Block-slider model of earthquakes
Battiston et al. (2011) have presented a model of the financial system which might look like one of Turcotte's slider-block models of earthquakes, which are comprised of numerous blocks of (possibly varying) masses, connected by springs, having to slide across a surface with a limited (and possibly variable) friction. Motion in one block can change the stress field across the model, possibly triggering slip in one or more other blocks.
The original slider-block model consisted of two blocks connected by a spring, both of which sat on a somewhat rough surface (so there would be friction between it and the blocks). If block A moves some small distance, then it will add to the forces on block B. That force may be enough to overcome the friction which kept block B stable. If both blocks move together, we have a larger earthquake. The simple two-block slider model exhibits chaotic behaviour (Turcotte, 1997). I remember attending a conference a few years before the above volume was published when Turcotte presented a more advanced model that looked something like the one below.
We are looking at a plan view of several interconnected blocks. The frictional forces vary for each block, and each block has its own driver. Once again, the slippage of a single block may trigger slippages in one or more blocs--the more blocks that slip, the larger the earthquake. We might expect such models to satisfy the Gutenberg-Richter law which is an observed distribution of earthquake sizes through time that is consistent with a system at self-organized criticality (SOC). But I'm not sure because I've never seen the results although comments on similar models used to study avalanches were consistent with SOC (there are those avalanches again).
Block-slider model of default cascades
According to Battiston et al. (2011), prior to the financial crisis of 2008, existing models suggested that major financial entities had diversified their debts and obligations sufficiently that the likelihood of systemic failure was negligible. The observed financial crisis suggests that this conclusion was unwarranted, to say the least. The authors attempt to study the effects of diversification on systemic risks using a model conceptually similar to the block-slider model above.*
In the financial model, the blocks represent financial institutions. There are a large number of possible interactions between one institution and its neighbours. Furthermore, there is a richness to the interactions that is missing in the earthquake slider-block model--the debts and credits between institutions may each be long- or short-dated, so that there may be a mismatch in maturities between the credits and obligations of any one institution.
In the above figure, which shows only a portion of the potential interactions among entities A, h1, h2, etc., the arrows point in the direction in which credit has been extended. Credit may be long- or short-term. For instance, entity A has extended long-term credit to entity j1, and short-term credit to entity m1; and in turn has borrowed long-term from entity h1, and borrowed short-term from entity n1.
The authors carry out the following experiment. Assume an initial allocation of assets and liabilities across different participants, and derive (logically rather than empirically) a law of "motion" related to financial robustness of each agent affected by one or more of the initial defaults, as measured by their equity ratio. Models are run and the size of the default cascade is compared to the initial distribution of robustness and risk diversification.
The interrelationships between all the balance sheets of the various financial institutions links the dynamics of the individual equity ratios in ways that are not easily predictable.
The authors identify two "externalities" to the triggers for default cascades: 1) variability of financial robustness of all of the interconnected financial entities; and 2) the average financial robustness of the interconnected entities.
If all parties have similar financial robustness (variability is low), then increasing connectivity makes the system more robust. Stability is even likely through diversification if the individual parties are not very robust. It was only when the initial robustness was highly variable across agents (i.e., some agents are weak and others strong) that increasing interconnectedness tended to stimulate systemic defaults.
The second "externality" is a consequence of incomplete information--and deals with the likelihood that creditors will force a foreclosure on an otherwise solvent entity due to the fear that some of its counterparties might fail. Losses may therefore be amplified along the chain if runs begin on entities which may be technically solvent, but which may then be forced to sell long-dated assets at fire-sale prices to raise cash. Model runs suggest that if the average robustness of agents is high, then increased connectivity is beneficial. For low levels of average robustness, then increased connectivity has no effect. For intermediate values of average financial robustness, increased connectivity tended to stimulate systemic defaults.
