This situation of central banks and governments rescuing financial firms is very similar to that of forest fires. Three researchers at the University of Cornell, Bruce Malamud, Gleb Morein, and Donald Turcotte, decided to simulate a forest fire game on the computer. In the game, the computer program basically plants trees on random squares. Now and then, after a certain number of trees have been planted, the program dropped a matchstick on a random square. The researchers dropped matches at various frequencies. In some cases, they dropped matches after every 100 trees were planted. In other cases they dropped matches after 2,000 trees had been planted. As expected, when matches were dropped more frequently, there were many more fires, in comparison to simulations wherein matches were dropped less frequently. In cases where matches were dropped after 2,000 trees had been planted, the fire spread from the tree on which the match had landed, to the entire forest. This was because by then the entire grid was filled with trees, and hence, the fire was catastrophic. The researchers came to the conclusion that when the fire starting frequency was low, there was a marked tendency for the fires to be catastrophic, all-consuming disasters.

Yellowstone effect This observation was called the “Yellowstone effect” by the researchers. The Yellowstone National Park, situated primarily in the American state of Wyoming, gets regular forest fires, and over the years some of them have been very big fires. Since 1890, the US Forest Service has followed a zero fire tolerance policy, wherein they have tried to put out each and every fire, even those that have started due to natural causes. This is the real-world equivalent of the game in which lesser matches are dropped. It appears to have similar consequences as well.

When the policy is to put out all fires, it leads to a situation wherein the trees age. Old trees are not replaced by new trees. At the same time, dead wood, grass, twigs, and dead leaves keep accumulating. All this makes for excellent fuel for any fire. Hence, there is combustible material everywhere and even a single strike of lightning or a cigarette butt can start off a big fire.

Given this, it is very important to let small forest fires run, so that all the combustible material that can lead to a big forest fire keeps getting burnt out. There is a striking example of the impact different fire control policies can have. The states of California in the United States and Baja California in Mexico have very similar vegetation and forests but different fire control policies. California puts out small fires regularly. Baja California does not. Hence, Baja California sees many small fires. But there are no big fires. On the other hand,

California has few small fires, but it experiences big fires. This is primarily because California keeps putting out small fires which leads to bigger fires. Smaller fires clear the brush, enrich the soil, and also unlock pine seeds.

As John Mauldin and Jonathan Tepper write in Endgame — The End of the Debt Supercycle and How It Changes Everything : “Global markets and economies are like forest fires…Avoiding small problems creates greater systemic problems when the brush between the trees build up…Trying to micromanage small fires in central banking and fiscal policy leads to growing confidence by risk takers, so you get fewer small fires and paradoxically a greater chance of a major catastrophic fire.

Same mistakes As we have seen throughout the book, the Federal Reserve has been dousing small fires constantly. And the dousing of these small fires led to the big fire of 2008. Ironically, the Federal Reserve continues to douse small fires. The mistakes that led to the crisis are being made again. Trying to prop up the housing market and not allowing the housing prices to fall as fast as they would have, is a part of the Fed strategy of dousing fires.

In fact, central banks around the developed world cut interest rates to close to zero percent after the crisis started and have since maintained them. This is the exact opposite of what Walter Bagehot had suggested.

Keeping in mind the issue of moral hazard, he had suggested that the Bank of England should be lending money at a very high rate of interest so as to keep speculators away.

Western central banks have kept interest rates at very low levels and allowed speculators to borrow at very low rates of interest. This has led to bubbles in stock markets and other financial markets all over the world.

A major factor that leads to banks or financial institutions being rescued is the fact that over the years, not enough of them have been let go. So, we do not really know clearly enough how things are likely to play out when a bank or financial institution is allowed to go bust. Sadly, unlike the physical sciences, wherein things can be tested out in a laboratory, the same cannot be done in the case of economics. Any learning has to occur from real life.

But a recent example does offer some learning on this front. Several of the biggest banks in Iceland went bust in October 2008. The country instead of bailing them out let them fail. It is now doing much better in comparison to other countries in Europe, which bailed out their banks, in particular, Ireland. As Mark Blyth writes in Austerity—The History of a Dangerous Idea : “Iceland not only survived letting its banks go bust, it became a healthier and more equal society in doing so.”

The Iceland example Of course, Iceland is a small country. But what we should be looking at is the fact that the banks that were allowed to fail were 10 times the size of the economy. As Blyth writes: “Although Iceland tiny, what matters in this case is not the size of the country, or its population, but the size of the banks relative to the size of the economy, its bank-assets-to-GDP ratio. In the United States that ratio was just over one to one. Iceland had 10 times the bust of the United States’ worst-case-ever scenario and it not only survived, it prospered.”

In fact, an interesting analogy from football can be used to explain why it is difficult to let banks and other financial institutions fail. A goalkeeper trying to save a penalty jumps toward his left or the right all the time. He stays at the center only 6.3 percent of the time, research points out, even though, 28.7 percent of the time the penalty taker is likely to blast the ball … toward the center of the goal.

Hence, goalkeepers are more likely to save the goal if they stay where they are and do not jump to their left or right. The trouble is that this strategy will make them look smart only on those occasions when the ball is hit straight. But they are likely to be very embarrassed when the ball hits the back of the net on either their left or right.

So, when banks and financial institutions are in trouble, the governments and central banks need to show that they are making an effort to save them. Letting them fail is a very difficult option because then they will be accused of not trying. And no government or central bank would want to be in that situation.

MEET THE AUTHOR

Vivek Kaul has worked at senior positions with the DNA and The Economic Times. His writings have appeared across various other publications including The Times of India, The Hindu and Business Line, Currently, he is a columnist for Firstpost.com

With permission from Sage India

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