Sand in the Machine the Key to Stable Markets- Mark Buchanan - Bloomberg

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Sand in the Machine the Key to Stable Markets: Mark

BuchananBy Mark Buchanan - Aug 24, 2011

(Corr ects nint h parag raph in a rticle published y esterday to say option in stead of futu res

contract.)

Efficiency is genera lly a g ood thing . We don’t w an t our car engines to waste fuel through

interna l friction or th e heat from our furn aces to slip out the w indow .

Yet th er e a re lim it s t o efficien cy ’s v ir tu e. It’s n o g ood h av in g a lig h tw eigh t su per-effic ientengine th at m elts w hen it heats up, or clatt ers into pieces on a bum py road. For a ny

technology , t oo mu ch efficiency can com prom ise properties tha t a re r equir ed for stability .

A nd sta bi li ty m a tter s, too.

The sam e is tru e in th e world of finan ce. Ev ery m odern economy depends on finan cial

m ar kets to efficient ly ha rn ess th e “w isdom of crow ds” to fun nel capital in to th e m ost

w orth w h ile en ter pr ises. But w e a lso w an t m a rket s t o be sta bl e en ou gh not to per iodic ally

collapse or fall int o fits of wild g y ra tion.

Follow ing th e ana logy w ith eng ines, w e m ight wonder: Is there a r elationship betw een

efficiency an d stability in th e m ar ketplace? Strang ely , standar d economic th eories don’t

addr ess th is basic qu estion.

The prev ailing explana tions of ma rket behav ior say plenty about efficiency . For about 5 0

y ea rs, th ey h a v e rested on th e idea th a t m a rket s g a th er and u se in for m a tion v er y w el l,

and th at m arkets becom e ev er m ore finely tun ed as par ticipan ts gain access to a bigger set

of instrum ents in w hich t o inv est. Efficient-ma rket th eory sug gests, in part icular , tha t

financial deriv ativ es should m ake m arkets more “com plete,” m ov ing th em towa rd anefficient ideal in wh ich inv estors can cr aft th eir positions w ith u nlim ited precision.

Stability is another m atter. In a 2 004 report for Goldma n Sa chs Group Inc., t he economists

R. Glenn Hu bbard and Wil lia m Dudley arg ued that th e rise of deriv ativ es m ade capital

m arkets m ore efficient tha n ev er, partly by m aking it m uch easier for banks to m anag e

their r isks. “Th is ability to tra nsfer risk facilitates gr eater risk-taking ,” th ey ar gu ed, “but

th is increased risk-ta king does not destabilize th e econom y .”



Derivatives Erode Stability

History didn’t agr ee. Neither h av e other r ecent studies tha t ha v e exam ined the

relationship between m ar ket efficiency and stability . They sug gest, contr ar y to

free-m arket ch eerleading, th at insofar as deriv ativ es m ake m ar kets m ore efficient, they

also erode their stability an d ultim ately lead to finan cial cr ises. In other w ords, the ideal of

perfectly efficient m ar kets m ay also be one of perfectly un stable m ar kets.

One problem , as identified fiv e y ears ag o by th e econom ists William Brock, Cars Hom m es

and Florian Wa gener, is that deriv ativ es tend to am plify any v olatility that occurs when

people cha se after th e latest inv esting str at egies.

The sim ple logic of their arg um ent begins with the w ay inv estors use deriv ativ es to hedge

risk. For exam ple, y ou m ay wa nt to buy Google Inc. stock, but worry that its v alue m ight

plum m et if another company com es up w ith a better sear ch eng ine. To protect y our self,

y ou bu y an opt ion g iv in g y ou th e r igh t to sell th e Google stock at a fixed pr ic e som et im e in

the futur e. You m ay nev er exercise this option, but h av ing it m eans y ou can ’t lose too

m uch ev en if the stock price falls to a penny a shar e.

Reducing risk seem s like a g ood thing , but w hen inv estors face low er risks, th ey ar e

generally wil l ing to inv est m ore m oney and m ake larger bets. This natu rally creates

bigger differen ces betw een th e pa y offs an d l osses, a nd lea ds in v est ors t o m ov e still m ore

quickly from one fund or strat egy to another . Hence, the v ery act of reducing som e risk

inv ites greater m arket v olatility .