The lesson here is diversification is not always a good idea. If you diversify across financial entities with wide risk profiles (i.e., some are weak and some are strong) you actually increase the likelihood of a financial calamity.
We don't have to confine ourselves to financial institutions. If we consider our agents to be sovereign, we expect the same problem. Creating a financial superpower out of a group of Germanys would be perfect--even a group of Greeces might be okay. But creating one out of Germanys and Greeces tends to encourage a financial catastrophe. Who could have predicted that?
The authors suggest that the "fix" for this situation is to concentrate risk rather than diversify it. I wonder--in whose hands will the risk be concentrated? Perhaps if you hold gold, the risk won't find its way into yours.
References
Battiston, S., Delli Gatti, D., Greenwald, B., and Stiglitz, J. E., 2011. Default cascades: When does risk diversification increase stability? ETH Risk Center Working Paper Series.
Turcotte, D. L., 1997. Fractals and chaos in geology and geophysics, 2nd edition. Cambridge University Press.
* one key difference between the default cascade and an earthquake--in an earthquake, the tsunami (if there is one) happens afterwards. The ocean of liquidity in which we find ourselves has preceded the major financial earthquake.
Its all interconected with re-hypothecated springs, one false move and POOF!
The problem with economic theory is that there are no defined laws, something that cannot be changed. If the US government decided the law of gravity was invalid, everyone would know that they are idiots. If the ISDA decides to ignore the rules set out in CDS agreements, well, they could do that, couldn't they? It is really difficult to come up with a quantitative theory when the rules of the game can be changed with the flip of a printer switch.
"If the US government decided the law of gravity was invalid, everyone would know that they are idiots."
True but then a department of gravity ststistics will be formed and come out with a graph that will prove beyond the shadow of doubt that gravity was in fact invalid.
I would say the biggest problems are
-Inability to repeat experiments. The result is a correlation is extrapolated to a causative law. (Like if motorcycle drivers are more likely to be male, do we say being male causes head injuries?)
-Huge bias in who funds research in economics. One excellent example is the "Nobel Prize" in Economics, which Nobel never would have funded, especially considering he started the endowment out of a sense of guilt from his part in the development of explosives.
-Incomplete data.
Economics is not as much a science as a political movement or a lobbying force.
I used to play with blocks like that with my brother when I was 6 and he was 7. But they were actually bricks from a house that was being built next door. We would pretend (his idea) that they were trucks running on mountains of sand also from the house being built next door. What we noticed was that when we run the trucks on top of little mounds of sand, the sand became unstable and the mounts would collapse.
What I am trying to say here is that PHD work is just a notch higher than children playing in the sand and not more. Reference is made to the PHD's in economics who only worked in academia. You guys have no experience with the real world and how it works.
Badabing,
Please, how many cousins do you have?
Thank you om
Badabing
People forget that everything is connected.
So true, but at one time we had savings banks, investment banks, insurance companys……
Today its to big to fail conglomerates.
What about WIFI?
I submit that the highest degree of co-movement is found for time-detrended variables and the lowest for differenced aggregates.
Eh, come again?
http://www.youtube.com/watch?v=8Moh7DXMk8g
That's right out of an egghead complexity book and is only relevant here in the sense that the banking/corporate/political racketeers and their eggheads have produced a system that synthesizes fiat value from complexity so as to suck the system dry through fraud.
Oh, and it could be applied to taking caution with options.
I have come to believe more than anything else about defaults that the governments won't allow them.
We too easily forget the Great Lesson of 2011 -- which is that governments will do anything to keep the wheels turning. Anything means anything.
If there is a threat, it will be forbidden. If someone "triggers" a swap, and presents demands to the counterparty for payment, that party will just refuse.
That means lawsuit to collect, and a government need only pass legislation to forbid funding to any court of law that might hear the case. It will never come up on the docket.
The swap holder will never get a judgment.
Governments will do ANYTHING to keep the wheels turning. Only things they cannot control will stop them -- oil and bullets in elite brains.
