Broken Symmetry

Geanakoplos and Farmer on the Nonequilibrium Statistical Mechanics of Markets

The WSJ leads with Geanakoplos today and Marginal Revolution picks the story up. Skimming through SSRN publications by Geanakoplos, I find this chestnut:

An alternative point of view is that, due to a lack of a perfect rational ity, the market is not in perfect equilibrium and thus prices do not simply passively reflect new information. Under this view the market acts as a non-linear dynamical system: agents process information via decision-making rules that respond to prices and other inputs, and prices are formed as a result of agent decisions. Since this information processing is imperfect, the resulting feedback loop amplies noise. As a result a signicant component of volatility is generated by the market itself.

From a paper co-authored with J. Doyne Farmer.

A Systems Theory of Financial Regulation

From Geithner and Summers:

First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.

Perfectly consistent with Summers's column on "Regulatory Systems Design" almost a year ago today.

For a systems theory of patent law, see Question 9 here.

The credit market debacle

Major financial scandals seem to transpire once every three to five years.  The cycle seems to go in four phases: (1) price crash; (2) journalist frenzy, usually ending with the revelation of scheme to "defraud" investors; (3) government investigation and prosecution; (4) private lawsuits and reorganization.  The quotes are there, of course, because for most people, most of the time what looks culpable in one context (e.g., when indictments are being handed down) looks merely aggressive in another (e.g., when everyone else is doing it and you're afraid of being at a competitive disadvantage if you don't).

We seem to be nearing the tail end of the cycle for options backdating scandals.  I'm thinking we're just now getting into phase 2 with the credit markets.  My prediction is that some major fraud in how collateralized debt obligations (CDOs) were packaged and repackaged into securities is going to be "discovered," and one of the major investment banks is going to be left holding the bag.  Like the risk profile for LTCM assets, the risk profile for CDOs was determined based on market data from the past.  And if there is one place where Shakespeare's dictum ("what is past is prologue") fails, it's the publicly traded markets.

Things may not end as badly as they did for Arthur Andersen.  Almost nobody's retirement is going up in smoke this time around.  But nobody's pension disappeared because of options backdating either, and there was nonetheless plenty of of public political activity in response.

UPDATE: looks like the SEC is ready to skip to phase 3, and the law firms to phase 4!

UPDATE 2: We're now definitively in phase 3.  Check out this photo.