Chasing the Dragon

Kevin just posted about a great article by Felix Salmon in Wired.  I underlined three quotes in my reading of it:

  1. “Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus.” (Tavakoli)
  2. “…the real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.” (Salmon)
  3. “Co-association between securities is not measurable using correlation…. Anything that relies on correlation is charlatanism.” (Taleb)

The take-away I get from this is that boom-bust cycles are inevitable.  Forget about protecting against the last one happening again, it won’t.  The next one is unpredictable, a black swan.  The longer we go on without one, the bigger and more certain the next one.  Taleb even argues that because of the increasing complexity, interdependence and information feedback in the global financial system, the frequency and magnitude are increasing.

The question becomes (in my mind), can we keep these cycles from having far-reaching collateral damage to “innocents”, and snowball effects as we are experiencing now?

Is there a way to let the air out of the tires every so often, sort of a controlled burn, possibly trading higher frequency for lower magnitude?

Psychologically, we are wired to fear change and desire stability and predictability.  But it seems that the illusion of stability and predictability is what gets us into trouble.

I only have the vaguest notion of what an economic controlled burn policy would look like, but the idea is that every so often (perhaps unpredictably) we change the rules and incentives that govern the financial markets.  It wouldn’t be so important how they are changed, but rather that they are changed.  Keep the markets (and by this I mean the market participants) on their toes, always reacting to and trying to figure out how to game the new system, but never actually reaching that point.

  • Jill B.

    Hi Rafe,

    Just noticed your blog full of interesting ideas. I think you’re right about changing up the rules. I’ve probably already mentioned this to you, but I’ll risk repetition. My gut (so far my best economic advisor) says that after the 2001 downturn was when monetary policy got out of whack with excessive monkeying around with interest rates. The interest rate lever became a reflex action, rather than a thoughtful approach to economic stability. With traditional safe haven instruments unable to produce adequate returns, the race was on for instruments that could. Credit default swaps were a natural outcome with “theoretically” low risk and good returns.

    From my experience, Wall Street loves to embrace theories. It’s like their religion. They can’t seem to really accept the randomness of financial systems (and human behavior), even though they say they believe in efficient markets. It’s like an atheist with rosary beads.

    The market loves to put things into black box models that make sense. Before they were called quants, they were called “chartists”–those with the belief that history essentially repeats itself, trying to create order out of chaos. Life and economic systems are messy and unpredictable. That’s a message that doesn’t sell financial products.

  • kevindick

    Actually, the article is by Felix Salmon, not Tyler Cowen. Tyler was just the person who pointed me to the article.

    As for boom and bust cycles, I certainly agree that they are inevitable in a market economy at anything near our current level of technology.

    IMHO, the best thing to do is commit to a generic countercyclical plan then really stick to that plan. It’s important that it be generic and you not make case-by-case exceptions. Otherwise, you create uncertainty in people’s expectations that just makes things worse.

    For example:

    – We will never bail out any non financial institution. You become insolvent, you go bankrupt. Period. Full stop. Don’t bother asking. Goodbye.

    – For, financial institutions, here’s what we do if you become insolvent. We wipe out all your stockholders. We convert all your bondholders to stockholders. We put you in receivership and guarantee your counterparty obligations. If you become solvent again within X amount of time and stay solvent for Y amount of time, you come our of receivership. If not, we assume your counterparty obligations and liquidate you.

    – Here is the schedule by which we adjust payroll taxes in response to the GDP growth rate (far enough negative and they become zero).

    – Here is the schedule by which we extend unemployment benefits in response to the unemployment rate.

    – If you believe in a Keynesian multiplier on government expenditures of > 1, here is the schedule by which we increase deficit spending in respond to GDP contraction.

  • I like the countercyclical concept, but I wonder if the certainty doesn’t lead it open to gaming ipso facto.

    For instance, under the above regime, it doesn’t make sense to become an institution. Rather, you find a front man to aggregate all the capital and cut side agreements on how profits are split (i.e. simulate equity participation). Then you hide behind personal bankruptcy laws. This may not be the right way to game it, but the point is there will be lots of pressure and a clear target with infinite time to game it.

    This is why I think that uncertainty is our friend here. We could insist that all stochastic policy changes be countercyclical in nature though.

  • kevindick

    We already have a pretty good framework of liability, banking, and securities laws to prevent this.

    I’d rather see the uncertainty put in the day-to-day regulatory regime than the bubble response regime. There’s been some research to show that this works. This typically means you have “spirit of the law” rather than “letter of the law” regulations.

  • I would be interested in seeing the research you refer to.

    [ps, I fixed the reference error.]

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