SINGAPORE (Reuters) - As the world grapples with the worst economic downturn in decades and the possibility of a flu pandemic, a growing body of research suggests the complexity of the modern global economy may make us more vulnerable than ever to catastrophe.
The financial crisis began as turmoil in one small segment of the U.S. mortgage market. Within months it had morphed into a global meltdown affecting almost everyone on earth.
“The speed at which these events unfolded was unprecedented,” said the World Economic Forum’s 2009 report on global risk.
“It has demonstrated just how tightly interconnected globalization has made the world and its systems.”
Disease, too, can spread faster than ever before. Modern air travel means that any contagious outbreak can be worldwide in a matter of days. In the past, it would have taken months or years.
The more complex and efficient a system, the faster and wider any contagion can spread. Yet this interdependence is by no means always negative. The complexity of the world economy means risk can be more easily distributed, and often more easily mitigated.
Complex systems can often be adaptable -- if one part fails, other parts of the network can assume the burden.
Network theory suggests that complex diversified systems can often bring greater stability. But only to a point.
“While this helps the system diversify across small shocks, it also exposes the system to large systemic shocks,” Raghuram Rajan, who has been an IMF chief economist and adviser to Indian Prime Minister Manmohan Singh, wrote in a 2005 research paper.
“It is possible that these developments...create a greater (albeit still small) probability of a catastrophic meltdown.”
One key issue is the so-called “butterfly effect” -- in highly complex systems, even a small event can be magnified and transmitted with highly unpredictable results. Edward Lorenz, a pioneer of chaos theory, noted that a butterfly flapping its wings in one corner of the world could cause a tornado far away.
Benoit Mandelbrot, a French mathematician and the father of fractal geometry, applied the theory to markets to show how “wild variability” is intrinsic to the system.
In network theory, one key finding is that complex interconnected systems organize themselves around key nodes. If one of these is hit, the whole house of cards can collapse.
This is one reason the damage done by the subprime crisis to major global investment banks had such a devastating impact.
And while specialization in global supply chains has brought significant efficiency gains, it has also brought vulnerability. Disruption to a key node in the supply chain can cause dramatic and unpredictable turbulence in the whole system.
This was why global semiconductor prices nearly doubled following an earthquake that hit Taiwan in 1999, and why Hurricane Katrina spread turbulence throughout world markets.
Security analysts also worry that even a single terrorist attack could have a magnified impact if it targets a key point in global supply chains -- for example, a major port.
In his book “The Black Swan,” which examines the impact of major unexpected events, Nassim Nicholas Taleb noted that the appearance of stability in complex systems can be illusory:
”Random insults to most parts of the network will not be consequential since they are likely to hit a poorly connected spot. But it also makes networks more vulnerable... Just consider what would happen if there is a problem with a major node.
“True, we have fewer failures,” he wrote. “But when they occur... I shiver at the thought...”
The complexity that makes financial shocks more potentially dangerous also means that pandemics can wreak greater havoc.
Analysts point out that when the Black Death plague hit Europe in the 14th century, killing around a third of the population, society did not collapse, because economic and social systems were relatively simple and so insulated from shocks.
By contrast, a plague that hit the Roman empire in the 2nd century, with a similar death rate, caused chaos -- Roman society was much more complex and economically advanced.
In modern society, if key nodes are taken out by disease, the impact could be magnified exponentially. The “nodes” could be people essential to the functioning of society and the economy -- doctors, truck drivers, engineers, port workers.
And just as with financial crisis, herd behavior, panic and the spread of inaccurate or incomplete information could provide negative feedback loops, making the catastrophe even worse.
“Economic disruptions on the supply side would come directly from high absenteeism... There may also be disruptions to transportation, trade, payment systems and major utilities,” the IMF said in a 2006 report on the impact of a global flu pandemic.
And beyond the immediate catastrophe, an overriding risk from both the financial crisis and any pandemic is that it causes a worldwide retreat from globalization, with profound long-term consequences for the world economy.
In its 2007 report on global risks, the World Economic Forum imagined the consequences of a simultaneous pandemic and global liquidity crisis -- a scenario that was purely speculative then but which now seems eerily prescient.
The result, it said, would be “a backlash against globalization, which in turn compounds the hit on global demand.” Across the world, it said, increased militarism and authoritarian tendencies would reshape global geopolitics.
The events of the next few months may show just how accurate such a scenario could be.
Editing by Bill Tarrant