How many economists does it take to see a crisis?

Some claim financial innovation will take us to the theoretical limit of perfect efficiency

PUBLISHED : Saturday, 07 September, 2013, 12:00am
UPDATED : Saturday, 07 September, 2013, 5:14am

Suppose you went into the street and hit passers-by with some breaking news.

"Listen," you say, "derivatives and other exotic financial products can sometimes make financial markets less stable and more prone to crises. What do you think about that?"

You would, I expect, see some perplexed faces. Those with any grasp of what you were talking about would say, "Are you kidding? We already know that. All that stuff is mostly used for gambling and speculation."

In the world of academia, it's no joke. The idea that derivatives might not make markets safer and more efficient is a relative novelty that is being pursued by a small group of economists.

One standout is Alp Simsek, a young assistant professor of economics at the Massachusetts Institute of Technology. The fact that his excellent work qualifies as a breakthrough illustrates the intellectual pretzel the field has got itself into.

The standard theoretical story in economics claims that derivatives and other financial products - including the infamous collateralised debt obligations that fuelled the US housing bubble and the credit default swaps that afflicted insurance giant American International Group - make markets more "complete".

By allowing participants great flexibility in crafting positions, they lead to better risk-sharing, lower transaction costs and better information for all. The story has strong appeal, both to academic purists and to executives who make their money crafting and selling financial products.

It reached perhaps its apotheosis in 2005, when the economists Robert Merton and Zvi Bodie published a paper celebrating "vast improvements in our understanding of how to use the new financial technologies to manage risk" and claiming further financial innovation could only lead to a progressive "spiralling" of markets towards the theoretical limit of perfect efficiency.

In short, finance professors have been socialised to believe some things that, to borrow a phrase of Bertrand Russell, are so absurd that only very learned men could possibly adopt them.

In recent years, some economists have been trying to reintroduce a bit of reality.

William Brock, Cars Hommes and Florian Wagener demonstrated in 2009 that we should in general expect more derivatives to make markets less stable: through the very act of reducing the risk of some strategies, they invite more vigorous gambling on others.

At about the same time, a group of physicists showed that the theoretical ideal of complete markets should actually be inherently unstable, because, in approaching this limit, tiny shocks to the economy come to demand huge changes in investors' portfolios.

The market can only remain efficient through an ever faster and more vigorous churning of investment positions.

Enter Simsek. In a paper published recently in Quarterly Journal of Economics, he takes direct aim at the theory of complete markets. By allowing the tailoring of positions, he argues, financial innovations actually enable investors to make larger bets focused on their areas of disagreement.

Humanity as a whole is worse off, because risk in the system increases without any attendant increase in wealth.

"In a world in which investors have different views, new securities won't necessarily reduce risks," Simsek said in an interview. "People bet on their views. And betting is inherently a risk-increasing activity."

If you find it surprising that this could come as a revelation to financial theorists, well, now you have some idea of the peculiar world they inhabit. Huge intellectual effort has been spent to make quite intelligent people believe the unbelievable. Hopefully, Simsek's work will help them recognise the obvious.