Systemic Breakdowns: Still Relatively Rare

Rick Bookstaber has stopped blogging, so does Jim Surowiecki feek a need to fill the gap? Here he is channelling Bookstaber in the pages of the New Yorker:

The situation illustrates a fundamental paradox of today's financial system: it's bigger than ever, but terrible decisions by just a few companies--not even very big companies, at that--can make the entire edifice totter...
When you have systems with lots of moving parts, some of them are bound to fail. And if they are tightly linked to one another--as in our current financial system--then the failure of just a few parts cascades through the system. In essence, the more complicated and intertwined the system is, the smaller the margin of safety.
Today, as financial markets become ever more complex, these kinds of unanticipated ripple effects are more common--think of the havoc wrought a couple of weeks ago when the activities of one rogue French trader came to light. In the past thirty years, thanks to the combination of globalization, deregulation, and the increase in computing power, we have seen an explosion in financial innovation. This innovation has had all kinds of benefits--making cheap capital available to companies and individuals who previously couldn't get it, allowing risk to be more efficiently allocated, and widening the range of potential investments. On a day-to-day level, it may even have lowered volatility in the markets and helped make the real economy more stable. The problem is that these improvements have been accompanied by more frequent systemic breakdowns. It may be that investors accept periodic disasters as a price worth paying for the innovations of modern finance, but now is probably not the best time to ask them about it.

I feel guilty, now, about pushing the meme that SocGen was responsible for the broad sell-off on Martin Luther King day; it feels weird now to deny that a rogue trader wrought havoc in the markets. But I do think that's an unfair characterization: the markets are perfectly capable of wreaking havoc on themselves, even sans rogue traders. Just look at the S&P 500 today, down 3.2% in a fit of increasingly-normal volatility.

More to the point, I just don't agree that there are "more frequent systemic breakdowns" nowadays than there used to be. I think we all got spoiled rather by the Great Moderation, and started to kid ourselves that systemic breakdowns were impossible. But such breakdowns were even more common in the 70s and 80s than they have been in recent years. There was the oil crisis, and the crash of 1986, and the pound crashing out of the European exchange rate mechanism, and lots more - it's easy to forget just how volatile markets used to be, long before computers had the tiniest fraction of their present abilities, and long before hedge funds and derivatives dominated large swathes of the financial markets.

Indeed, as systemic breakdowns go, this one is relatively mild - touch wood. The US might enter a recession, but the rest of the world is likely to keep on growing, and even after today's fall the stock market is still higher than it was in the last week of January, let alone where it was a couple of years ago. Yes, it's prudent to worry about systemic breakdowns. But let's not kid ourselves that they're more frequent now than they ever used to be.

Update: Surowiecki, in the comments, makes the excellent point that he wasn't comparing the present day to the 70s and 80s, but rather the past 30 years or so - including the late 70s and the 80s - to the post-war era of say 1945 to 1975. And on that front there's no argument: systemic risk is surely greater now than it was back then.

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