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2 January 2009

Contagion

It has been a remarkable thing watching the effects of the financial crisis spread to every corner of the economy. Certainly, in my lifetime, there has not been anything quite so systemic. Internationally, we see Iceland, essentially, going bankrupt, and Mongolia bailing its banking system out. The machine tools sector in Germany is suffering mightily because China's imports in this area have collapsed, because US demand for products from Chinese factories are way down. Domestically, it has struck me how much shorter are lines at security checkpoints in airports; taxi drivers tell me that business is way down, and a friend who is a physical therapist tells me that she no longer has a waiting list (people live with their aches and pains in a down economy, I suppose).

All of this can be seen as contagion (see my earlier posting on the madness of crowds), through a wide array of mechanisms of interdependence. Real estate took a dive, and because of the increase in dependence of the financial sector on real estate (amplified by leverage in various ways), the financial sector took an even bigger hit. The financial sector, arguably, is at the center of the global economy, and this has resulted in a transmission to many, many other economic actors. And there are, of course, various other mechanisms of transmission--e.g., the very headlines about the economy creates contraction in demand, as do the conversations amongst people about hardships in their particular corner of the economy.

The two questions now are: (1) how, now, to create a positive contagion, and (2) how to reduce the probability of such an event again. On the first, as one looks to the lessons of the Great Depression, the issue is whether our responses will help or hurt (clearly, they hurt in the 1930s). Certainly, the received wisdom (especially where I stand) is that our understanding of the economy is vastly better than 70 years ago. But I wonder if this is hubris, whether the complex interdependencies of the international economy, the messiness of mixing levels of analysis and phenomena that cross disciplines--e.g., individual psychological versus governmental response-- have actually outstripped our analysis. After all, our theories of the world become embedded within our institutions and policies. That is, if we truly understood the world so well, we wouldn't be in the mess we are currently.

On the second, a metaphor that has always been evocative to me is the building code in San Francisco. There are certain spaces mandated between buildings in SF. Typically, these spaces are quite tiny, but the rationale is that they prevent chain collapses when there are earthquakes. One does not (I would guess) need a rich theory of architecture to justify such a policy, nor is such a policy difficult to enforce. The question is whether there are equivalent economic policies . Clearly, yes--indeed, much of banking regulation is designed to reduce contagion (e.g., bank runs)--but, equally clearly, some work needs to be done in this department. And it is not clear to me that the current analytic foci of economics are well suited for understanding contagion in a networked economy.

Oh yes, and happy new year.

Posted by David Lazer at January 2, 2009 9:29 PM

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