You got that right!, just look at AIG if it went under none of the big boys would have got paid. the same with Greece.
You're turning this into a semantic question - to me massive currency devaluation is also a type of default.
CrashisOptimisic: love your post, I agree that last 3+ years have demonstrated the Governments will do anything to avoid default. However... it assumes that there are options were cascade default is avoidable. Either party A gets paid out through the CDS or suffers the loss or party B eats the loss when there made to pay out on the CDS contract. Or, the Government (taxpayer) eats the loss when they bail out either of the two party's. This can be scaled up fro countries to the global economic system.
To use your example; If someone "triggers" a swap, and presents demands to the counterpart for payment, that party will just refuse.
That means lawsuit to collect, and a government need only pass legislation to forbid funding to any court of law that might hear the case. It will never come up on the docket.
If a credit event occurs and triggers a CDS contract, but the counterpart cant pay and the government see this as a threat to the system they step in and void the CDS agreement. However this leaves the original party exposed to the loss for the original event. the government either lets them (potentially) fail (potentially triggering other CDS etc) or bails them out. The government (whether they can print or not*) can only absorb the costs for so long before they default. There is a limit were taxpayers just cant fund the bailouts, even if future generations are included.
*The printed money comes with interest attached. printing will only by time not solve the problem as eventually the interest payment will kill the taxpayers.
I've been reading Zerohedge for the last 3 years (and am not an expert in economic or politics), so forgive me if I way off mark. And please point out were I'm wrong as I would really like to be wrong.
Whippings will continue daily until your morale improves....
i posted this 18 months ago on the "impending euro doom" and "how you can set your watch by it." Clearly Donald Duck was Trichet...and the expert is now in charge. Still..."kinda complicated." Good luck doing the math. I recommend someone young. VERY young:
http://www.youtube.com/watch?v=EM2LjQrwO6g&feature=player_detailpage
Haven't these guys ever played with "Dominoes"?
it is interesting, it is perhaps again a model of physics envy by economists and it sure looks for me like a big leap of faith of jumping from those models to the assertion "But creating one out of Germanys and Greeces tends to encourage a financial catastrophe"
Ludwig von Mises would probably agree on this and point to the unpredictability of human action
Yeah, from an epistemological standpoint this is beyond stretching it. Physics was a methodological model for psychology and we know how that ended up.
I was thinking today about writing an article about Dr. Krugman's favourite books that led him to become an economist: "The Foundation" of Isaac Asimov. Traces of the US belief of the 50's about the human capability of crunch anything into numbers.
I blame Descartes (with reverence, of course). Seeing the mathematical composition of the universe is not the same as charting it's course - particularly when you have those pesky humans exerting their bloody own will.
Descartes was a bond guy btw. Spent his final years in Sweden i believe.
'I blame Descartes'
LOL, you're starting to come around to my recent obsession with the limits/nature of knowledge.
'Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.' --GK Chesterton
Descartes breaks down and seems silly once you really get into Pascal.
Well, you could... If you could know the value of all the variables... Which are infnite, so you can't.
Godel's and Bell's Theorems also figure in this, no infinities are really necessary to provide the limitations to Human knowledge.
A thought exercise that ends with:
'Perhaps if you hold gold, the risk won't find its way into yours.'
should always be simpler than this piece.
Gold is tantamount to a firewall.
Good point! gold has no springs attached.
Gold is the ultimate insurance.
And to prove it has a lot to do with insurance: behold, it caused me to cash in the insurance of three boats.
