1. Identifying Stability or Instability in Economic Systems:
Circular and Linear Analyses of Financial Crises
Stuart Umpleby
President of the Executive Committee
International Academy for Systems and Cybernetic Sciences

2. An overview of my presentation
How the financial crisis happened, an analysis using causal influence diagrams
The magnitude of the crisis
How economists think about financial crises
A method for monitoring the stability of economic, social and political systems

3. Credit cycles Credit cycles are a normal part of market activity
(Fig. 1)
Economic growth raises asset values, which increases lending, which increases economic activity
Prior to 2008 a super credit cycle was encouraged by new financial instruments, a belief in “market fundamentalism,” and other factors

4. Figure 1 The Usual Credit Cycle

5. Creating a causal influence diagram
Arrange the key variables according to how each variable affects other variables
If variables A and B move in the same direction, the sign on the arrow is +
If variables A and B move in opposite directions, the sign on the arrow is –
To find the sign on a loop, treat the arrows as if they are + and - ones

6. A super credit cycle The usual brakes on lending were removed
The repeal in 1999 of some provisions of the Glass-Steagall Act of 1933 allowed investment banks to make home loans as well as banks and savings and loans
By selling mortgages to third parties investment banks could increase the amount of money they loaned out (Fig. 2)

7. Figure 2 Reserve Requirement and Selling Loans to Third Parties

8. Commissions drove a search for borrowers
Increased lending increased commissions for both the institutions creating mortgages and the institutions selling the packaged mortgages
Spreading the risk to third parties was thought to make the financial system more resilient
Ninja loans (no income, no job) were accepted by some banks (Fig. 3)

9. Figure 3 Desire for Commissions Drives Subprime Lending

10. Financial innovations
The reselling of mortgages was increased further by packaging them into Collateralized Debt Obligations (CDOs)
The new financial instruments were not thoroughly understood either by the executives in the institutions creating them or by the rating agencies that should have been evaluating their safety (Fig. 4)

11. Figure 4 Financial Innovations and Reduced Understanding of Financial Instruments

12. A change from negative to positive loops
The large number of positive loops drove the super credit cycle
The repeal of a key provision of the Glass-Steagall Act – the separation of investment banks and commercial banks – changed a stable system with many negative loops into an unstable system with mostly positive loops

13. The international dimension
The US had been buying oil from the Middle East and manufactured goods from China (Fig. 6)
With the money earned from exports these producing countries bought US treasury bills as an investment
The demand for treasury bills was so high the US govt could sell them while paying very little interest

14. Figure 6 The International Aspects of the Super Credit Cycle

15. The search for high yielding investments
Eventually people began looking for high yielding investments
They found CDOs, which were packages of home mortgages
The purchase of CDOs gave money back to the banks who could then loan it out for home purchases and consumer spending

16. How lobbying paid off
Wall Street firms spent $300 million on lobbying in the 1990s to change the laws
During the 2000s the financial sector grew to become 40% of US business activity
When the financial crisis happened, the govt bailed out the banks with $700 billion
This was a VERY high return on investment

17. Interpreting the diagrams
Positive feedback loops indicate growth or decline
Negative feedback loops indicate stability
Many positive feedback loops indicate a system “out of control”

18. Very large losses
The Bank of England said losses arising from banks having to mark their investments down to market prices stand at $3,000 bn, equivalent to about a year’s worth of British economic production
The Asian Development Bank has estimated that financial assets worldwide may have fallen by more than $50,000 bn – a figure about as large as annual global output

19. How could people have been so mistaken?
The banking reforms of the 1930s had been steadily weakened over time
The Federal Reserve had several times acted to bail out businesses “too big to fail”
Competition rewarded in the short term companies that took big risks

20. Misperception
“I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”
Alan Greenspan

21. Why did banks not see, or act on, the danger?
Banks with high earnings attract more investors
Prudent banks have lower returns during a period of expansion
Banks were using very high leverage to increase returns
A Wall Street executive, “When the music is playing, you have to get up and dance”

