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On 16 November 2002 the first official case of Sars was recorded in China. Panic ensued. Uncertainty about its causes and contagious consequences brought many neighbouring economies to a standstill. Occupancy rates in Beijing's five-star hotels fell to less than 2%. Media and modern communications fed this frenzy and transmitted it across borders. Parents kept their children from school in Toronto, dockers refused to unload a ship from China in Tacoma. There was a boycott of Chinese restaurants across the United States.
The cost of this panic will never be known but is probably more than $100 billion (£68 billion) at 2003 prices. Growth rates across Asia reduced by up to 4%. Yet by any historical standard it was not a serious epidemic. Only about 8000 people were infected and 1000 died. The economic consequences were out of all proportion to the size of the original shock.
The parallel, however, is not with this week's outbreak of swine fever in Mexico City. The link — drawn in a brilliant lecture yesterday by Andrew Haldane, director of financial stability at the Bank of England — is to a rather different systemic shock. In September last year, Lehman Brothers filed for bankruptcy. Panic ensued. Uncertainty about its causes and contagious consequences brought many financial markets and institutions to a standstill. Media and modern communications fed this frenzy and transmitted it across markets. Banks hoarded liquidity for fear of lending to infected banks. Letting Lehman fail basically brought the world capital market down.
The cost of this panic may never be known either, but the IMF has clipped 5% off global growth since Lehman's failure. Yet the direct losses from the collapse are relatively small. Net payouts on Lehman's credit-default-swap contracts so far are only around $5 billion.
Haldane's point is that, to understand why a relatively small failure like Lehman had such a dramatic effect, we need to think of the world financial system as a network. To control it, we need to deploy expertise not from the world of business but from the world of complex networks, such as rainforest ecosystems, marine biology and fish stocks, or indeed epidemiology.
Each such system appears perfectly stable, indeed it is so big and diverse and complex that it seems impossible to think of it as changing at all. But this disguises how all the parts are mutually dependent on each other, and how each system has a tipping-point which can be reached after what appears at the time to be a relatively minor event.
Once tipped, it disintegrates. The rain forest does not regenerate, the cod disappear, the Mexico City disease becomes a global pandemic. The butterfly flapping its wings sets off a tsunami on the other side of the world.
Epidemiology gives us two useful thoughts. One is the concept of six degrees of separation — that we are much closer to everyone else than we could possibly imagine, and indeed only six people away from everyone else in the world. That, applied to finance, explains how the Lehman virus has transmitted to everybody — even to the 99% of us who, in our innocence, had never heard of a CDO or a subprime mortgage a year ago, let alone bought one.
The other insight is the 80/20 rule — where 80% of the trouble comes from 20% of the participants. Dealing with an epidemic, you don't try to vaccinate everybody but instead target your inoculation at the 20% who are most likely to be the problem.
In finance, similarly, you don't impose blanket rules on everyone — you search out those likely to be behaving in a way which could destabilise the whole network. But — and this is the relevant point — to do so requires a regulatory philosophy and information systems relevant to that task. It requires this basic understanding of how networks behave.
Haldane has a further insight. Response to instability take two forms, “ hide” or “flight”. Sars was contained because people kept away from the trouble spots, which meant the infection stayed local. Flight, in contrast, spreads the disease globally. Thus yellow fever in Memphis spread out along the railway lines when half the population fled the city in 1878.
And the same thing happened in Lehman, except that both responses made things worse. Banks hid by hoarding liquidity rather than lending it to others and created enduring stress in the money markets. Or they sought to flee by selling their toxic assets, which created downward pressure on prices and spread the infection to their institutions.
What were individually rational decisions became collectively disastrous because of the network effect — the health of each participant can be influenced by the ill-health of any of the others. They all depend on each other.
This analysis will no doubt be too much of a stretch for those who think all our problems will be solved by giving a regulatory role back to the Bank of England and toughening up the rules on bank capital. What it shows is that the world really is no longer that simple. If we are to avoid a repeat of the current disaster, finance regulation needs to learn from the other, non-financial networks.
