How do you prevent a cascade of collapsing firms, banks, or seaside European states? A new model suggests taking a holistic approach, one that looks beyond balance sheets to understand the complex network of financial interactions at play.
At first glance, preventing those cascades isn’t so difficult. Step one: Increase diversification, the number of firms any particular entity owns shares in. Then, one firm’s failure isn't enough to bring down others. Step two: Decrease integration—that is, the extent to which firms, rather than private investors, own each other. That way, firms are less exposed to each other’s foibles.
If businesses own shares in just a few others, they might be very sensitive to failures among those few, but the economy is not so interconnected that the failures spread very far.
And that’s not necessarily bad advice—it’s just that it ignores the complex web of interconnections between financial organizations, argue economists Matthew Elliott, Benjamin Golub, and Matthew Jackson in a study forthcoming in the American Economic Review. While some fear that globalization and interdependency lead to financial danger, the network of interactions means “there’re two ways to go,” Golub says.
To see why, start with diversification. If businesses own shares in just a few others, they might be very sensitive to failures among those few, but the economy is not so interconnected that the failures spread very far. As diversification increases, connectivity grows, and, with it, the potential for cascading failures. It’s only at higher levels where the standard intuition works—there, firms’ investments are finally diversified enough that no one failure is likely to bring any other firm down.
In other words, whether more diversification is good depends on how diversified financial institutions already are. Integration works similarly. At low levels, bumping it up a bit makes potential cascades worse, but when organizations are highly integrated, it has a way of spreading out the consequences of collapsing, Golub says. “They all share the shock enough that they survive.”
So what are central bankers and other economic decision makers to do? For one thing, it may not be a good idea to back off on their current policies. “It’s more complicated than, ‘This is bad, let’s undo it,’” Golub says.
“They have to take a more holistic view of things, and I think people realize that,” Jackson adds. To understand how the system works—and how to intervene when necessary—means mapping out the web of connections between organizations. “It provides a base that they can begin to work from.”