Without further ado, we hand over the mic to the author:
This study considers the relationship between a global systemic banking, monetary and solvency crisis and its implications for the real-time flow of goods and services in the globalised economy. It outlines how contagion in the financial system could set off semi-autonomous contagion in supplychains globally, even where buyers and sellers are linked by solvency, sound money and bank intermediation. The cross-contagion between the financial system and trade/production networks is mutually reinforcing.
It is argued that in order to understand systemic risk in the globalised economy, account must be taken of how growing complexity (interconnectedness, interdependence and the speed of processes), the de-localisation of production and concentration within key pillars of the globalised economy have magnified global vulnerability and opened up the possibility of a rapid and large-scale collapse. ‘Collapse’ in this sense means the irreversible loss of socio-economic complexity which fundamentally transforms the nature of the economy. These crucial issues have not been recognised by policy-makers nor are they reflected in economic thinking or modelling.
As the globalised economy has become more complex and ever faster (for example, Just-in-Time logistics), the ability of the real economy to pick up and globally transmit supply-chain failure, and then contagion, has become greater and potentially more devastating in its impacts. In a more complex and interdependent economy, fewer failures are required to transmit cascading failure through socio-economic systems. In addition, we have normalised massive increases in the complex conditionality that underpins modern societies and our welfare. Thus we have problems seeing, never mind planning for such eventualities, while the risk of them occurring has increased significantly. The most powerful primary cause of such an event would be a large-scale financial shock initially centring on some of the most complex and trade central parts of the globalised economy.
The argument that a large-scale and globalised financial-banking-monetary crisis is likely arises from two sources. Firstly, from the outcome and management of credit over-expansion and global imbalances and the growing stresses in the Eurozone and global banking system. Secondly, from the manifest risk that we are at a peak in global oil production, and that affordable, real-time production will begin to decline in the next few years. In the latter case, the credit backing of fractional reserve banks, monetary systems and financial assets are fundamentally incompatible with energy constraints. It is argued that in the coming years there are multiple routes to a largescale breakdown in the global financial system, comprising systemic banking collapses, monetary system failure, credit and financial asset vaporization. This breakdown, however and whenever it comes, is likely to be fast and disorderly and could overwhelm society’s ability to respond.
We consider one scenario to give a practical dimension to understanding supply-chain contagion: a break-up of the Euro and an intertwined systemic banking crisis. Simple argument and modelling will point to the likelihood of a food security crisis within days in the directly affected countries and an initially exponential spread of production failures across the world beginning within a week. This will reinforce and spread financial system contagion. It is also argued that the longer the crisis goes on, the greater the likelihood of its irreversibility. This could be in as little as three weeks. This study draws upon simple ideas drawn from ecology, systems dynamics, and the study of complex networks to frame the discussion of the globalised economy. Real-life events such as United Kingdom fuel blockades (2000) and the Japanese Tsunami (2011) are used to shed light on modern trade vulnerability.
Think of the attached 78-page paper as Nassim Taleb meets Edward Lorenz meets Malcom Gladwell meets Arthur Tansley meets Herman Muller meets Werner Heisenberg meets Hyman Minsky meets William Butler Yeats, and the resultant group spends all night drinking absinthe and smoking opium, while engaging in illegal debauchery in the 5th sub-basement of the Moulin Rouge circa 1890.
The final product is frightfully spot on and should be read by every person even remotely close to setting policy (which is why it won't be).
Another rather notable excerpt dealing with financial system supply-chain cross contagion:
Something sets off an interrelated Eurozone crisis and banking crisis, a Spanish default say, which spreads panic and fear across other vulnerable Eurozone countries. This sets off a Minsky moment when overleveraged speculators in the banking and shadow banking system are forced to unwind positions into a one-sided (sellers only) market. The financial system contagion passes a tipping point where governments and central banks start to lose control and panic drives a (positive feedback) deepening and widening of the impact globally. In our tropic model of the globalised economy, the banking and monetary system keystone hub comes out of its equilibrium range, crosses a tipping point, and is driven away by positive feedbacks to some new state.
