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Back to Basics: Investing in a Global Network Where Systemic
Volatility, Contagion and Knightian Uncertainty Reign1
Roger W. Clark
Austin Peay State University
P.O. Box 4415
Clarksville, TN 37044
United States of America
Phone: 931-221-7574
Email: clarkr@apsu.edu
George C. Philippatos
University of Tennessee
Professor of Banking and Finance (Emeritus)
Knoxville, TN 37996-0540
United States of America
Voice: 865-690-9684
Email: gcphilipp1@gmail.com
1
Paper presented at the Cambridge Conference of Business and Economics, Cambridge, U.K. June 27-28, 2012.
Earlier versions of the paper were presented at several university workshops where constructive suggestions were
presented and incorporated in the present version. While we thank the contributors for constructive suggestions,
we retain full responsibility for any remaining errors.
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All money is a matter of belief.
~Adam Smith ~
There was a little girl,
Who had a little curl,
Right in the middle of her forehead.
When she was good,
She was very good indeed,
But when she was bad she was horrid.
~H. W. Longfellow~
Abstract
The recent (2008-Present) Market crisis in Europe, the USA, and the rest of the world have
focused the attention of economists and financiers on the steady state equilibrium conditions of global
financial markets. It is the purpose of this paper to trace some of the sources of disequilibrium,
employing network theory, nested game theory, and standard monetary analysis. The paradigm for
purposes of comparison is the generalized Capital Asset Pricing Model (CAPM) which has been shown to
handle both idiosyncratic and systematic (Market) risks, as we move rapidly to the dark environment of
Knightian uncertainty.
The basic premise of our analysis is that the debt overloads observed in sovereign entities (e.g.
Greece, Ireland, Portugal, et al); business enterprises (Lehman Brothers, Bear Stearns, AIG, General
Motors) and other institutional investors (e.g. Freddie Mac, Fanny May, and the subprime mortgage
fiasco) are negative externalities perpetrated in the belief that the rest of the world will absorb the cost
of the bailouts through supranational institutions (IMF, ECB, EEU, and FRS). However, when negative
feedback and cascading patterns amplified systemic volatility the prescribed conventional medicine was
shown to be ineffective. That is as the supranational institutions internalized the market for bailouts,
the global financial markets weakened and nearlyy atrophied. As the IMF and ECB fought for turf
ground, contagion spread from small countries and institutions to larger relatively healthy entities that
had been sidestepped by the markets due to the aforementioned internalization process. This
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anomalous decay nearly forced the global economy to the abysmal world of Knightian uncertainty,
where the conventional economic paradigms are at least inoperative or, at most, irrelevant.
I.
INTRODUCTION AND PERSPECTIVES
Small, weak economies in the underbelly of the Eurozone Region (e.g. Greece, Portugal, Ireland,
et al) create negative externalities1 (through debt overloads), whose costs are borne by the other
Eurozone countries, EEU countries, the U.S.A., and supranational institutions like the International
Monetary Fund (IMF), the European Central Bank (ECB), other national central banks, and by tradition,
the U.S.A. Federal Reserve System (FRS) that extend bailout packages to the countries and/or
institutions in need.
Since there has been no provision to date in the Eurozone charter for expelling repeat offenders
(and no political will to do so), these small countries expect a priori, repeat bailouts and eventually do
get them in the form of loans and refinancing agreements for several fiscal periods. Similar behavior has
been observed in the USA mortgage debacle through the so called subprime loans that were facilitated
by such pass-through institutions as Freddie-Mac and Fanny-May.
In order to delay (avoid) the dislocations of formal bankruptcy, fiscal and monetary authorities
in economic unions (EEU) and individual countries (USA) came to the assistance of the weak entities by
providing large bailout packages for several fiscal periods . These actions, in effect, internalize the
financial network to a few institutional participants while the free financial markets are weakened and
eventually atrophy. That is, these actions strengthen the institutional roles of the healthier economies
and further diminish the roles of the weaker players in the financial markets.
