Sand in Machine Makes a Stable Market: Mark Buchanan

(Corrects ninth paragraph in article published yesterday to say option instead of futures contract.)

Aug. 25 (Bloomberg) -- Efficiency is generally a good thing. We don’t want our car engines to waste fuel through internal friction or the heat from our furnaces to slip out the window.

Yet there are limits to efficiency’s virtue. It’s no good having a lightweight super-efficient engine that melts when it heats up, or clatters into pieces on a bumpy road. For any technology, too much efficiency can compromise properties that are required for stability. And stability matters, too.

The same is true in the world of finance. Every modern economy depends on financial markets to efficiently harness the “wisdom of crowds” to funnel capital into the most worthwhile enterprises. But we also want markets to be stable enough not to periodically collapse or fall into fits of wild gyration.

Following the analogy with engines, we might wonder: Is there a relationship between efficiency and stability in the marketplace? Strangely, standard economic theories don’t address this basic question.

The prevailing explanations of market behavior say plenty about efficiency. For about 50 years, they have rested on the idea that markets gather and use information very well, and that markets become ever more finely tuned as participants gain access to a bigger set of instruments in which to invest. Efficient-market theory suggests, in particular, that financial derivatives should make markets more “complete,” moving them toward an efficient ideal in which investors can craft their positions with unlimited precision.

Stability is another matter. In a 2004 report for Goldman Sachs Group Inc., the economists R. Glenn Hubbard and William Dudley argued that the rise of derivatives made capital markets more efficient than ever, partly by making it much easier for banks to manage their risks. “This ability to transfer risk facilitates greater risk-taking,” they argued, “but this increased risk-taking does not destabilize the economy.”

Derivatives Erode Stability

History didn’t agree. Neither have other recent studies that have examined the relationship between market efficiency and stability. They suggest, contrary to free-market cheerleading, that insofar as derivatives make markets more efficient, they also erode their stability and ultimately lead to financial crises. In other words, the ideal of perfectly efficient markets may also be one of perfectly unstable markets.

One problem, as identified five years ago by the economists William Brock, Cars Hommes and Florian Wagener, is that derivatives tend to amplify any volatility that occurs when people chase after the latest investing strategies.

The simple logic of their argument begins with the way investors use derivatives to hedge risk. For example, you may want to buy Google Inc. stock, but worry that its value might plummet if another company comes up with a better search engine. To protect yourself, you buy an option giving you the right to sell the Google stock at a fixed price sometime in the future. You may never exercise this option, but having it means you can’t lose too much even if the stock price falls to a penny a share.

Reducing risk seems like a good thing, but when investors face lower risks, they are generally willing to invest more money and make larger bets. This naturally creates bigger differences between the payoffs and losses, and leads investors to move still more quickly from one fund or strategy to another. Hence, the very act of reducing some risk invites greater market volatility.

Other research suggests that efficiency may bring on instability in an even more fundamental way. This has to do with the notion of economic equilibrium, a state of balance achieved when all actors in the marketplace behave in their own rational self-interest. According to theory, any disturbance to the economy should stir up incentives for more action -- forces that restore equilibrium.

Working with economists’ standard models of equilibrium, the Italian physicist Matteo Marsili has explored how market stability changes as it comes to include a large number of financial firms selling derivatives. Because these investments come with risks, purchasers hedge their bets by trading assets with one another.

Complicated Hedging

Marsili’s mathematical analysis confirms that as the number of different derivatives increases, the financial firms can hedge their risks more effectively, so the market gets more efficient -- just as the prevailing theory suggests. At the same time, however, as hedging becomes ever more complicated, instability creeps in. With more and more derivatives, financial firms have to quickly readjust their holdings to remain fully hedged.

As the market becomes more precarious, tiny shocks lead to increasingly large consequences. The market remains in equilibrium, but just barely, like a pencil balanced upright on your fingertip. In the limit, as markets reach the ideal of perfect efficiency, they become utterly unstable. (Some further technical discussion of the work of Marsili and of Brock and colleagues can be found on my blog.)

This conclusion has always been implicit in the models economists use but, as Marsili points out, “Their emphasis has always been on efficiency. As far as I know no one has really looked at stability.”

Instead, economists have generally considered financial crises to arise from market failures. For example, poorly designed incentives might lure managers to act against the best interests of their firms, because they personally profit from doing so. Or, powerful firms might find ways to manipulate market outcomes, moving the market away from the perfectly competitive and efficient ideal. But if instability is a central condition of efficiency, we should think anew about how to prevent episodic crises. Traditionally, anything that brings greater efficiency -- more derivatives, freer markets, less regulation -- has been considered beneficial. But efficiency is only part of the story.

Ensuring market safety may require some throwing of sand into the machinery, giving up a little efficiency to gain greater stability. The sand might, for example, take the form of a tiny tax on speculative trading. The trouble is, such a tax might turn out to reduce efficiency without actually improving stability, as some economists have argued. We don’t yet know.

What is clear is that no solution can emerge from models that neglect the importance of stability, and count efficiency as the sole measure of economic health.

(Mark Buchanan, a theoretical physicist and the author of “The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You,” is a Bloomberg View columnist. The opinions expressed are his own.)

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