The Strange Dynamics of Crises

Felix Salmon of Reuters has an interesting post yesterday on the possible dynamics leading to a default on municipal debt. He was riffing on comments made by the banking analyst Meredith Whitney on 60 Minutes. What was interesting to me is how well he captured the strange dynamics behind a possible scenario in which multiple municipalities default on their debt. Whitney is certain there will be many defaults, but Salmon quotes the arguments of others pushing back with all the reasons why the probability is small that any individual muni would choose default. But then Felix Salmon writes “The problem with this line of argument is that it ignores the way in which the correlations all go to 1 in a crisis.” He goes on to explain.

Rick Bookstaber, now of the SEC, provided a similar explication of the strange dynamics of market crises in a post on his blog back in June. In a crisis, all the dynamics suddenly change dramatically.

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