22. Institutions
Globalization creates interlocking fragility. The growth of giant banks gives the appearance of stability, but it raises the risk of systemic collapse. When one fails, they all fail.
Nassim Taleb

23. Amplifying factors Greed – higher returns, more commissions
Lax regulation due to a belief in “market fundamentalism”
Excessively loose monetary policy
Fraudulent borrowing
Managerial failure
Complexity and opacity of modern finance

24. Journalists vs. economists
The causal loop diagrams are based on articles by journalists. Front pages in 2008 were filled with talk of boom and bust cycles
But economists saw no need for new theory, just less “ideology” (market fundament.)
Articles by economists use linear thinking which does not reveal motivations and events as well as circular causal descriptions

25. How do economists think about financial crises?
Milena Ristovska, a visiting scholar, went to the library and to find recent academic articles on financial crises
The following pages present brief abstracts and then diagrams of the relationships that the articles report on
The articles look for independent and dependent variables

26. Consequences of banking crises
Banking crises lead to a decline in output (for a long period of time), to a decline in the stock market, and to a decline in the currency (about 30%)
Boyd, Kwak, and Smith in Money, Credit and Banking, 2005

27. Banking crisis > decline in output
> decline in stock market
> decline in currency

28. Bank bailouts or bank closures
In response to banking crises governments have chosen policies that vary between rescuing insolvent banks (bailout) and enforcing bank closures. What political factors influence these decisions?
Rosas in American Journal of Political Science, 2006

29. Political factors > policy to bail out banks
or to force closure

30. The role of institutions in achieving financial liberalization
In emerging economies banking crises illuminate the role played by institutions in financial liberalization. Institutions help to solve financial instability and enforce the market process.
Allegret, Courbis, and Dulbecco, Review of International Political Economy, 2003

31. Institutions > solve financial crises
> enforce market processes

32. Containing contagious financial crises
A financial crisis can spread contagiously. A crisis can be contained through intervention. International organizations play an important role in achieving collective action to contain the spread.
Hausken and Plumper in Public Choice, 2002

33. International organizations bring about
> collective action which
> limits financial contagion

34. How firms cope with financial crises in emerging markets
Firms have taken steps to protect themselves against financial crises and to deal with crises once underway. The strategies are divided into short term, immediate responses to a crisis, intermediate steps during the period of downturn, and long-term continuing responses.
Mudd, Grosse, and Mathis, Thunderbird International Business Review, 2002

35. Actions by firms > short term steps
to deal with > intermediate steps
financial crises > long term responses

36. Early warning for financial crises
The goal is to develop an early warning system that can detect financial crises. The system monitors several indicators that exhibit unusual behavior in the periods preceding a crisis.
Edison, International Journal of Finance and Economics, 2003

37. Monitor several > early warning of
indicators financial crisis

38. Why do economists use linear models?
They want to imitate the physical sciences
Statistical techniques are available to test assumed relationships among variables
Economists have a view of how to do science
The conception of science is changing

39. Observing differences
Journalists, particularly Gillian Tett, who has a PhD in anthropology, created circular descriptions
Economists thought in terms of independent and dependent variables
Economists wanted to make statistical tests
Journalists were interested in the thoughts of the actors involved

40. Conclusions Which method is better? Use both
A description that uses several methods will explain more facets of the phenomenon
Stability is a very important consideration when dealing with social systems
Social scientists are using a conception of science created for physical systems
Our conception of science is changing

41. Lessons
Causal influence diagrams describe what is happening in an economy – what people are thinking and what steps they are taking
Look at the number of + and – feedback loops
If many – loops, the system is likely stable
If many + loops, the system is likely unstable

42. Contact Information
Prof. Stuart Umpleby
Department of Management
School of Business
George Washington University
Washington, DC USA
blogs.gwu.edu/umpleby

43. Prepared for a conference at the
Financial University under the
Government of the Russian Federation
Moscow, Russia
November 21-23, 2018