This directly links to another keystone-hub, production flows. Failing banks, fears of currency re-issue, fears of further default, collapse in Letters of Credit, and growing panic directly quickly shut down trade in the most affected countries. As the week progresses factories close, communications are impaired, social stress and government panic increases. After a week almost all businesses are closed, there is a rising risk to critical infrastructure.
Almost immediately internal trade and imports stops in the most affected countries, and there is impairment in a growing number of other countries. Trade is impaired globally via a credit crunch. This undermines exports from some of the most trade-central countries, with some of the most efficient JIT dependencies in the world. This cuts inputs into the production and trade into countries that were initially weakly affected by direct financial contagion. Globally, the spread of trade contagion depends on complexity, centrality, and inventory times and once a critical threshold is passed spreads exponentially until the effect is damped by a large-scale global production collapse (implying another keystone-hub, economies of scale is driven out of equilibrium).
Trade contagion and its implications feed back into financial system contagion, helping drive further disintegration. The interacting and mutually destabilising effects of keystone-hubs coming out of equilibrium destroy the equilibrium of the globalised economy initiating a systemic collapse.
Growing risk displacement in an increasingly vulnerable system is increasing the risk of system failure. Once the financial system contagion crosses a particular threshold the de-stabilisation of the globalised economy will be exceedingly difficult to arrest; this point may be in as little as ten days. Once a major system collapse occurs, scale, hysteresis, entropy, loss of critical functions, recursion failure, and resource diversion is likely to ensure that the features associated with the previous dynamic state of the globalised economy can never be recovered.
The above explains why the central planners of this world, all of them well-aware of the implications of what has just been said, will literally fight to the death to prevent the global system from reacquire its balanced natural state, which for 30 years they have been pushing further and further away from in other to perpetuate as long as possible, an unstable status quo, which has benefited a disproprtionately smaller number of systemic participants, and has lead the system far beyond its tipping point level. Sadly, the system will eventually regain balance: that is what nature dictates. When it does, a politically correct way of saying what happens it that "the previous dynamic state of the globalised economy can never be recovered" while a less PC framing would be "all hell will break loose."
The author continues:
We have outlined how the risk of a major shock arising from decades of credit expansion and imbalances is growing. We have also seen that we could expect a similar shock from the effects of peak oil on the economy. What unifies both is a catastrophic collapse arising from a loss of confidence in debt, and the solvency of banks and governments. What would be unique is the scale of the shock and its ability to strike at the heart of the world’s financial system. But the implications are not just within the financial and monetary system. They would immediately affect the trade in real goods and services. As our economies have become more complex, de-localised and high speed, the implications on supply-chains could be rapid and devastating.
There are three general points that are worth noting. Together they point to the likelihood that the crisis whenever it comes can be expected to be very large and society unprepared.
The first is temporal paralysis:
As financial and monetary systems become more unstable, the risks associated with doing anything significant to change or alter the course increase (see also the discussion of lock-in in the final section). In addition, the diversity of national actors, public opinion, institutional players and perceptions works against a coherent consensus on action. Therefore the temptation is to displace immediate risk by taking the minimal action to avert an imminent crisis. This increases systemic risk. Some steps in the evolving crisis might be handled, for example, a Greek default. However, each new iteration of the crisis is likely to be bigger and more complex than the one before, while the system is becomes ever less resilient.
A second issue is what might be called the reflexivity trap:
The actions taken to prevent a crisis, or preparations for dealing with the aftermath of a crisis, may help precipitate the crisis. Therefore to avoid precipitation, the preparation has to be low key and below the radar of the public and markets. This limits the extent and scope of preparation, increasing the risk of a chaotic and slow response.
The final point is about black swans & brittle systems:
The growing stress in our very complex globalised economy means it is much less resilient, see the discussion in section 3.1 and figure 2. Thus a small shock or an unpredictable event could set in train a chain of events that could push the globalised economy over a tipping point, and into a process of negative feedback and collapse.
One cannot predict how such a financial and monetary collapse will occur, or when. However, in this section we are considering a scenario, ideally one that in the light of what we know of the economic conditions sketched earlier seems at least reasonable. This scenario should be considered a warning, but also a more general guide to how supply-chain cross contagion might operate in any financial/ monetary collapse.
