On crashes

Whenever a stock market crash, or conversely a rally, occurs in world financial markets, the newspapers are immediately filled with analyses by ‘experts’ on why the crash occurred and what should be done in future to prevent such crashes. People point to bad business decisions on the part of companies, bad monetary policy, bad regulations, or any number of other reasons. I’m of the view that most of the time these analyses are fundamentally misguided and ignore the real reason for market crashes. The real reason for market crashes can manifest itself at any time, even when all the fundamentals of the economy are in good shape. What is the real reason? Markets are complex systems, and most complex systems are characterized by chaos and instabilities. This is an inherent trait of complex systems and has nothing to do with whether businesses are making good or bad decisions, or whether monetary policy is enlightened or misguided. Additionally, global financial markets have many inherent positive feedback loops. That is, when a trend emerges it has the ability to reinforce itself. Consider for example when the stock market begins to take a dive. People see the dive, assume that it will continue, and try to protect themselves against losses by taking a short position (e.g. by selling stock or buying appropriate derivatives). This behaviour reinforces the trend by driving prices further down. Conversely, an up-trend could equally well reinforce itself when people try to take advantage of the trend by taking a long position (e.g. by buying the stock). Importantly, the ability for these patterns to materialize is inherent, and has little to do with the underlying strength or structure of the economy.

As an example, to this day there is little consensus on what caused the Asian financial meltdown of 1997. It was completely unexpected and occurred without any obvious reason. Various commentators will attempt to retrospectively explain it away by pointing to various economic indicators or the behaviour of various financial institutions. But I don’t believe there will ever be consensus, because the reasons for the crash probably cannot be attributed to any specific action or policy. Rather, the dive was most likely a collective phenomenon, associated with the fundamental instability of a complex system.

So the question is, what can be done to avoid crashes? The answer is, short of massive regulation of the financial system (which is both unviable and probably counterproductive), probably not much, since large markets are inherently comprised of a large number of individual market participants, which will inevitably lead to a complex system with chaotic and sometimes highly unstable dynamics.

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