"gold is a firewall" indeed. while the outrage is only being mentioned now is how much plain old stealing...not by mere MF Global...but the Banks themselves are doing. This IS real money. Under a gold standard "you would have to account for everything." Not with Bailout Nation. "Money Heaven" indeed.
don't forget that for many US residents it was nothing between 1933 and 1974, and then it was the stuff of a bubble - in USD.
good example: for Indians, the price is just rising relentlessly since ever
I wonder what the next MF Global is going to be - now that they have found out they can just rob client accounts I don't see them stopping
one problem for those that steal is that the USA is bascially the world's biggest "planned community." George Washington was a surveyor...a tradition that still lives on. Surveyors are interesting folks (used to be one myself)...establishing the boundaries of private property such that ownership could be determined and an asset ("land") defined and borrowed against. If you take a history of American Law class you will discover very quickly that the bulk of the cases in Massachusetts (where this history defined law itself) revolved almost exclusively around water rights. In short "America's first great battle over energy policy." We had little to no gold...but as English citizens it didn't take long for "de Americans" to realize the power of water in creating vast "empires of fabric" via huge textile mills (some of these companies still exist down in North Carolina today.) Back then it was called "the triangle trade" as slaves came from Africa to the Carib, who were traded for molassas which made it's way to New England, which was traded for just about everything that was made there and then shipped to Europe. this trade lasted for a couple hundred years...only dying out when the British wiped out the slave trade. After that "America turned westward" to finance it's expansion. Canals, railroads, Great Lakes shipping--all financed by New York City. Now look at them--simply stealing client money. And amazingly "the answer the media gives to this is to attack Iran." Pathetic. You've rightly pointed out the great dollar bubble bursting in 1974...but not only did gold soar in price...so did land. And there is no market for land. You either "gotz" or "you don't gotz." And when the price of that soars--let's just say "risk takes on a whole new and PERMANENT meaning."
In a faith based monetary system, gold is for the faithless. 'Nuff said.
And faith is a renewable resource. With endless exploitation possibilities, as history teaches.
------
"From black hills I descend, a barbarous Man. A wolf amid sheep, among humanity's finest.
Far better to be of faith Black and Barbarous, then one of the flock... destined to die.
A pauper of life's riches. Destined to die. A pauper of Souls."
A little bird told me that a false-flag using 2 remote controlled F-14s attacking US ships would be used to start a war against Iran. Possibly as soon as March 2.
/just saying
My little bird just died.
Too bad I can't leave the coal mine....
Written well enough but it seems to take a while to point out the obvious--'don't hang out with poor people and you'll be OK.'
Another thing they could toss in there--monolithic entities tend to be stable, until they're not. The stability found in diversity requires that no one element become TBTF.
This has "PONZI" written all over it. Are you listening, Central Bankers? These so called " Models are exactly why the " CLUSTER FUCK" , was (born,spawned,hatched,cloned, ect..) This SHIT makes me sick! Can't a trader have decent Saturday in WB-7's trailer park?
There are many kinds of earthquakes. But the tsunami and avalanche is the only possible outcome when x pressure rises to critical on n blocks. Rather like an asteroid impact? or a Solar eruption that takes out the electric grid. Quietly destroying the framework and network within seconds of impact.
Ya just gotta love the way the numerical illiterate get confused by the term mathmatical "proof" and fail to realize that there is really no such term as "proven" in the "scientific method." There is "apparent validation of the theory" or the experiment failed indicating the theory is not valid, or we have tested a new theory and it seems to model what is happening with a much greater degree of accuracy. Mean while back at the ranch we have those famous words, "Communism weel work, eet es "scientifeec."
Kinda like CERN breaking the speed of light? Although I must admit, Einsteins theories are getting rusty!
lovely
This was always fucked. The complexity is insane. I don't mean I can't follow it, I mean no one can follow it, truly. Capital pops in and out of existence constantly. The dimensions which capital is tracked on can change mid tracking and lose capital in translation. This is nuts, nuts, nuts.
I understand how the money vaporized at MF Global now. Heisenburg's uncertainty principle.
Um, no. Once you understand that these are two different dimensions then it becomes easier. Simple formula:
Physics = Observations of the physical world. It regards matter.
Economics = Basically, politics. NO constants.