Of course, the internalization of the financial markets is not a new phenomenon, as it was
practiced frequently by Transnational Corporations since the 1960s for tax-sheltering purposes via
subsidiary financing, transfer pricing, etc. However, with the advent of modern derivative securities,
[e.g. Mortgage-backed Securities (MBSs), Collateralized Debt Obligations (CDOs), and Credit Default
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Swaps (CDSs)], fewer and fewer assets support the obligations of the debtor entities. And, what is
perhaps worse, both the securities and the issuing entities appear similar, in the eyes of the investing
public to the point where they cannot really distinguish the substantive differences among, say, Lehman
Brothers, Bear-Stearns, and AIG. Moreover, with fewer players in the market, systemic risk increases
and the basic homeostatic equilibrium becomes unattainable or possibly indeterminate. That is, the
substitutabilities of financial instruments transmute to similar phenomena in institutions (entities), and
the same is observed for complementarities. Moreover, the standard remedies imposed by
supranational organizations require the financial transgressors to engage in such counterproductive
activities as the privatization of public enterprises, increases in tax revenues as well as reduction of
salaries and pensions that further aggravate the weak economic situations of the countries and
institutions involved. In effect, the measures of economics austerity, combined with the fear of
sovereign/private default mutate to uncertainty about the future, leading to social unrest, as witnessed
in Greece, Spain, Italy, and even the U.K.
In the present world of integrated financial and real markets, economic recession in the
underbelly of the Eurozone is quickly transmitted to the healthier members of the European Economic
and Monetary Union (EEMU). Similarly, 2.8 million housing foreclosures in the U.S.A. threaten the
welfare of the American banking system2 as Wall Street and Main Street strive for survival in the midst
of such anarchistic movements as “Occupy Wall Street” and “every symbol of the established order”.
The structure of our paper is as follows: Section II focuses on the root-economic causes of the
debt-overload phenomena, negative externalities3 which morph into negative feedback effects and
amplify into cascades of financial distress. Section III deals with the internalization of the financial
markets by a few big players, such as the ECB, the IMF and some large sovereign players like Germany
and the U.S.A. This internalization process is facilitated by the advent of derivative securities whose
existence and trading alter the substitutability and complementarity (price and income effects) of both
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financial claims and issuing entities. Section IV discusses how the above factors amplify systemic risk and
briefly reviews the rudiments of Nested Game Theory where each clinical case (sovereign country or
institution) involves games in multiple arenas and institutional design as a systematic way to account for
contextual factors (the situation in other arenas) which, by influencing the pay-offs of the actors in one
arena, lead to the choice of different strategies. Section V deals briefly with the phenomenon of
financial contagion and the conditions which lead to further financial distress and potential breakdown
of the global financial system. Finally, Section VI presents a brief summary and some afterthoughts.
II.
NEGATIVE EXTERNALITIES, NEGATIVE FEEDBACK EFFECTS, AND MARKET CRISES
As is well known, negative externalities can be both technological and pecuniary, whose cost is
generally not borne by the economic perpetrators but rather by other people. The former type of
externalities affect other people in non-market ways (e.g. environmental pollution) and create a prima
facie case for policy intervention in the interest of efficiency. The later type affect other people through
the market and policy intervention is generally justified on grounds of income distribution. In the case of
financial markets and institutions we may have technological externalities perpetrated through fraud
that causes a bank failure (e.g. see Iyer and Alcalde 2006) or through conflicts of institutional interests
that lead to significant portfolio losses. Moreover, since the advent of financial innovations (MBSs,
CDOs, Credit Default Swaps, etc.), it has become possible to engage in activities that lead to
technological negative externalities that are hard to detect and even harder to prove in court. For
example, in the European Sovereign Debt Crisis, there were allegedly cases of financial institutions that
transacted sovereign junk quality bonds and credit default swaps on such bonds. To the extent that such
behavior can be documented forensically, we can see how modern financial innovations facilitate the
perpetration of negative externalities. Such externalities are typically internalized by fines, settlements,
and additional regulation (e.g. The Dodd-Frank Act).
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However, in financial markets, the most frequent occurrences of externalities are of the
pecuniary type. In effect, such externalities result in the impoverishment of clients and employees
through layoffs, loss of work benefits, loss of pensions, and loss of social status (e.g. The Enron
Corporation in the U.S.A.). These types of pecuniary externalities result in a society of haves and
havenots without the beneficial presence of economic middle classes.
To recap, negative externalities in the financial markets and institutions are also reinforced by
negative feedback and cascading phenomena that amplify systemic risk.
III.
INTERNALIZATION OF GLOBAL FINANCIAL MARKETS BY SUPRANATIONAL INSTITUTIONS
AND LARGE CENTRAL BANKS.
