The Resilience Stability Tradeoff: Drawing Analogies between River Flood Management and Macroeconomic Management
In an earlier post, I drew an analogy between Minsky’s Financial Instability Hypothesis (FIH) and the ecologist Buzz Holling’s work on the resilience-stability tradeoff in ecosystems. Extended periods of stability reduce system resilience in complex adaptive systems such as ecologies and economies. By extension, policies that focus on stabilisation cause a loss of system resilience. Holling and Meffe called this the Pathology of Natural Resource Management which they described as follows: “when the range of natural variation in a system is reduced, the system loses resilience.That is, a system in which natural levels of variation have been reduced through command-and-control activities will be less resilient than an unaltered system when subsequently faced with external perturbations.” This pathology is as relevant to macroeconomic systems as it is to ecosystems and I briefly drew an analogy between forest fire management and economic management in the earlier post. In this post, I analyse the dilemmas faced in river flood management and their relevance to macroeconomic management.
A Case Study of River Flood Management: River Kosi
The Kosi is one of the most flood-prone rivers in India. The brunt of its fury is borne by the northern Indian state of Bihar and the Kosi is aptly also known as the “Sorrow of Bihar”. Like many other flood-prone rivers, the root cause lies in the extraordinary amount of silt that the Kosi carries from the Himalayas to the plains of Bihar. The silt deposition raises the river bed and gravity causes the river to seek out a new course – in this manner, it has been estimated that the river Kosi may have moved westwards by an incredible 210 km in the last 250 years. During the 1950s, in an effort to provide “permanent salvation from floods” the Indian government embarked on a program of building embankments on the river to curb the periodic shifting of the Kosi’s course – the embankments were aimed at converting the unpredictable behaviour of the river into something more predictable and by extension, more manageable. It was assumed that the people of Bihar would benefit from a stabilised and predictable river.
Unfortunately, the reality of the flood management program on the river Kosi has turned out to be anything but beneficial. The culmination of the failure of the program was the 2008 Bihar flood which was one of the most disastrous floods in the history of the state. So what went wrong? Was this just a result of an extraordinary natural event? Most certainly not – As Dinesh Mishra notes, in 2008 the Kosi carried only 1/7th of the capacity of the embankments and at various points of time since the 50s, the river had carried far greater quantities of water without causing anywhere near the damage it caused in 2008. This was a disaster caused by the loss of system resilience, highlighted by the inability of the system to “withstand even modest adverse shocks” after prolonged periods of stability.
So what caused this loss of system resilience? As Dinesh Mishra explains: “By building embankments on either side of a river and trying to confine it to its channel, its heavy silt and sand load is made to settle within the embanked area itself, raising the river bed and the flood water level. The embankments too are therefore raised progressively until a limit is reached when it is no longer possible to do so. The population of the surrounding areas is then at the mercy of an unstable river with a dangerous flood water level , which could any day flow over or make a disastrous breach.” As expected, the eventual breach was catastrophic – the course of the Kosi moved more than 120 kilometres eastwards in a matter of weeks. In the absence of the embankments, such a dramatic shift would have taken decades. With the passage of time, a progressively greater degree of resources were required to maintain system stability and the eventual failure was a catastrophic one rather than a moderate one.
As the above analysis highlights, the stabilisation did not merely substitute a series of regular moderately damaging outcomes for an occasional catastrophic outcome (although this alone would be a cause for concern if a catastrophic outcome was capable of triggering systemic collapse). In fact, the stabilisation transformed the system into a state where eventually even minor and frequently observed disturbances would trigger a catastrophic outcome. As Jon Stewart put it, even “regular storms” would topple a fragile boat. When faced with the possibility of a catastrophic outcome, the managing agency has two choices, neither of which are attractive.
Either it can continue to stabilise the system using ever-increasing resources in an effort to avoid the catastrophic outcome. But this option must only be followed if the managing agency has infinite resources or if there is some absolute limit to this vicious cycle of cost escalation that is within the resource capabilities of the agency. Or it can allow the catastrophic outcome to occur in an effort to restore the system to its unstabilised state. But this option risks systemic collapse – it is not just the unprecedented nature of the outcome that we have to fear from, but the very fact that the adaptive agents of the complex system may have lost the ability to deal with even the occasional moderate failures that the unstabilised system would throw up. In other words, once the system has lost resilience, managing it is akin to choosing between the frying pan and the fire.
For example, in the pre-embankment era when the Kosi was allowed to meander and change course in a natural manner, the villagers on its banks had a deep understanding of the river’s patterns and its vagaries. The floods sustained the fertility of the soil and ensured that groundwater resources were plentiful. This is not to deny that the Kosi caused damage but because the people had adapted to its regular flooding patterns, systemic damage only occured during the proverbial 100-year flood. This highlights an important lesson in complex adaptive systems: The impact of disturbances cannot be analysed in isolation to the adaptive capacities of the agents in the system. If disturbances are regular and predictable, agents will likely be adapted to them and conversely, prolonged periods of stability will render agents vulnerable to even the smallest disturbance.
