500 Words — Day Forty Two: Cascading Failure
In an interconnected system, the failure of a single, small subsystem can throw the entire system out of balance and cause the entire thing to collapse. In economics, the risk of cascading failures is referred to as systemic risk. The idea of some entity being too big to fail suggests that the entity in question would introduce too much systemic risk if it were allowed to collapse. Rather than risk the collapse of the system, such entities are propped up to maintain enough stability in the system to return to some equilibrium. The hope would be to reduce the amount of risk concentrated in such entities to prevent cascading failure in the event of future faults.
So, why talk about cascading failure now? Well, in the past we have had major catastrophes that required governments to intervene and prop up institutions to survive the threat of cascading risk via the failure of key institutions. These were of course the coronavirus epidemic starting in March of 2020 and the Great Financial Crisis of 2008. However, it is important to note that not everyone was saved in either of these events. Again, an strongly interconnected system can survive the failure of minor entities as long as they don’t pose a large enough risk to the system’s overall stability. This meant banks were saved in 2008 versus subprime homeowners who lost their homes and in some cases their jobs. This meant some key important industries such as airlines were saved while other businesses like restaurants and gyms were sacrificed in the name of preserving the system. The smallest businesses being the most effected. And here we are still standing.
But given the current war between Ukraine and Russia, and the nuclear level sanctions that are starting to be implemented by the European Union and the United States on Russia, we threaten to undermine the overall global economic ecosystem. This sanctions threaten to annihilate the stability of Russia’s economy and the stability of their country overall. Russia is essentially being completely isolated from the global banking network by being disconnected from the SWIFT communications network and Russian assets external to Russia are being seized and frozen from their owners. In less than a week, Russia’s currency has experienced major collapse and their bonds are now being rated as junk. Stocks of Russian companies were trading at pennies to the dollar on exchanges around the world. Flights from Russia are being banned. The outside world is closing itself from Russia and Russia seems doomed to the path of complete economic doom. Perhaps this is fair given their position as the aggressors in this conflict, but is Russia too big to fail?
Russia was one of the top producers of energy in the world and energy exports are a huge portion of its economy. Europe is experiencing an energy problem and is in desperate need of energy while transitioning to green energy that isn’t filling in the demand gap as quick as they need it to. An increased demand for fossil fuels has meant increased energy prices. The United States is also following a similar energy policy but is in a less ominous position. But what impact do massive energy cost spikes have? It’s hard to say. But couple increased costs with inflation and reduced sales by banning sales to Russia and a slowing economy and the risk for stagflation exists. Of course, perhaps we can save ourselves by propping up other cogs in the overall system and hope that we can stabilize the shock this ultimately creates.