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Thursday, September 18, 2008

Connectedness

From a member of the Physics Department here at the UO:

Notional vs net: complexity is our enemy, Information Processing: The credit default swap (CDS) market, where AIG played, had notional outstanding value of about $45 trillion at the end of 2007. Of course many of these contracts are partially canceling, so the the net value of contracts in the market is much smaller than the notional value.

Unfortunately, the network diagram (network of contracts) probably looks something like this:

Imagine removing -- due to insolvency, lack of counterparty confidence, lack of shareholder confidence, etc. -- one of the nodes in the middle of the graph with lots of connections. What does that do to the detailed cancelations that reduce the notional value of $45 trillion to something more manageable? Suddenly, perfectly healthy nodes in the system have uncanceled liabilities or unhedged positions to deal with, and the net value of contracts skyrockets. This is why some entities are too connected to fail, as opposed to too BIG to fail. Systemic risk is all about complexity.

If bonds are issued to finance government spending, and if they are treated as new wealth by the private sector, they will stimulate new spending. However, if taxes are also increased at the same time, then the assets (bonds issued to finance the debt) and the liabilities (taxes) cancel each other out exactly and the bonds will be neutral, i.e. they will not stimulate any new spending since no net wealth is created.

Realizing this, people then asked, what if you give the bonds to the present generation as you run a deficit, and save the taxes for the next generation, wouldn't bonds be net wealth in that case? One group gets the benefits, the other the costs. Robert Barro answered the question in the paper "Are Bonds Net Wealth." He pointed out that if parents care about their children, then they will adjust their bequests to account for these kinds of changes in intergenerational distribution of assets and liabilities. Under the right conditions, e.g. perfect capital markets, the present value of all future liabilities will exactly match the present vale of all assets and no net wealth is created.

A key element here, though, is the connectedness of generations. Not everyone has children, for example, and Barro's mechanism works by putting the utility of children as an argument in the parents utility function. In the 1980s, in response to Barro's paper, I remember seeing a seminar given that attempted to estimate intergenerational connectedness. I can't remember exactly what the paper found after all these years, but the main point is that measures of connectedness exist. [In answer to the question, are bonds net wealth?, many people who have examined the empirical work take an intermediate position and use 50% as a rule of thumb, i.e. that 50% of bonds are net wealth, the other 50% is offset through anticipated tax liabilities).

Since measures of connectedness exist, and I presume physicists also have such measures (of complexity), I'm wondering if financial market regulators should start developing measures along these lines. Can we measure the connectedness of financial institutions econometrically? If so, can we also follow along the lines of the Hirfandahl index for monopoly power and develop guidelines for when a firm is too interconnected with other firms, so interconnected that it's failure threatens the overall system? Couldn't we then "break-up" the firms the way we do monopolies, "disconnect" the firm until it's failure wouldn't be so devastating?

As pointed out above, size alone isn't the key feature, the degree of connectedness (complexity) is also important, and regulators - as far as I know - don't have good empirical tools for assessing this aspect of financial markets.

    Posted by on Thursday, September 18, 2008 at 03:33 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (20)

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