Quantitative trader and controversialist Espen Gaarder Haug uploaded a very interesting little paper to the Social Science Research Network in April. After Thursday’s brief insanity on Wall Street, I couldn’t help but go back to it, Justin Fox, editorial director of the Harvard Business Review Group writes in a new blog post.
“Exchange officials are still trying to puzzle out what exactly happened to cause the price of dozens of stocks to suddenly plummet by more than 60%.”
The paper is charmingly titled “When Will God Destroy Our Money?” The key passage is this:
“A very large coronal mass ejection from the sun that could cause a super solar storm if it should hit the earth might wipe out the global money system within minutes from impact. Stock exchanges would not operate, banking systems would not function, and both credit cards and ATM machines would stop working. We could find ourselves without the use of our modern electronic forms of money for months and possibly years.”
Solar storms of a magnitude experienced in 1859 and 1921 probably wouldn’t cause the total monetary-system wipeout Haug describes. He cites a recent National Academy of Sciences report that says a 1921-strength storm could knock out electrical power for more than 130 million people in the U.S.
Haug’s point is that nobody really has the faintest idea when a 1921-strength storm — or a far stronger one that could destroy all our money — might hit again. As his sometime co-author Nassim Nicholas Taleb has been telling us all for the past decade, standard bell-curve statistics is no help at all in understanding or predicting the extreme “black swan” events that can change the world in an instant.
That’s one possible line of reasoning. Another has to do with just how fragile the complex systems we’ve created to manage our economic lives have become.
Exchange officials are still trying to puzzle out what exactly happened to cause the price of dozens of stocks to suddenly plummet by more than 60%. But it seems likely that it has something to do with the new infrastructure of high-frequency trading that now accounts for the bulk of stock market activity.
To function well, stock exchanges need market makers — that is, firms that are willing to keep buying and selling in a particular stock at all times. On the New York Stock Exchange these are the “specialists” (who are now kept around mainly as backdrop for CNBC reporters).
On Nasdaq they are simply called market makers. They make money off the difference between what they bought and sold a stock for (the spread). Over the past decade, though, spreads have shrunk as traditional market makers have been pushed aside by high-frequency trading firms that take advantage of millisecond-by-millisecond price changes and the tiny premiums that exchanges pay to “liquidity providers” (a.k.a. market makers) to make money even at infinitesimal spreads.
At one level this is much more efficient than the old system. The spreads are smaller, so investors are getting a better deal, right? Well, not if the system also becomes much more fragile, and susceptible to sudden collapses. Over the past three decades our financial system has become vastly more complex in terms of technology and diversity of available financial products. By some measures it has become more efficient — trading commissions have certainly come down. But it has also become more prone to crisis and (maybe) collapse.
Efficiency (and this is an argument borrowed from Taleb) breeds fragility.
I’m not sure this semi-Luddite line of reasoning applies quite as well outside of financial markets. The problem of excess complexity has certainly come up in relation to Toyota’s recent troubles. But the fact that the iPhone in my pocket is vastly more complex than the Motorola I carried around in my briefcase 15 years ago doesn’t mean it isn’t also vastly better.
The key issue probably has something to do with centralization. Complexity and the constant striving for more efficiency in a huge, centralized system (a power grid, a financial market) carries with it far more danger than complexity and efficiency in a smartphone.
But as we approach the singularity, are we sure we’re going to be able to tell the difference?
By Justin Fox
Editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street.
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