Everyone who is curious how the European endgame will (not may) plays out (especially all the bureaucrats at the ECB and the Bundesbank) should read what ensues. Because it is not pretty. Here is a snapshot:
Globally, monetary systems would become increasingly opaque. A lack of money, operational banks, currency re-issue, inflation and hyper-inflation expectations would become a reality in many advanced economies in and outside the Eurozone. Debt deflation would in its formal sense start to die-nobody would (even if they could) pay down debt, nor would there be any credit. Production would be increasingly shut down, while complex societies got a rapid lesson on the extent of system dependency.
The perception of continued socio-economic disintegration would alter behavioural responses such as trust radii and social discount rate.
Finally, financial system supply-chain cross-contagion is a re-enforcing negative feedback driving the globalised economy away from its stable state and into a new collapse one.
Granted the above is dubbed a worst-case outcome, but one which is inevitable unless authorities admit that it is a distinct possibility and actively prepare a contingency plan, which however in itself is somewhat self-defeating because as the Eurozone crisis has demonstrated the mere admission of reality is enough to propagate the system into a whole new level of unsustainability, and so on until the system cross a final threshold beyond which there is no salvageability. The author himself acknowledges this:
We do not like to think of ourselves as potentially irrational herd animals (that will be the Jones’s). We seek narrative frameworks that purport to explain our good fortune, ideally in ways that flatter. Reinhardt and Rogoff called it the This Time It's Different syndrome as each age sought to deflect warnings by arguing we're smarter now, better organised, or living in a different world. Just as the sellers of an overpriced home will convince themselves that it was their interior decorating skills not an inflating bubble that got them the good deal.
Of course warnings may keep coming, and almost by definition, from the fringes. When assessing risks that challenge consensus, people are more likely to defer to authority, which generally sees itself as the representative of the consensus. Furthermore, as a species with strong attachments to group affirmation, being wrong in a consensus is often a safer option than being right but facing social shaming, or especially if found to be wrong later.
Far better to say: “Look, don't blame me, nobody saw this coming, even the experts got it wrong!”
But even if we can appreciate a warning, the inertia of the status quo generally ensures acting on such warnings is difficult. In general we chose the easiest path in the short-term, and the easiest path is the one we are familiar and adaptive with. We would rather put off a hard and high consequence decision now, even if it meant much higher consequences some time in the future. However, if each step on the path of least resistance is a step further from where we ideally should be, the risks associated with doing anything rise as the divergence is so much wider. Eventually one's bluff may be called, but not yet, and hopefully on somebody else’s watch.
The consensus can often be correct and the marginal voices may be deluded. The point for the risk manager is to try and step through cognitive and social blind-spots by first recognising them. This is particularly true if the risks (probability times impact) considered are very high.
Unfortunately, it is very clear that we have learned almost nothing general about risk management as a societal practice arising from the financial crisis. We have merely adopted a new consensus, with a questionable acknowledgement that we will not let this type of crisis happen again. However, the argument in this following report is that we are facing growing real-time, severe, civilisation transforming risks without any risk management.
Which brings us to the conclusion:
We are locked into an unimaginably complex predicament and a system of dependency whose future seems at growing risk. To avoid catastrophe we must prepare for failure.
We are entering a time of great challenge and uncertainty, when the systems, ideas and stories that framed our lives in one world are torn apart, but before new stories and dependencies have had time to evolve. Our challenge is to let go, and go forth.
Our immediate concern is crisis and shock planning. It should now be clear that this is far more extensive than merely focussing on the financial system. It includes how we might move forward if a reversion to current conditions proves impossible. That is we also need transition planning and preparation. Even while subject to lock-in and the reflexivity trap, this will be most effective if it works from bottom-up as well as top-down.
Finally, neither wealth nor geography is a protection. Our evolved co-dependencies mean that we are all in this together.
Everyone who wishes to know what will happen unless everyone is aware of what may happen, should read the attached paper.
Trade-Off: Financial System Supply-Chain Cross-Contagion: a study in global systemic collapse (pdf)
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