The problems of managing floods on the river Kosi are not unique – many rivers around the world pose similar challenges. For example, the Yellow River, aptly named the “Sorrow of China” and the Mississippi river basin, the story of which was captured so well by John McPhee. So is there any way to avoid this evolutionary arms race against nature? Are we to conclude that the only sustainable strategy is to avoid any intervention in the complex adaptive system? Not necessarily - interventions on the system must avoid tampering with the fundamental patterns and evolutionary dynamics of the system. Indeed the best example of river management that works with the natural flow of the river rather than against it is the Dutch government’s aptly named “Room for the River” project in the Rhine river valley. Instead of building higher dikes, the Dutch have chosen to build lower dikes that allow the Rhine to flood over a larger area thus easing the pressure on the dike system as a whole. This program has been adopted despite the fact that many farmers need to be relocated out of the newly expanded flood zones of the river.
Axel Leijonhufvud’s “Corridor Hypothesis” postulates that a macroeconomy will adapt well to small shocks but “outside of a certain zone or “corridor” around its long-run growth path, it will only very sluggishly react to sufficiently large, infrequent shocks.” The adaptive nature of the macroeconomy implies that stability and by extension stabilisation reduces the width of the corridor to the point where even a small shock is enough to push the system outside the corridor. Just as embankments induced fragility in the river Kosi, bailouts and other economic transfers to specific firms and industries induce fragility into the macroeconomic system. Economic policy must allow the “river” of the macroeconomy to flow in a natural manner and restrict its interventions to insuring individual economic agents against the occasional severe flood.
This sentiment was also expressed by that great evolutionary macroeconomist of our time, Mancur Olson. In his final work “Power and Prosperity”, Olson notes: “subsidizing industries, firms and localities that lose money…at the expense of those that make money…is typically disastrous for the efficiency and dynamism of the economy, in a way that transfers unnecessarily to poor individuals…A society that does not shift resources from the losing activities to those that generate a social surplus is irrational, since it is throwing away useful resources in a way that ruins economic performance without the least assurance that it is helping individuals with low incomes. A rational and humane society, then, will confine its distributional transfers to poor and unfortunate individuals.” Olson understood the damage inflicted by rent-seeking not only from a systemic perspective but from a perspective of social justice. The logical consequence of micro-stabilisation is a crony capitalist economy - rents invariably flow to the strong and the result is a sluggish and an inegalitarian economic system, not unlike many developing economies. Contrary to popular opinion, it is not limiting handouts to the poor that defines a free and dynamic economy but limiting rents that flow to the privileged.
On the Damage Done by the Greenspan Put Variant of Monetary Policy
Clearly, some fiscal policies aimed at firm and industry stabilisation harm the economic system. But what about monetary policy? Isn’t monetary policy close-to-neutral and therefore exempt from the above criticism? On the contrary – the Greenspan Put variant of monetary policy damages macroeconomic resilience as well as being inegalitarian and unjust. Monetary policy during the Greenspan-Bernanke era has focused on stabilising incumbent banks and helping them shore up their capital in response to every economic shock, as well as a focus on asset prices as a transmission channel of monetary policy i.e. the Greenspan Put. Unlike a river system where the buildup of silt is a clear indicator of growing fragility, there are no clear signs of loss of system resilience in a macroeconomy. However, we can infer loss of macroeconomic resilience from the ever-increasing resources that are required to maintain system stability. Just as the embankments of the Kosi were raised higher and higher to combat even a minor flood, the resources needed to stabilise the financial system have grown over the last 25 years. In the early 90s, bank capital could be rebuilt by a few years of low rates but now we need a panoply of “liquidity” facilities, near-zero rates and quantitative easing aimed at compressing the entire yield curve to achieve the same result.
As I mentioned earlier, such a stabilisation policy may be credible if there is a limit to the costs of stabilisation. For example, the rents that can be extracted by any small, isolated sector of the economy are limited. Unfortunately, and this is a point that cannot be emphasised enough, there is no limit to the rents that can be extracted by the financial sector. Every commitment by the Central Bank to insure the financial sector against bad outcomes will be arbitraged for all its worth until the cost of maintaining the commitment becomes so prohibitive that it is no longer tenable. Of course, as long as the stabilising policy is in operation it appears to be a “free lunch” – the costs of programs such as the TARP appear to be limited and well worth their macroeconomic benefits just like flood protection appears to be a successful choice in the long period of calm before the eventual disaster. The loss of resilience and rent extraction is exacerbated as other financial market players are encouraged to mimic banks and take on similarly negatively skewed bets such as investing the proceeds from securities lending in “safe” assets.
In my last post, I noted the connection between inequality and rents emanating from the moral hazard subsidy but the larger culprit is the toxic combination of Greenspan Put monetary policy and a dynamically uncompetitive cronyist financial sector. Even if the sector were more competitive it is inevitable that monetary policy focused on shoring up asset prices will benefit the primary asset-holders in the economy, which in itself is a regressive transfer of wealth to the rich. The idea that supporting asset prices is the best way to support the wider economy is not far away from the notion of trickle-down economics (or as Will Rogers put it: “money was all appropriated for the top in hopes that it would trickle down to the needy.”).
Finally, although it goes without saying that even a fiat currency-issuing central bank does not have infinite resources, the move over the last century from a gold standard to a fiat money regime does have some important implications for system resilience. In evolving from a decentralised gold standard monetary system to a fiat-currency issuing central bank regime, the flexibility and resources at the monetary authority’s disposal have increased significantly. In the hands of a responsible central bank the ability to issue a fiat currency is beneficial, but in an excessively stabilised economy, it allows the process of stabilisation to be maintained for far longer than it would otherwise be. And just like in the case of the river Kosi, the longer the period of the stabilisation the more catastrophic are the results of the inevitable normal disturbance.