Friday, July 17, 2009

SINGAPORE, April 27 (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. 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 organise 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.

And while specialisation in global supply chains has brought significant efficiency gains, it has also brought vulnerability. Disruption to a key node in the supply chain can cause dramatic and unpredictable turbulence in the whole system.

This was why global semiconductor prices nearly doubled following an earthquake that hit Taiwan in 1999, and why Hurricane Katrina spread turbulence throughout world markets.

Security analysts also worry that even a single terrorist attack could have a magnified impact if it targets a key point in global supply chains -- for example, a major port.

In his book "The Black Swan", which examines the impact of major unexpected events, Nassim Nicholas Taleb noted that the appearance of stability in complex systems can be illusory:

"Random insults to most parts of the network will not be consequential since they are likely to hit a poorly connected spot. But it also makes networks more vulnerable... Just consider what would happen if there is a problem with a major node.

"True, we have fewer failures," he wrote. "But when they occur... I shiver at the thought..."


The complexity that makes financial shocks more potentially dangerous also means that pandemics can wreak greater havoc.

Analysts point out that when the Black Death plague hit Europe in the 14th century, killing around a third of the population, society did not collapse, because economic and social systems were relatively simple and so insulated from shocks.

By contrast, a plague that hit the Roman empire in the 2nd century, with a similar death rate, caused chaos -- Roman society was much more complex and economically advanced.

In modern society, if key nodes are taken out by disease, the impact could be magnified exponentially. The "nodes" could be people essential to the functioning of society and the economy -- doctors, truck drivers, engineers, port workers.

And just as with financial crisis, herd behaviour, panic and the spread of inaccurate or incomplete information could provide negative feedback loops, making the catastrophe even worse.

"Economic disruptions on the supply side would come directly from high absenteeism... There may also be disruptions to transportation, trade, payment systems and major utilities," the IMF said in a 2006 report on the impact of a global flu pandemic.

And beyond the immediate catastrophe, an overriding risk from both the financial crisis and any pandemic is that it causes a worldwide retreat from globalisation, with profound long-term consequences for the world economy.

In its 2007 report on global risks, the World Economic Forum imagined the consequences of a simultaneous pandemic and global liquidity crisis -- a scenario that was purely speculative then but which now seems eerily prescient.

The result, it said, would be "a backlash against globalisation, which in turn compounds the hit on global demand". Across the world, it said, increased militarism and authoritarian tendencies would reshape global geopolitics.

The events of the next few months may show just how accurate such a scenario could be.

(Editing by Bill Tarrant)
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