History Repeats: when Will Financial Markets Ever Learn?

Listener 21 November 1998.

Keywords: Business & Finance

Desperately keen to go to a film in a fire-prone theatre, you choose a seat which gives you a good view, near an exit. A fire starts during the screening. You head for the door, and are crushed as everyone else does too. Your mistake is the “fallacy of composition”: that which applies for the individual, may not apply if every individual acts on it. One of my earliest lessons in economics seems forgotten today.

It was forgotten in computer trading, which gave a guaranteed return based on the investor selling out if the share fell to a certain point. The idea was so simple a computer could do it. Everyone did it, so when the share dropped to the trigger point, they tried to sell, could not, share prices plunged, and the 1987 US share market collapsed.

You would think they would learn, but no. The enthusiasm switched to hedge funds, which trade complicated financial assets (derivatives). The most prestigious was Long Term Capital Management (LTCM), not least because of its board of directors included two financial economists awarded the 1997 Nobel prize in economics for a sure-fire investment strategy for hedge funds. This time the call of “fire” was in the Russian markets, LTCM (motto – “there wasn’t any”) could not liquidate its position in the way the equations assumed and …

We are not sure what comes after the “and”. Optimists hope that a bank financed rescue plan will work, and the financial instability – most evidently seen in the $US to Yen exchange rate as financiers rapidly unwound their hedges – is but a temporary disturbance. Pessimists think that the LTCM plunge will be remembered as the event which precipitated the US and world economy into the “millennium depression”. (The hope had been the Asian crisis had been insulated from the rest of the world.)

Prudence suggests the cautious will give more weight to the depression scenario than the optimistic one. Unfortunately, the fallacy of composition says that if everyone behaves cautiously, a depression is more likely.

Optimists argue that even so, the world will not repeat the mistakes of the 1930s. This assumes policy caused that world depression, whereas it might have occurred anyway, and the policy response only exacerbated it. We place too much faith in the ability of policy to correct underlying failures. Politicians have a vested interested in this view, and their journalist and academic acolytes chorus them. In any case, given the recent record of financial markets, why should politicians to do any better?

As if to compensate for the crassness of its 1997 award, the 1998 economics Nobel prize was given to Amartya Sen for his contributions in the theory of social choice and poverty. Sen’s award is deserved, something one cannot say of all previous prizewinners. (His first name “immortal to his mother” was suggested by Nobel prizewinner in literature, Rabindranath Tagore, a close family friend from the same Indian village.)

I reported one of his findings – that famine could occur when their was a food shortage if the poor had not the means to acquire the food, as happened in the great Bengali famine – in a column (14 Dec 1985). He extended our understanding of social choice (collective decision making). His seminal work on poverty measurement has still not been applied in New Zealand. Most fundamentally, he questioned the utilitarian foundation of economics, arguing that “capabilities” – the possibilities open up to the individual – are more relevant than just material consumption. By doing so he returns economics to its philosophical roots, challenging its foundations.

Cynics suggest the switch from the 1997 Nobel prize topic of get-rich-easy-schemes to poverty in 1998 may be a prediction on the part of the awarding committee. On their record they are not as smart as that.