When small debtor countries like Greece signal high distress and potential default,
supranational institutions (e.g. The IMF, or the ECB) attempt to control the situation by
interposing themselves between the weak country and the financial markets. Similar behavior is
observed with large central banks like the U.S. Federal Reserve System. As these large financial
institutions enter the global financial markets to prepare rescue packages for countries in distress, they
inadvertently displace the thousands of small institutional and individual investors. Thus, an open
market for sovereign claims, from say Portugal, becomes highly oligopolistic4, whose systemic risk
increases greatly, leading to strong negative feedback and cascading effects. These latter effects are
further aggravated by such claims as “credit default swaps.” In effect, then, the Eurozone market for
sovereign and private bonds, in which thousands of institutional and individual investors participated, is
now relegated to the status of an oligopoly managed by the IMF, the ECB and the Central Banks of the
individual Eurozone countries. And, since the Buy-sell decisions are assigned (dictated) by the
supranational institutions, this so-called Eurozone Bond Market, resembles more-or-less a cartel whose
primary objective is the avoidance of default by individual countries and the embarrassing dissolution of
the Eurozone arrangement. Under such circumstances, true economic decisions are superseded by
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strategic/political decisions and turf-wars for positioning. Hence, estimations of idiosyncratic and market
risks (e.g. provided by the standard paradigm like CAPM) become inoperable and perhaps irrelevant. At
this stage, we find ourselves in the vortex of Knightian Uncertainty.
IV.
AMPLIFICATION OF SYSTEMIC RISK AND NESTED GAMES IN MULTIPLE ARENAS
As outlined earlier in Sections I to III, the negative externalities and feedback effects
augmented by institutional internalization of the financial markets, amplify systemic risk and seriously
undermine the effectiveness of the conventional paradigms like CAPM.
Since the solutions provided in a market dominated by supranational institutions are
negotiated rather than derived from a price-discovery mechanism in free markets, we shall employ the
Theory of Nested Games to model the conflicts among various actors – namely, the IMF, the ECB, the
Government of the distressed countries and such national entities as business sectors/labor sectors as
well as external creditors. This framework has been utilized in the default and debt restructuring of
Argentina5 in 2001-2003. Nested-Gaming allows for the possibility of several games being played by the
actors contemporaneously (such games are called arenas). In the case of games in multiple arenas many
of the actors’ moves have consequences in all arenas, i.e. “an optimal alternative in one arena (game)
will not necessarily be optimal with respect to the entities’ network of arenas in which the actor is
involved…” The actor may choose a suboptimal strategy in one game, if this strategy is expected to
maximize the payoff when all areas are taken into account. The basic contribution of employing games
in multiple arenas is that it presents a systematic way to take into accounts contextual factors (the
situation in other arenas). Such contextual factors influence the payoff of actors on one arena, leading
to the choice of different strategies; hence the outcomes of the game are different when contextual
factors are taken into account (Tsembelis, p. 4).
In addition to multiple arenas, Nested-Gaming allows for the case of institutional design,
whereby rational actors in distress like Greece, seek to increase the number of alternatives, thereby
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enlarging their strategy space. Instead of confining themselves to a choice among available strategies,
they redefine the rules of the entire game, choosing among a wider set of options; therefore, changes in
institutional design can be explained as conscious planning by the actors involved6. Thus, institutional
design provides a systematic way to analyze financial/political innovations (Tsembelis, pp. 9-10).
V. FINANCIAL CONTAGION, LONG INTERMEDIATION CHAINS, AND INCOMPLETE NETWORKS
The transmission of crises (a.k.a. contagion) in financial systems is generally explained along the
following lines7.
1. The Institutional Developments in Financial Markets
To wit, as market agents attempt to disperse credit risk to those who are better able to bear it,
they engage in intense securitization which leads to the lengthening of intermediation chains; then risk
becomes concentrated in the intermediary sector with damaging consequences for financial stability
(Shin, 2009, pp. 1-5). This old conventional wisdom, which extolls the positive role played by
securitization in dispersing credit risk, thereby enhancing the resilience of the financial system to
defaults by borrowers, had worked well in the U.S.A. for nearly three decades before the subprime
mortgage crisis. This old conventional wisdom has now been replaced by a new forensic conventional
wisdom that emphasizes the chain of unscrupulous operators who pass on bad loans to the greater fool
next in the chain. Known as the “hot potato” hypothesis, this idea is attractively simple and has been
embraced by many central bankers and politicians, who prefer to look for socio-economic scoundrels as
perpetrators of events like the U.S.A. subprime mortgage market.
In addition, as Shin (2009, pp. 2-3) points out, this simplistic forensic approach fails to
distinguish between selling a bad loan down the chain and issuing liabilities backed by bad loans. That is,
when you sell a bad loan to the greater fool down the intermediation chain you eliminate it from your
Balance Sheet. But when you issue liabilities against bad loans, the “hot potato” remains on your
balance sheet or on the books of Special Purpose Entities (SPEs) that you are sponsoring. In effect, the
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financial intermediaries are the last in the chain. And, since financial intermediaries are highly leveraged,
they risk wipe-outs of their equity capital8.
