Not long ago, a group of distinguished regulators and executives from some of the world's largest financial institutions convened at the Haas School of Business at the University of California at Berkeley to debate the intriguing question of who controls global capital markets. The consensus was that no one does. Today's financial markets are too big, too complex, and too interdependent to be controlled by any single actor, private or public. Even cooperation among central banks may not be enough to guarantee desired outcomes. Is the lack of control over global capital markets a cause for concern? Yes, at least in some circumstances.
Under normal conditions, financial markets behave efficiently to direct scarce capital resources to their best uses while allowing individual investors to adjust their portfolios in accordance with their tastes for risk, return, and current vs. future income. And under normal circumstances, financial markets, like other markets, are self-stabilizing. When prices of particular assets rise, demand tends to fall, and when prices of the same assets fall, demand tends to rise. In developed capital markets such as those in the U.S., regulatory and supervisory agencies promote the timely provision of credible information, curtail excessive risk-taking, and penalize dishonest behavior.
ROUND THE CLOCK. By expanding the knowledge available to market participants and reducing the cost of market transactions, new information technologies have further enhanced the efficiency and stability of financial markets under normal conditions. Moreover, such technologies have enabled the development of sophisticated new instruments to unbundle risks and allocate them to the market players who are most willing and able to bear them. As the regulators at the Haas conference remarked, new information technologies have enabled the development of more effective risk management and supervisory procedures.
But the new technologies have not reduced the volatility of financial markets. Indeed, the opposite appears to be the case. Asset prices have always fluctuated much more than the fundamentals on which they are supposedly based. Better access to knowledge about these fundamentals through round-the-clock, round-the-world information sources has only intensified these fluctuations. Nor have better access to market information and sophisticated risk-management tools eliminated sharp, unpredictable reversals in confidence and destabilizing market behavior.
The last decade has given us several periods of frenzied, shortsighted, and self-destructive binges of asset inflation or deflation large enough to threaten macroeconomic stability. Such largely unexpected and inexplicable disturbances have rocked currency, equity, and real estate markets.
Of course, financial crises are as old as financial markets themselves. And recent crises, including those in U.S. equity markets in 1987, European currency markets in 1993, Mexico in 1995, and the emerging market economies in 1997-98 indicate that appropriate policy responses can contain their destabilizing tendencies and real-economy effects.
RUSH TO THE DOOR. But policymakers failed to predict these crises and were highly uncertain about the effectiveness of their remedies. And by intervening to limit destabilizing downward movements in asset prices while failing to take action against destabilizing upward movements, policymakers may be inadvertently encouraging excessive risk-taking, thereby increasing the likelihood of future crises.
The experts who gathered at the Haas conference were not optimistic that new information technologies would enhance the ability of market participants and policymakers to predict reversals in financial markets. At the same time, they agreed that such technologies may well aggravate crises when they arise. Immediate access to information about market trends, combined with the reduced cost of trading, mean that when market confidence begins to falter, investors can easily see their colleagues rushing to the door and quickly join the global race to get there first.
The benefits of new information technologies, like all new technologies, ultimately depend on the wisdom of the human beings who design and use them. When investors fail to act prudently, the same technologies that promote greater efficiency can encourage greater market volatility, increase the likelihood of destabilizing behavior, and intensify the magnitude of recurrent disturbances in the world's capital markets.