Saturday, January 10, 2009

Forever blowing bubbles

In a Wall Street Journal op-ed (PDF) Paul Rubin* suggests that bubbles and crashes are a natural part of capitalist markets. More to the point, the very factors that have recently increased the efficiency of markets – notably the internet – have also facilitated the formation of bubbles.

Technology is double-edged, as always: the internet facilitates both the functioning and malfunctioning of markets. Of course, the difference between function and malfunction is in the eye of the beholder. As John Sterman famously said, “There are no side effects—only effects.”

While this is a perennial problem, the internet may have caused a qualitative change in the degree of interconnection, which leads to significantly less resilience. Note the paradox: The internet is more resilient as a communication system, but it causes the systems that use it to be less resilient.

The corollary is that regulators face an impossible task: one can’t eliminate the downsides of the internet without simultaneously eliminating the benefits.

My study of the complex adaptive systems literature leads to the same conclusion:
  • more interconnected systems are less resilient
  • crashes are healthy, because they allow new entrants to flourish
  • the regulatory task is not to avoid crashes (this just makes the eventual correction worse) but to manage them
As if the regulatory job weren’t tough enough, the political challenge is even harder. “This should never happen again” are the first words out of a politician’s mouth after a catastrophe. That’s what people want to hear, but it’s not realistic – and not desirable either. It will surely happen again, and it’s necessary for renewal and innovation. Managing crashes includes both reducing their severity and mitigating their impacts.

[*] Paul Rubin is a professor of economics and law at Emory University and a senior fellow at the Technology Policy Institute. He served in a senior position in the Federal Trade Commission in the 1980s.


Shafeen Charania said...

Hi Pierre,

Great point about the paradoxical nature of communication on the internet. I think we are in the midst of the communication revolution (industrial to information to communication), and are still grappling with its implications.

The industrial revolution created mechanical speed; the information revolution changed space (specifically, the distance between points in space); and the communication revolution changed time, in this case response time, which as you say creates problematic effects when the "system" can't keep up with the pace of awareness and action that individuals can take.

One more thing - I think the role of regulators should also (or maybe only) be to ensure integrity. The system (whether at a high or a low) should always behave with integrity, and the only player in the system that can ensure that is the regulator. If the system is failing, it's because it should, and if we attenuate the ripple effects too much, I don't believe we learn from our mistakes. Then we end up back where we started.

I also think mistakes are generational. It doesn't seem to me that the benefit translates well beyond that - so we need to keep making them, and feeling their effects fully to make them stick as much as possible:).

I plan to write about this at some point:)

Pierre de Vries said...

Very interesting thoughts as always, Shafeen; thank you.

Could you say more about what you mean by "integrity"? Presumably ensuring integrity doesn't mean that the regulator prevents disintegration; rather, I assume you're pointing to honesty, adherence to moral and ethical principles, etc.

In a limited sense, that means observing the laws, which is the role of the judiciary, not the executive. More broadly, it might refer to establishing norms and encouraging players to observe them through the hallowed techniqe of "raised eyebrow".

Shafeen Charania said...

Hi Pierre -

Yes - I meant the latter, though with a bit more punch than the raised eyebrow:). There's this concept in the Canadian legal system (not sure if the American BAR does the same thing) that requires all members (lawyers, judges, etc.) to never act in a way that puts the system in disrepute.

I think that's a powerful ideal, but tough to police, especially in the financial markets (where 'creativity' is at a premium), and accountability less so.

One approach could be to create some kind of insurance fund that the "members" pay into with a percentage (say 25% of gross) of their commissions, and a dividend is returned to those whose clients have not been disadvantaged (the $ would have to be held for a couple of years to account for time-related effects). The advantage of that would be a more long-term perspective on the part of the dealers, etc. as well:).

Not sure this type of approach has possibilities, but I was trying to conceptualize something that would be as easy to police as possible, and yet carry a meaningful motivation for the players.