How fragile are today’s financial markets?

The U.S. stock market continues to hit new highs. Interest rates remain remarkably low compared to historical norms. It’s almost 8 years since the last U.S. economic recession. But nothing lasts forever.

Feedback loops drive market behavior

At some point, the economic cycle will turn—it always does—and that will most likely mean that markets turn, too. This post is not about when that might happen or what might trigger it (the thoughts of those better qualified than I to comment on those questions can be found here)—but rather about the fragility of modern financial markets.

Regular readers of this blog will be familiar with the perspective of financial markets as a complex adaptive system: a system whose behavior is better described with analogies from nature and biology than with analogies from physics. One difference lies in what it means for a system to be stable.

A complex system is stable when negative (or reactive) feedback dominates. For example: if a bee hive gets cold, the bees huddle together and start wiggling around. This generates heat and the temperature of the hive gets pulled back up. But if a bee hive gets too warm, the bees spread out and use their wings as fans to cool it down. So the regulation of temperature in a bee hive shows how a negative feedback loop can lead to stability.

The obvious example of negative feedback in the financial system is the pricing mechanism: when prices go up, markets become less attractively priced, and that should attract sellers and deter buyers. Similarly, a falling market leaves things more attractively priced. If that were the only form of feedback loop, then we would see the stable markets that classical economics predicts, not the volatile creatures we see in real life.

Markets are more volatile than classical theory predicts because there are also positive feedback loops in financial markets, a herd instinct, a tendency for events to feed off of their own energy. That’s how bubbles develop, that’s how crashes happen.

Interconnectedness can lead to fragility

Positive feedback loops in a complex system mean that there’s a connection between homogeneity and instability.

Consider our bee hive: what if every bee had their actions triggered at the exact same temperature? No bee would respond to a slight drop in temperature until a certain point is reached, and then every bee would suddenly huddle together all at once and start to generate heat. The hive would quickly overheat, and they’d all spread out at once and start to fan their wings. The temperature would become highly unstable. In reality, however, there are groups of bees whose response is triggered at different temperatures—and that’s why the system is stable.

The modern financial world is highly interconnected and more homogenous than it’s ever been. Within markets, there has been a significant change in the make–up of trading activity in recent years, and this has changed how the feedback loops are working. The behavior of investors around the world has become more similar. The ideas that lie behind the actions of a high net worth individual in Asia, or a foundation in Europe or a sovereign wealth fund in the Middle East, these are all more similar today than ever before. And a more connected world, a more homogenous world, is a more fragile world.

In the aftermath of the financial crisis, the journalist Felix Salmon wrote:

“Human complexity is always best approached modestly, without the kind of certainty that is common to financiers and scientists. … Just as a long history of rogue traders never seems to prevent another one from popping up somewhere, it's equally certain that our long history of financial crises won't be slowed down or stopped by the magnitude of the one that began in 2007–8. There will be more such crises, and they will probably be even worse than the one we just lived through. And although they might not be caused by credit default swaps or models designed by physicists, they will certainly be caused by people who are very sure indeed of what they're doing.”

I strongly suspect that one day he will be proved right. Let’s hope that day is a long time coming.