Chalk Two Up for “Too Brittle To Sustain”

I’m a big proponent of the “Too Brittle to Sustain” theory of financial collapse. Today, I find that I am in the company of two others. From Leigh Caldwell:

The real problem has been identified by Garett Jones in a prescient tweet earlier this year. Not “Too big to fail” but “Too correlated to fail”:

“In a financial crisis, TBTF seems to matter less than Too Correlated To Fail. Type-of-asset beats out size-of-liability.”

The problem was that nearly every bank put its money into the same asset class. This both exposed the system to a much higher risk, and in itself contributed to the bubble in property prices.

I’m putting Garett Jones* down in the TB2S category as well. Here is a diagram I use to explain the concept:

Imagine that there is a forest with only (or that is heavily biased toward) evergreen trees. Would you say would be a sustainable ecosystem? Of course not…the homogeneity would cause the forest to be susceptible to things like disease and pests, and also be very fire-prone. While it is very likely that such an ecosystem could be designed this way, it is highly unlikely that such an ecosystem would be able to sustain itself. Indeed, there is a forest of evergreen trees near me that looks to be a “planned forest”, which is dotted by dead trees due to disease — people can’t cut them down fast enough to stop the spread. I’m willing to bet that zero biologists would say that it is a good idea for you to plant a large forest of only evergreens.

Now, substitute in “market” for “forest”, “economy” for “ecosystem”, and “sub-prime mortgages” for “evergreens”…and you can make up some creative words to fill in the gaps. Sustainability is a balance between efficiency and diversity. That is what makes markets so robust — indeed, diversity is what allowed our economy to endure three real shocks before the big crash (2008Q3-Q4)**. The housing market, on the other hand, is pretty much shaped by regulatory structure to look like a 100% evergreen forest.

*Garrett Jones “liked” one of my posts on Facebook, which is pretty awesome.

**1. Sub-prime mortgage crisis, 2. Auto and construction industry collapse, 3. Energy price shock.


3 thoughts on “Chalk Two Up for “Too Brittle To Sustain”

  1. Thanks for the link – I had read your previous item on this but forgot to mention it in mine. We’ve clearly been thinking along similar lines, though I don’t necessarily agree that regulation is the main enemy of diversity. I think there are network tendencies built into the finance markets which themselves promote conformity.

  2. In response to Mr. Caldwell,

    Assuming Mr. Blanchard gives a correct narrative, I see the leveraging rules to have absolutely contributed to the over-concentration in certain asset classes, and subsequent fragility.

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