Has globalization made us more catastrophe-prone?

Wed Apr 29, 2009 10:36am EDT

By Andrew Marshall, Asia Political Risk Correspondent

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."

BUTTERFLIES, BLACK SWANS AND SWINE FLU

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.....

art. cont.