Sunday, May 27, 2012

Market Lessons, Fragility, and Debt

How does the market make sure businesses learn the right lesson?

(Photo credit to Seven Bedard)

What is the invisible hand?  How does it push businesses towards the right prices, the right contracts, the right decisions?  Introductory supply and demand models suggest that businesses are always profit maximizing, thus changes in the market induce changes in business behavior to maximize that profit. However, this is, at best, a theoretical abstraction. While businesses may intuitively know the law of demand, they do not have some demand curve available to them for analysis. To optimize price, they tinker until they find a satisficing option. Given enough tinkering, the firms eventually reach a price that is profit optimizing. The trial and error of individual firms eventually crafts a market equilibrium.

But how does this work on a larger scale, with more complicated decisions? How do businesses decide between the right balance of debt and equity? How do they determine what their production function to determine the "optimal" amount of investment? What's the "expected value" of long term research to power the company? These are all unknown values; how does the market then move firms to act optimally with respect to them?

According to an evolutionary approach, the market does not teach or push existing firms to the optimal levels, rather those who fail to reach the optimal levels are naturally selected out of the market. Firms don't need rational expectations about price growth, all that is necessary is that the market is deep enough that the irrational expectations are purged from the system. Along with the adaptive market hypothesis, this suggests that markets only work as our idealized models would predict if and only if the market is fast paced with strong pressures that punish "irrational" strategies. These markets need to have constant sources of volatility so the invisible hand can keep on pushing businesses in the right direction. Market don't teach, they destroy. In the end, efficient markets are only the result of survivorship bias, as every inefficient market loses firms until the remaining ones act "rationally".

If evolution is why markets equilibrate, then we need to be especially concerned about systemic crises and debt. Taleb warns about the impact of debt crises in his list of steps towards a Black Swan free world;
5.  Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to  be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.  
From his description, one can see many channels through which debt disrupts the evolutionary process in markets. If there's no room for slack and redundancy, and if these crises go systemic, there would be no firms left untouched by the crisis. As a result, no firms are left and there's nothing left that the evolution in markets can teach them. Systemic crises destroy the history record of firms with better models for long term growth, so the evolutionary pressure evaporates.

Moreover, the buildup of debt suppresses short term volatility in exchange for long-term blowups. Debt financing can tide you over in the short run, but eventually debt catches up with businesses, resulting in a catastrophic, if not systemic, collapse later on. This suppression of volatility also crimps the ability of markets to force firm evolution, as there is no longer the short term volatility to promote tinkering. Given these diverse channels in which debt interferes with the evolutionary equilibrium of markets, the fragility imposed by debt should draw greater attention in the regulation of complex economies.

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