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Place your bets: Market as marvelous mechanism or crapshoot
By Xavier Vives |
January 5, 2009, Monday
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THE financial crisis, credit crunch, and ensuing economic downturn have severely damaged the credibility of financial markets, institutions and traders. More and more people are claiming that markets are characterized by irrationality, bubbles, fads and frenzies, and that economic actors are driven by behavioral biases.
George Soros' recent book on the credit crisis exemplifies this line of thinking. He suggests established financial theory is obsolete. His view essentially means the current financial crisis is final proof that markets do not process information efficiently.
If this is true, we are closer to John Maynard Keynes' view of the market as a casino than to Friedrich von Hayek's view of it as a marvelous mechanism for processing dispersed information.
For example, the recent spike in oil prices would have been driven by an irrational frenzy in futures markets. Market operators would have miscalculated systematically, been overconfident about their information, and overreacted to news.
I believe, however, that there is another explanation for these phenomena, which is based on rational calculation and information processing by institutions and traders.
The problems in financial markets have very much to do with lack of good information, misaligned incentives, and, in fact, rational responses to the environment. When information is scarce and unevenly distributed, prices may well depart from the reality of fundamentals.
We see this when new technologies arrive, like the Internet bubble, but a similar phenomenon occurred with railway construction more than a century ago.
We can argue the sophisticated loan packages recently created by banks are, likewise, a new and unknown product, so information and experience to aid pricing has been scarce and dispersed.
In such circumstances, prices may well depart from the fundamentals as assessed by a hypothetical collective wisdom that would pool all information in the market. Trading on the momentum of price movements may then become a rational activity that becomes self-fulfilling, as investors decide to "ride the bubble'' while it lasts.
The bubble is inflated further by the asymmetry between those who bet that prices will rise and buy, and those who forecast a fall, but stay out because to sell short is too costly.
This means that relatively persistent and large departures from "reasonable" prices are possible, even likely, when information is dispersed - but a reality correction will always follow.
So how does this explain the overexposure of many institutions to sub-prime mortgage risk and the collapse of the interbank market? Were banks that chose to securitize sub-prime loans behaving irrationally? Again, informational asymmetries and misaligned incentives are at the root.
Irrational?
Keeping those loans on the books would have meant banks would have had to maintain large capital and monitor the loans - a high cost.
Securitization avoided high costs and placed the new product advantageously, with complicity of rating agencies, which profited from investors' inexperience and lack of information. Executives collected generous bonuses, equity holders had limited liability.
Informational failure was the probable cause of the interbank market collapse.
This a well-known phenomenon. Banks don't trust each other, since each wonders how many skeletons the other has in its closet. There is no irrationality here.
The debate over the irrationality of financial markets is not academic. If we believe economic actors are irrational, then we will enact paternalistic policies to control behavior or bail out failed agents and institutions.
The calls to curb speculation in derivatives markets or short sales have this flavor. If, on the other hand, we believe economic actors will respond rationally to incentives and information, then we can usefully reform regulatory frameworks with well-targeted measures, including restrictions on off-balance sheet vehicles, tougher disclosure requirements, and controls on rating agencies' conflicts of interests.
(Xavier Vives is professor of economics and finance at IESE business school in Spain and author of "Information and Learning in Markets." Copyright: Project Syndicate, 2008. www.project-syndicate.org)
George Soros' recent book on the credit crisis exemplifies this line of thinking. He suggests established financial theory is obsolete. His view essentially means the current financial crisis is final proof that markets do not process information efficiently.
If this is true, we are closer to John Maynard Keynes' view of the market as a casino than to Friedrich von Hayek's view of it as a marvelous mechanism for processing dispersed information.
For example, the recent spike in oil prices would have been driven by an irrational frenzy in futures markets. Market operators would have miscalculated systematically, been overconfident about their information, and overreacted to news.
I believe, however, that there is another explanation for these phenomena, which is based on rational calculation and information processing by institutions and traders.
The problems in financial markets have very much to do with lack of good information, misaligned incentives, and, in fact, rational responses to the environment. When information is scarce and unevenly distributed, prices may well depart from the reality of fundamentals.
We see this when new technologies arrive, like the Internet bubble, but a similar phenomenon occurred with railway construction more than a century ago.
We can argue the sophisticated loan packages recently created by banks are, likewise, a new and unknown product, so information and experience to aid pricing has been scarce and dispersed.
In such circumstances, prices may well depart from the fundamentals as assessed by a hypothetical collective wisdom that would pool all information in the market. Trading on the momentum of price movements may then become a rational activity that becomes self-fulfilling, as investors decide to "ride the bubble'' while it lasts.
The bubble is inflated further by the asymmetry between those who bet that prices will rise and buy, and those who forecast a fall, but stay out because to sell short is too costly.
This means that relatively persistent and large departures from "reasonable" prices are possible, even likely, when information is dispersed - but a reality correction will always follow.
So how does this explain the overexposure of many institutions to sub-prime mortgage risk and the collapse of the interbank market? Were banks that chose to securitize sub-prime loans behaving irrationally? Again, informational asymmetries and misaligned incentives are at the root.
Irrational?
Keeping those loans on the books would have meant banks would have had to maintain large capital and monitor the loans - a high cost.
Securitization avoided high costs and placed the new product advantageously, with complicity of rating agencies, which profited from investors' inexperience and lack of information. Executives collected generous bonuses, equity holders had limited liability.
Informational failure was the probable cause of the interbank market collapse.
This a well-known phenomenon. Banks don't trust each other, since each wonders how many skeletons the other has in its closet. There is no irrationality here.
The debate over the irrationality of financial markets is not academic. If we believe economic actors are irrational, then we will enact paternalistic policies to control behavior or bail out failed agents and institutions.
The calls to curb speculation in derivatives markets or short sales have this flavor. If, on the other hand, we believe economic actors will respond rationally to incentives and information, then we can usefully reform regulatory frameworks with well-targeted measures, including restrictions on off-balance sheet vehicles, tougher disclosure requirements, and controls on rating agencies' conflicts of interests.
(Xavier Vives is professor of economics and finance at IESE business school in Spain and author of "Information and Learning in Markets." Copyright: Project Syndicate, 2008. www.project-syndicate.org)
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