Finance = 'money' is a minds construct for medium of exchange. It can be something or nothing. Western democracies are fiat, it is creditmoney which is a contract agreed to by both parties and as we can see now, totally amendable.
Keep them separate and you'll be fine.
BTW, MF 'money' is at JP see Whalen interview from CNBC from yesterday.
Maybe yes, maybe no.
"Something is wrong with science -- fundamentally wrong. Theories just keep getting stranger and stranger."
Tom Van Flandern, discussing the state of modern Astro-Physics or the policies of
Ben von Numbnuts, I forget which;)
Yes, but a chain still breaks at its weakest point, and these idiots have no concept of unintended consequences.
If the CDS as an instrument is well and truly dead, and I think it is, who will buy bonds, especially rat shit European bonds? The obvious answer is Ben the Bug Headed, but he gets more scrutiny every day. What will break first? Probably us, American consumers, the last of the private sector..., then all bets are off.
False statement.
Diversification is always a good idea, however you should be aware how much correlation your diversified parts still have, and not wrongly assume them to be totally uncorrelated. And sometimes real diversification is not acheivable!
Interesting article.
And I always enjoy learning more about 'unexpected' outcomes. ;)
This kind of analysis is a good way to check assumptions, because like it or not, everyone makes assumptions about how the big picture arises from the parts.
At the the system level, the analysis is consistent with how the trend toward self-regulation (where regulators compete for the privilege to "regulate/train to be lobbyists"), and relaxed standards (like mark to model) both lead to systemic risk.
Apply this same analysis to a megabank as a system, and it agrees with how one slipshod/toxic/fraudulent division can take the megabank down.
Why don't we just assume that gravity doesn't exist? Then we can negate the friction aspect of this differential equation. That would be simpler.
Look! the King has no clothes! (tired, but forever true).
A Blivett = 10 pounds of shit in a five pound bag.
Blivett, a fictional unit of measurement.
A Blivett was observed moving from Warsaw to Paris in the trunk of a 1998 Mazda sedan, the recorded oscillations were found to be similar to the oscillations of Pomigranites, moving from Tulsa to Dallas (at night in the winter months), certain aspects of the Frictional and Vibrational ratios have been found to corellate with CDS purchases in Madrid in the 2009/10 time frame!
W.T.F?
Distracted much? got ammo?
Can u say "Liquidity Trap"?
http://strikelawyer.wordpress.com/2012/02/22/liquidity-trap-explained/
http://strikelawyer.wordpress.com/2012/02/25/liquidity-trap-theory-and-p...
...brilliant! Love it Jerry. Even the title ''Lawyers on Strike'' is genius. Thanks for the (re)confirming read.
Reminds me of an American with Greek roots. Lol. Where is Kojack when you need him? http://www.youtube.com/watch?v=dABsJlUvlpA&feature=related
P.S. Yes, Liquidity Trap
Can you say ''Black Hole''? Lol.
http://www.youtube.com/watch?v=Bwz3d12uHLY < all that's missing from Keynesian kick in the Fannie Mae I have another kick the can down the zero road parable is the ''w.com'' for Zillow.com''. lol,
Servayor says; not even an Irish man can smoke at an Irish Bar in Ireland these days http://www.youtube.com/watch?v=WULhkipzltU thars no freedom in the land, not even in yer arms darling. Lol.
Stake holders are the howling dogs of war,.. Hmm? ...Verses the Suicide Vampire Squid of the Great Wal Mart of China. http://www.youtube.com/watch?v=L5OP5_m8cNE
diversification is not always good.
http://www.jinrongbaike.com
http://www.cnhedge.com
"...existing models suggested that major financial entities had diversified their debts and obligations sufficiently that the likelihood of systemic failure was negligible".
Errm, how, when globalisation and interconnectedness have done nothing but LINK debts and obligations? Flaw one in existing models. But, of course, this how NO ONE saw it coming in 2008.
DavidC