Other research suggests that efficiency m ay bring on instabil ity in an ev en m ore

fundam ental w ay . Th is ha s to do with the n otion of economic equilibrium , a state of

ba lance a ch iev ed w h en all a ctors in th e m arket place beh av e in th eir ow n rational

self-interest. A ccording to theory , an y distur bance to the economy should stir u p incentiv es

for m ore a ction -- forces th at restore equilibr ium .

Working w it h ec onom ists’ standa rd m odels of equili br iu m , th e Ita li an ph y sicist Matteo

Marsili has explored how m ar ket stability chan ges as it com es to include a la rge n um ber of

finan cial firm s selling deriv ativ es. Because these inv estm ents com e with risks, pur cha sershedge their bets by tra ding assets w ith one another.

Complicated Hedging

Marsili’s m ath em atical an aly sis confirm s tha t as the nu m ber of different deriv ativ es

increases, th e finan cial firm s can hedge their r isks m ore effectiv ely , so the m ar ket gets

m ore efficient -- just as the prev ailing th eory sug gests. At t he sam e time, h ow ev er, as

hedging becom es ev er m ore com plicated, instability creeps in. With m ore an d m ore



deriv ativ es, fina ncial firm s ha v e to quickly readjust their holdings to rem ain fully hedged.

A s t h e m arket becom es m ore pr ec a r iou s, tiny sh ocks lea d to increa singly lar ge

consequences. Th e m ar ket rem ains in equilibrium , but ju st bar ely , like a pencil balanced

uprigh t on y our fing ertip. In th e limit, a s ma rkets reach th e ideal of perfect efficiency , th ey

becom e u tter ly u nsta bl e. (Som e fu r th er tec h nical discu ssion of t h e w ork of Ma rsili and of

Brock an d colleagu es can be foun d on m y blog .)

Th is conclu sion h as alw ay s been im plicit in th e m odels econom ists use but , as Mar sili points

out, “Th eir em phasis ha s alway s been on efficiency . A s far as I know no one h as really

looked at stability .”

Instead, econom ists hav e genera lly considered fina ncia l crises to ar ise from m ar ket

failures. For exa m ple, poorly designed incentiv es m ight lur e m ana gers to act ag ainst the

best in ter est s of th eir firm s, beca u se th ey per sona ll y pr ofit fr om doing so. Or , pow er fu l

firm s m ight f ind way s to m anipulate mar ket outcom es, m ov ing the m arket awa y from theperfectly com petitiv e and efficient ideal. But if instability is a cent ra l condition of

efficiency , w e should think anew about how t o prev ent episodic crises. Tr aditiona lly ,

any thin g th at bring s great er efficiency -- m ore deriv ativ es, freer m ar kets, less regu lation

-- ha s been considered beneficial. But efficiency is only par t of th e story .

Ensuring m arket safety m ay require som e throwing of sand into the m achinery , giv ing u p

a little efficiency to gain gr eater stability . Th e san d m ight, for exa m ple, take th e form of a

tiny tax on speculativ e trading. The tr ouble is, such a tax m ight tu rn out to reduce

efficiency w ithout actu ally im prov ing stability , as som e economists ha v e argu ed. We don’t y et know .

Wh a t is clea r is th at no solu tion ca n em er ge fr om m odels th a t neg lec t th e im por ta nce of

stability , a nd coun t efficiency as the sole m easur e of economic h ealth.

(Mark Buchan an, a th eoretical phy sicist an d the aut hor of “The Social Atom: Why the Rich

Get Richer , Ch eater s Get Cau gh t an d Your Neigh bor Usually Looks Like You,” is a

Bloom berg V iew colum nist. Th e opinions expressed are h is ow n. )

Read m ore Bloom berg V iew colum ns.

To conta ct the wr iter of this article Mar k Buch an an a t bucha na n.m ar k@gm ail.com

To conta ct th e editor responsible for t his ar ticle: Mar y Duen w ald at

[email protected]

®2011 BLOOMBERG L.P. ALL RIGHTS RESERVED.

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Sand in the Machine the Key to Stable Markets- Mark Buchanan - Bloomberg