A new study of the 2008 collapse has joined economics and network theory in a graphic depiction of inevitable failure.

In the preceding years, formerly far-flung sectors of the economy had been pulled together, linked by a newly deregulated financial industry. Thus intertwined, the economy took a form known to network theorists as "intrinsically fragile," in which a local glitch would cascade into system-wide catastrophe.

"The fact that the system became fundamentally fragile is very clear in the data," said systems theorist Yaneer Bar-Yam, president of the New England Complex Systems Institute. "The financial sector was responsible for many of the crucial links in the economy that allowed for shocks to be propagated from one sector to another."

Economists have pointed to financial industry entanglement with the entire U.S. economy as a crucial factor in the 2008 collapse, but Bar-Yam's team drives the point home with new clarity.

In the study, published November 16 on arXiv.org, the researchers used network-mapping tools to analyze the relationships between 500 corporations with the highest stock-trading volume. These were linked to oil prices, bond prices and interest rates.

From this analysis came two striking figures. The first is a map (below) of links between companies in five key economic sectors: technology, oil, other basic materials, finance linked to real estate and other finance. As of 2003, the sectors are relatively distinct, with real estate isolated. By 2008, they're a tightly linked jumble, with finance at the center.

The second figure (below) charts how, as the sectors came together, changes in one affected the others. This correlation rises steadily from the millennium's turn until 2008, when the graph reaches its end and its peak.

Other research on network dynamics has shown that interdependence can promote stability, but eventually reaches a point of reversing returns (see "Networked Networks Are Prone to Epic Failure"). Shortly after the peak of interdependence at the end of Bar-Yam's graph came those fateful months when the real estate bubble popped, followed by financial-sector collapse and a hastily averted implosion of the U.S. economy.

Since then, long-standing debates about the role and nature of financial regulation have taken center stage in American politics. Often these degenerate into ideological battles between people who believe market regulation is necessary, and those who think markets should be completely free.

Bar-Yam's group doesn't overtly take a side, but they hope their analysis can provide an understanding of the economy's systemic properties and how they've changed.

"We're identifying the actual system. We're not coming in here as ideologues. We're asking, what's going on, and how do we characterize it," he said. "If we don't recognize the vulnerabilities of the system, we will repeat and suffer the consequences."

"Their methodology is a good way of showing what the correlations look like over time," said Federal Reserve Bank of Boston research director Jeffrey Fuhrer. "It gives you a way to look at it that's not biased by a particular ideology. This is what interconnectedness and correlations look like."

Bar-Yam's team traces the financial sector's collapse-inducing economic centrality to the dissolution of Depression-era economic reforms, especially the 1999 repeal of the Glass-Steagall Act. Glass-Steagall had separated deposit banks, where most people keep their savings, and which handled mortgages, from investment banks.

Thus freed and enlarged, the financial sector became the prime source of capital for major parts of the U.S. economy. When the housing market collapsed, the rest followed. Even if housing stayed healthy, it was probably only a matter of time before something else crashed the system, said Bar-Yam.

Under the Dodd-Frank Act, passed in July of this year, the Financial Stability Oversight Council will be responsible for system-oriented market regulations intended to prevent a repeat of the 2008 collapse.

Those regulations have yet to be designed, and what form they might take is unknown. According to applied mathematician Steven Strogatz of Cornell University, inspiration may come from examples of stable networks in biology and even software design.

"I've often wondered why, in biology, cells don't fail when a few reactions go wrong. They don't, because biology has built things in a very modular way. When failures occur, they don't necessarily prove catastrophic," said Strogatz. "In both biology and software design, you don't want the parts to be too tightly tied to each other."

Images: 1) Flickr, Rafael Matsunaga. 2) Linkage change from 2003 to 2008 in technology (blue), oil (dark grey), other basic materials (light grey), finance including real estate (dark green) and other finance (light green)./New England Complex Systems Institute. 3) Graph of the amount of correlation among stocks from all economic sectors from 1985 to 2008. The solid black line is the baseline number; shades of grey represent that figure when market-peaking days are removed./New England Complex Systems Institute.

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Citation: "Networks of Economic Market Interdependence and Systemic Risk." By Dion Harmon, Blake Stacey, Yavni Bar-Yam, and Yaneer Bar-Yam. arXiv, November 16, 2010.

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