Inside Money, Procyclical Leverage, and Banking Catastrophes

We explore a model of the interaction between banks and outside investors in which the ability of banks to issue inside money (short-term liabilities believed to be convertible into currency at par) can generate a collapse in asset prices and widespread bank insolvency. The banks and investors share a common belief about the future value of certain long-term assets, but they have different objective functions; changes to this common belief result in portfolio adjustments and trade. Positive belief shocks induce banks to buy risky assets from investors, and the banks finance those purchases by issuing new short-term liabilities. Negative belief shocks induce banks to sell assets in order to reduce their chance of insolvency to a tolerably low level, and they supply more assets at lower prices, which can result in multiple market-clearing prices. A sufficiently severe negative shock causes the set of equilibrium prices to contract (in a manner given by a cusp catastrophe), causing prices to plummet discontinuously and banks to become insolvent. Successive positive and negative shocks of equal magnitude do not cancel; rather, a banking catastrophe can occur even if beliefs simply return to their initial state. Capital requirements can prevent crises by curtailing the expansion of balance sheets when beliefs become more optimistic, but they can also force larger price declines. Emergency asset price supports can be understood as attempts by a central bank to coordinate expectations on an equilibrium with solvency.Comment: 31 pages, 10 figure

Jigsaw percolation: What social networks can collaboratively solve a puzzle?

We introduce a new kind of percolation on finite graphs called jigsaw percolation. This model attempts to capture networks of people who innovate by merging ideas and who solve problems by piecing together solutions. Each person in a social network has a unique piece of a jigsaw puzzle. Acquainted people with compatible puzzle pieces merge their puzzle pieces. More generally, groups of people with merged puzzle pieces merge if the groups know one another and have a pair of compatible puzzle pieces. The social network solves the puzzle if it eventually merges all the puzzle pieces. For an Erd\H{o}s-R\'{e}nyi social network with $n$ vertices and edge probability $p_n$, we define the critical value $p_c(n)$ for a connected puzzle graph to be the $p_n$ for which the chance of solving the puzzle equals $1/2$. We prove that for the $n$-cycle (ring) puzzle, $p_c(n)=\Theta(1/\log n)$, and for an arbitrary connected puzzle graph with bounded maximum degree, $p_c(n)=O(1/\log n)$ and $\omega(1/n^b)$ for any $b>0$. Surprisingly, with probability tending to 1 as the network size increases to infinity, social networks with a power-law degree distribution cannot solve any bounded-degree puzzle. This model suggests a mechanism for recent empirical claims that innovation increases with social density, and it might begin to show what social networks stifle creativity and what networks collectively innovate.Comment: Published at http://dx.doi.org/10.1214/14-AAP1041 in the Annals of Applied Probability (http://www.imstat.org/aap/) by the Institute of Mathematical Statistics (http://www.imstat.org

Coupled catastrophes: sudden shifts cascade and hop among interdependent systems

An important challenge in several disciplines is to understand how sudden changes can propagate among coupled systems. Examples include the synchronization of business cycles, population collapse in patchy ecosystems, markets shifting to a new technology platform, collapses in prices and in confidence in financial markets, and protests erupting in multiple countries. A number of mathematical models of these phenomena have multiple equilibria separated by saddle-node bifurcations. We study this behavior in its normal form as fast--slow ordinary differential equations. In our model, a system consists of multiple subsystems, such as countries in the global economy or patches of an ecosystem. Each subsystem is described by a scalar quantity, such as economic output or population, that undergoes sudden changes via saddle-node bifurcations. The subsystems are coupled via their scalar quantity (e.g., trade couples economic output; diffusion couples populations); that coupling moves the locations of their bifurcations. The model demonstrates two ways in which sudden changes can propagate: they can cascade (one causing the next), or they can hop over subsystems. The latter is absent from classic models of cascades. For an application, we study the Arab Spring protests. After connecting the model to sociological theories that have bistability, we use socioeconomic data to estimate relative proximities to tipping points and Facebook data to estimate couplings among countries. We find that although protests tend to spread locally, they also seem to "hop" over countries, like in the stylized model; this result highlights a new class of temporal motifs in longitudinal network datasets.Comment: 20 pages, 4 figures, plus a 6-page supplementary material that contains 5 figures. Accepted at Journal of the Royal Society Interfac