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Network Theory Can Explain US Credit Crunch

By Sonia Arrison
Oct 3, 2008 4:00 AM PT

The financial crisis currently consuming the U.S. has led tech industry leaders, such as Microsoft's Steve Ballmer, to speak out in favor of quick Congressional action. Tech stocks, as well as general stocks, have plummeted, and there is confusion over why this crisis is happening and spreading so fast. One explanation that makes a lot of sense draws on network and information theory.

Network Theory Can Explain US Credit Crunch

"[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.

Three Supernodes Down

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. This reality led John McCrea, vice president of marketing at Plaxo, to say in a recent interview that "in such uncertain times, one certainly is not surprised to see an awful lot of activity in services like Plaxo and LinkedIn. Now would be a good time to make sure that one's information and network are up to date. ..."

That is, job hunting is about to become more difficult and competitive. Of course, this is not the first time such a crunch has happened.

Decentralization of Power

The capital market outage of 2000-2004 is also discussed in Rutledge's book and back then, he says, the failing node was the Treasury, because it forced the banks into credit-rationing by diverting reserves into treasury securities instead of bank loans. So, if the failure of supernodes is a key reason for the U.S.'s financial crises, what, if anything, can be done to make the network more stable?

The answer may be greater decentralization so that power is not concentrated. America desperately needs to "push power down to local regulators to break up the supernodes," Rutledge argues. This doesn't necessarily mean the creation of hundreds of new agencies. Rather, it could simply mean the creation of regional or local offices of the same agency with authority to make independent decisions, so that huge central planning decisions and mistakes are avoided.

Congress should have been seeking out such good advice and acting on it. Instead, Congress is caught up in blame games and indecision. It is time for the nation's leaders to reconfigure America's capital market network, and they should start by reading Rutledge's book.

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