Forest fires and risky interdependencies

I have recently proposed the idea (in a comment to this article) that government interventions in the economy are a bit like rangers stopping forest fires. In the short run, it seems as though the intervention works to protect the ecosystem, lives, and property. In the long run, the absence of regular small forest fires leads to a proliferation of undergrowth, which causes an eventual big fire that's so strong, it cannot be contained, and it proceeds to destroy everything.

Forest rangers have since learned that controlling undergrowth is key to long-term safety, so they will allow small fires to burn, and will even start fires on their own, so as to prevent a spread of undergrowth that might provide fuel for future fires.

In the economy, leveraging and other rewarding but risky interdependencies are similar to forest undergrowth. The more such risky interdependencies there are in the economy, the greater the risk of a failure becoming a catastrophe.

Such systemic risk cannot be avoided by simply outlawing complex interdependencies. If people want to put themselves at risk, they will find ways to do so that avoid breaking the law, while still creating risky interdependencies.

The way to avoid systemic risk is to discourage people from wanting to expose themselves in ways that inflate systemic risk. The way to do so is to take the people with most hubris - those whose confidence builds risky interdependencies - and to make them slightly more afraid of systemic risks. And the way to make such people afraid of the systemic risk is, there needs to be a fresh memory of real losses, incurred by people much like them, who ignored systemic risks.

In other words - the forest undergrowth needs to be regularly cleared through periodic small fires.

Is the current financial crisis a small fire? It is not. I'd say it is a medium-to-large fire. I am speculating that we may be having this fire now because past problems, which posed a threat to risky interdependencies, were quickly "fixed" through government intervention, limiting losses and encouraging the build-up of systemic risk.

We are now at a point where Deutsche Bank is leveraged 50 times, with total liabilities about 80% of German GDP. That means that, if Deutsche Bank's assets lose just 2% of their value, the bank lost all its capital. If that happens, Germany is too small to save Deutsche Bank; only the European Central Bank could, by printing large volumes of money - thus taking from everyone else in the Euro economy.

In the UK, Barclays is leveraged 60 times, with liabilities roughly equalling the GDP of the UK. This means that, if the assets of Barclays lose more than 1.6% of their value, the bank is done. No one can save it. The UK cannot print as many pounds as the ECB can print euros; the pounds are backed by a much smaller economy.

It could be that the opportunities to let the fires burn to clear the undergrowth have come and gone. Ten years ago, the Federal Reserve Bank of New York orchestrated a bailout of Long-Term Capital Management. In 2002, government passed onerous laws tightening regulation after the Enron and other bankruptcies. In 2007, U.S. government facilitated a Bear Stearns bailout.

What officials are saying, every time they intervene in the economy, is that when there's systemic risk, people can count on the government to "do something". The behavior this encourages is that people structure their business as if there is no systemic risk. This, in turn, creates systemic risk.

Had the government not intervened, losses in each instance might have been greater, but so would be the fear of systemic risk. An increase in such fear would have prevented the build up of risky interdependencies, which grow more threatening as each new crisis comes along. If they don't kill us this time, they will in the next, yet bigger crisis.

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