2. The Network Structure of Financial Markets
Specifically, we consider a financial network in which n financial intermediaries (i.e.
banks) are randomly linked together by their mutual claims. Borrowing the language of graph theory,
each intermediary represents a node on the graph and the interbank exposures of bank i define the links
with other banks. These links are then directed and weighted to reflect the fact that interbank exposures
comprise both assets and liabilities whose size is important for contagion analysis.
A crucial attribute of such graph theoretic structures is their degree distribution. To wit,
in a directed graph, each node has two degrees, an in degree (the number of links that point into the
node) that reflect the monies owed to the bank by a counterparty; and an out degree (the number of
links pointing out) that reflect the intermediary’s interbank liabilities. Eventually we construct the joint
distribution of in and out degrees which governs the potential for the spread of shocks (contagion)
through the network. In effect this modeling framework helps explain how contagion due to the direct
inter-linkages of interbank claims and obligations may be reinforced by indirect contagion on the asset
side of the Balance Sheet, particularly when the market for financial system assets is illiquid. Here again
the relationship between financial system connectivity and contagion comes to the surface as we
consider the nonlinear dynamic properties of complex financial systems9. (see P. Gai and S. Kapadia,
“Contagion in Financial Networks,” Working Paper No. 383 Bank of England, March 2010, pp. 1-10).
3. Complex Networks and Contagion in Financial Systems
The literature on Complex Networks is frequently applied to the study of epidemiology and
ecology, due to the obvious parallels between financial systems and other complex systems (e.g.
ecology). However, there are two key differences in the spread of disease and economic crises in
networks: (a) In epidemiological models, the susceptibility of an individual to contagion from a partially
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infected “neighbor” does not depend on the health of their other “neighbors.” By contrast, in financial
contagion, distress to a particular institution following default is more likely to occur if another of the
counterparties has also defaulted: (b) in most epidemiological models, higher connectivity simply
creates more channels of contact through which infections can spread, thus increasing the potential for
contagion. However, in financial contagion networks, greater connectivity also provides counteracting
risk-sharing, as exposures are diversified across a wider set of entities/institutions (countries).
VI.
SUMMARY AND SOME AFTERTHOUGHTS
The organizing theme of this paper has been the overall systemic impact of negative
externalities engendered by some countries and other entities through debt overloads. These negative
externalities are augmented by negative feedback and cascading effects that lead to serious financial
crises.
While the negative externalities through debt overloads are seen as the root cause of financial
distress, they do not morph into crises until and unless supranational financial institutions internalize
the Global Financial Markets in their quest to raise funds for bailout packages. This internalization
process alters the substitutabilities and complementaries of both financial claims and issuing entities
augmented by the advent of modern derivative instruments, (e.g. Mortgage Backed Securities,
Collateralized Debt Obligations and Credit Default Swaps). The intermediate result is a series of Nested
Games in multiples Arenas and Institutional Design which are played in an environment of complete and
incomplete stochastic networks that lead to financial contagion and Knightian uncertainty.
In the dark world of Knightian uncertainty, the conventional paradigms for asset
valuation (e.g. the standard CAPM, the consumption CAPM, [CCAPM] and the International CAPM
[ICAPM] are rendered ineffective and perhaps irrelevant. Hence we are left with the option of going
back to basics, such as fundamental analysis and Ratio Analysis.
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Nevertheless, not all is lost as we may begin to work with Beyesian Econometric and
other subjective probability models and create more realistic scenarios for the analysis of financial
crises.
Cambridge Conference [2012] R.W. Clark and G. C. Philippatos
1
Externalities are activities whose cost (negative) or benefit (positive) is generally not borne or enjoyed by the
perpetrator, but by society at large. Externalities may be technological or pecuniary; the former affect other
people in non-market ways (e.g. polluting the environment); the latter affect other people through the market
(e.g. a new industry may raise labor costs for other employers, or reduce the value of their capital by capturing
their market share. Pecuniary externalities do not create any prima facies case for policy intervention, except
possibly on grounds of income distribution (See John Black Oxford Dictionary of Economics, Oxford, U.K., Oxford
University Press, 1997).
