’t know either, but I think that if we continue to ignore the 6.9 billion pound gorilla in the room that a catastrophic collapse produced by any of many potential causes will result in the simultaneous suffering of billions of poor souls. I’m concerned for myself, my loved ones and everyone else – I just hope that some representation of our species can survive.

    This is by far the largest human population that has ever existed at any time in in history – it’s quite an experiment!

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  7. 7. pfhenshaw 11:02 am 01/22/2011

    I guess I basically agree with comment 1., that something about economic models gives us expectations that are quite unnatural and sure to fail. Economic models assume that anything we can’t disprove is possible, and that’s not true. It’s a fundamental clash between physical systems an information systems, our needing to live in one and steer with the other when information systems are rather incomplete.

    I wrote the Encyclopedia of the Earth article on Complex Systems and have three other papers pending or published from last year that present several sides of a better approach.

    We could think of economies as the organization that develops out of the actively creative learning of people as they search their changing environments for opportunity. Most people say, "Hey you can’t write an equation for that!", and that is precisely the point. What you can do is monitor that to see what opportunities and constraints the search processes of the system working as a whole are discovering. It’s a more "diagnostic" approach than a struggle to reduce what is irreducible to equations.

    JM Keynes discovered what seems to be the definitive reason a financial learning system cannot grow independently of the physical learning system. To understand it you need to take a diagnostic approach, though, thinking of the economy as an organism and considering what its different parts are learning. An argumentative approach about which model is correct… of course, is weakened by all models being wrong for active learning systems.

    The full comment is on the Nature website, in response to their editorial. Phil Henshaw

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