Sunday, September 13, 2009
One of the leaders of the new science of financial modeling - Rama Cont - points out that Adam Smith was wrong about the "Invisible Hand".
Specifically, investors in financial markets rationally pursuing individual profit can produce outcomes that are bad for almost everyone.
As an article in City Journal notes:
Simple forecasts can also be mistaken if they fail to account for the actions of market participants themselves: investor strategies can influence prices, which in turn influence future strategies in a feedback loop that can cause considerable instability. Cont recalls the severe stock-market crash of October 1987, which seemed to strike out of the blue, since nothing significant was happening in the real economy. Subsequent research, though, blamed the crash in part on a new investment strategy, “portfolio insurance,” which a large number of fund managers had simultaneously adopted. Based on the famous Black-Scholes options-pricing model, this strategy recommended that fund managers reduce their risks by automatically selling shares whenever their values fell. But the approach didn’t take into account what would happen if many investors followed it simultaneously: a massive sell-off that could send the market plummeting. The 1987 crash was thus not provoked by events in the real economy but by a supposedly smart risk-management strategy—and the current downturn, of course, also derives at least partly from a global craze for a seemingly foolproof financial innovation...
Investors in financial markets rationally pursuing individual profit, then, can produce outcomes that are globally negative. Doesn’t that contradict classical economic theory? “Both theory and empirical facts do tend to show that, on the financial markets, the Invisible Hand does not always lead to welfare-improving general outcomes,” Cont replies.