Network Theory and the Credit Crunch

For those of us out there, economists and laypeople alike, who are left scratching our heads at the current economic crisis, here’s a new theory, based on the study of information networks, that might shed some light on the problem:

“[The U.S.] market economy is nothing more than a vast, parallel-processing information network,” explains noted economist John Rutledge in his new book Lessons From a Road Warrior . Network theory, the examination of interconnected systems, can help us understand the current market crisis, because it can aid in identifying and understanding cascading information network failures.

When a “super node” in a network goes down, for example, it has the potential to take down the whole system, since these key nodes are connected to many others. Perhaps the most familiar crash of this sort is a power blackout. If a storm or accident takes down a single power line, it can lead to a power loss for a whole city. That type of crash, Rutledge explains, is exactly what is happening now.

In the current U.S. capital market network, the supernodes include actors such as the Federal Reserve, the Treasury, Wall Street banks and mortgage agencies Fannie Mae and Freddie Mac. Which ones went down? It’s common knowledge that Fannie and Freddie took a huge hit. Three weeks ago, the government seized control of the agencies, and now both are facing a federal grand jury investigation into their accounting practices.

As if that weren’t bad enough, Rutledge notes that the Federal Reserve has made things worse by “providing hail Mary liquidity lines to troubled institutions,” while simultaneously selling Treasury bills that “shrink bank reserves by an equal amount each time.” What this means is that bank reserves are not increasing, and the Fed’s actions are essentially taking “reserves away from a healthy bank to give to a sick one.”

So, three major nodes in capital markets went down, and Americans are now facing a huge credit crunch. Companies that need loans in order to buy more server equipment or hire employees are going to have a very hard time indeed . . . .

I’m sure this very same thing is being said differently and more articulately in other places, but the network theory explanation is helpful for economic-illiterate computer geeks such as myself.