2
. As reported in Greenlaw, Hatziurs, Kashyap, and Shin (2008), of the approximately $1.4 trillion total exposure to
subprime mortgages, around half of the potential losses were borne by U.S. leveraged institutions, such as
commercial banks, securities firms and hedge funds. When foreign leveraged institutions are included, the total
exposure of leveraged institutions rises to two thirds. Indeed, the most sophisticated financial institutions amassed
the largest exposures to the bad assets. (See Greenlaw, et al (2008), “Leveraged Losses: Lessons from the
Mortgage Market Meltdown,” U.S. Monetary Forum Report 2,
3
The concept of significant negative externalities is also employed by Rajkamal Iyer, and Jose Luis Pedro Alcalde
(April 2006) to explain three types of interbank contagion that arise from financial crises (See R. Iyer and J.L.P.
Alcalde, “Interbank contagion: Evidence from Real Transactions,” The European Central Bank Working Paper, April
2006, pp. 1 – 40).
4
We believe that these cases reflect a special form of oligopoly, known as “conjectural variations oligopoly.” That
is, instead of Cournot competition, where each entity (firm) takes the others’ output as given, or Bertrand
competition, where each entity takes the others’ prices as given, under conjectural variations each competitor
assumes that others will follow any change in their price or output to the extent of some proportions, which need
not equal either 0 or 1.
5
A Nested-Gaming approach to the Argentinian default and restructuring is found in Roger W. Clark and George C.
Philippatos, “The Games Countries Play Under Financial Distress…” Paper presented at the Oxford Conference,
2007. See, also George Tsembelis, Nested Games: Rational Choice in Comparative Politics, Los Angeles, University
of California Press, 1990.
6
Clinical cases of Nested-Gaming in multiple arenas and institutional design for the Argentinian Default and
Restructuring have been documented in R.W. Clark and G.C. Philippatos, ibid. Similar observations can be made in
the current reactions of Greece, Ireland, and Italy.
7
Shin (2009) provides examples of cases which may be exceptions to this rule: (a) covered bonds (a.k.a.
subordinated bonds) are one form of securitization that do not fall foul of this principles; (b) counter-cyclical
capital requirements for Boom-and Bust scenarios that mitigate the conditional value at risk for financial
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intermediaries; and (c) the Spanish-style statistical provisioning, which appears to mitigate the harmful effect of
lengthening intermediation chains (See Shin 2009, pp. 1-31).
8
As R. Iyer and J. L. Pedro Alcalde (April 2006) clarify, there is contagion if the failure of a financial entity causes a
significant externality to other entities. These types of contagion that may arise are: (a) Financial contagion due to
interbank linkages whereby the failure of a bank leads to a loss in value for its creditor banks which hold interbank
claims in the failed bank. Furthermore, the losses of the creditor banks may increase, due to the (over) reaction of
their depositors and other creditors; (b) the second type of contagion is “information” – based; Here, the failure of
a bank could make depositors and creditors to revise their priors about the likelihood of failure of other banks with
similar attributes to the failed bank; (c) Finally the third type is “pure” contagion. In this case, the contagion is
purely random and is unrelated to interbank linkages or information commonalities (ibid, pp. 2-4). As we will see
later on, there are other more technical explanations of contagion based on stochastic network theory and
epidemiological studies. At any rate, financial contagion due to interbank linkages has been often posited as a
great threat to the stability of banking systems, despite the lack of strong empirical evidence.
9
Allen and Gale (2000) have shown that the spread of contagion depends crucially on the pattern of
interconnectedness between market entities (banks). When the network is complete, with all banks having
exposures to each other such that the amount of interbank deposits held by any bank is evenly spread over all
other banks, the impact of a financial shock is readily alternated. Every bank suffers a small “damage” and there is
no contagion. However, when the network is incomplete with banks having exposures to a few counterparties, the
systems is more fragile. That is, the initial impact of a financial shock is concentrated among neighboring banks.
When these banks succumb, the premature liquidation of long-term assets and the concomitant loss of value bring
previous by unaffected banks to the forefront of contagion. Along the same lines, Freixos et al (2000) demonstrate
that tiered financial systems with money centered banks, where banks on the periphery are linked to the center
but not to each other, are also likely to suffer contagion (See Gai and Kapadia [March 2010] ibid, pp. 4-7).
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References
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3. Black, John, Oxford Dictionary of Economics: Oxford, U.K., Oxford University Press, 1997
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5. Clark, Roger W., and George C. Philipppatos (2007) “The Games Countries Play Under Financial Distress: A
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Transactions”, ECB Working paper series, April 2006, pp. 1-40
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distributions and their Applications”, Physical Review E, Vol 64, Issue 2
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