May 31, 2011
What can we do so that we’re not fighting yesterday’s war?
That was the question posed by Richard Bookstaber when he spoke at the sixth annual MIT Sloan Investment Management Conference on April 29. Bookstaber, a Senior Policy advisor to the SEC and to the Financial Security Oversight Council, offered an elucidating perspective on the origins of economic crises and the proper role of regulation.
Bookstaber’s main assertion was that unrestrained capitalism, contrary to classical economic theory, creates incentives that fail to optimize social welfare and ultimately devolve into socialism– as he put it, that “unrestrained capitalism ultimately isn’t capitalism,” because these misaligned incentives force governments to intervene in order to optimize the well-being of their citizenry.
While we cannot predict the source of our next financial crisis, Bookstaber said – although he expressed no doubt that it was coming – we should look towards unregulated industries. Banks, he said, are currently under too much scrutiny to pose much risk to the economy. The warning sign that Bookstaber most emphasized was the complexity of a system.
Bookstaber laid the blame for the 2008 crash on two factors: complexity and “tight coupling.” In this context, tight coupling is the “causal relationships” we tend to create with ETFs and globalized market interactions. It serves to increase complexity and to propagate the shock of crisis much more quickly and widely than it otherwise could spread. Ultimately, however, Bookstaber said complexity is the real villain.
Bookstaber’s primary concern with complex markets is that they are difficult to understand. While some may understand what is happening in a highly complex system, the vast majority of participants are unlikely to fully grasp its dynamics, which weakens the assumption of perfect information used by classical economists to justify the free market. When market participants act in an effective state of ignorance, there is a high likelihood that they will make suboptimal decisions. This is what happened with risk allocation in our recent recession.
Bookstaber took special note of so-called “financial engineers” in his talk. To call them “engineers,” he claimed, was misleading. Engineers design bridges and stable structures. In contrast, he declared, “financial engineers are going to war instead of building hospitals.” The use of risk management tools developed in scientific fields, such as physics, engineering and biology, is inappropriate in finance, said Bookstaber. The origin of the risk in the former professions is entirely different from that of financial risk. This assertion ultimately stems from Bookstaber’s description of financial activities as “war.”
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