What made the market crash? Or a psycho murder?

09 May 2010

The New York stock exchange went haywire a couple of days ago, and now they’re trying to figure out why. But the way they’re going about it, it seems like a futile task.

The New York Times reports that there’s an investigation going on to figure out what happened. The answer so far? “Origin of Wall Street’s Plunge Continues to Elude Officials” reads the headline. The article says: “Maddeningly, the cause or causes of the market’s wild swing remained elusive.”

But maybe it’s a mistake to think we can actually find these causes.

It reminds me of what trader and author Nassim Nicholas Talib has to say in his book, The Black Swan, about people looking for causes of ups and downs of the market: “We harbon a crippling dislike for the abstract…. Whenever there is a market move, the news media feel obligated to give the ‘reason.'”

He gives the example of how Bloomberg News touted Saddam Hussein’s capture as the reason for a drop in the markets: “U.S. TREASURIES RISE; HUSSEIN CAPTURE MAY NOT CURB TERRORISM”.

But then half an hour later, the market wasn’t looking as hot. They put up a new headline: “U.S. TREASURIES FALL; HUSSEIN CAPTURE BOOSTS LURE OF RISKY ASSETS”.

This echoes what’s happened with the most recent glitch on the stock market.

Initially it was blamed on some kind of mistake—a glitch or human error—in which someone attempted to sell billions of dollars of stocks, rather than millions. But now it seems the cause lies elsewhere, the New York Times article says: “A government official who was involved in the investigation said regulators had moved away from a theory that it was a trading mistake — a so-called fat finger episode — and were examining the links between the futures and cash markets for stocks.”

It seems they’re looking a bit at more fundamental aspects of how the markets work: “The initial focus of the investigations appeared to center on the way a growing number of high-speed trading networks interact with one another and with venerable exchanges like the New York Stock Exchange. Most investors are unaware that these competing systems have fractured the traditional marketplace and have displaced exchanges like the Big Board as the dominant force in stock trading.”

Really? I didn’t know that, but I’m not an investor. Knowing this kind of thing seems like a crucial first step in recognizing the nature of the beast. If it’s true that most investors aren’t aware of this, that’s scary.

These kind of network effects can be destabilizing—running counter to the idea some have that, basically “networks are good”—that globalization and networking would make us all interconnected, and that would bring stability. Political scientist Thomas-Homer Dixon covers this in his latest book, The Upside of Down. And as he argued in his earlier book, The Ingenuity Gap, the world is getting so complex that it’s becoming more and more difficult just to understand it, let alone control it.

A recent post on Global Dashboard makes the same point: “Our economy, I think, has surpassed human understanding. We can bash, poke and kick it, and hope it will start running smoothly again. But it would be foolish to trust those who confidently pronounce this crisis over, and even less those who claim to know what is coming next.”

The investigators looking for the “cause or causes” of the recent nosedive seem to me like detectives trying to understand exactly why a psychopath killed a young woman in a park on a Tuesday afternoon. Why her? Why then?

If there’s a serial killer on a rampage, then detectives should try to understand him as far as they can, so that they can catch him. But understanding why he did it, when he did it? Seems impossible, a waste of energy.

If our goal as a society, on the other hand, is to avoid getting slaughtered by psychos, we shouldn’t get caught up asking what sets off a particular psycho at a particular time. The real questions are: How can we recognize psychopaths before they kill? Can we do something to stop them from killing? And is there something we can do to stop people from becoming psychopaths in the first place?

It seems to me that Wall Street is taking the first approach—playing detective, trying to understand particular dips and jumps.

The Securities and Exchange Commission and the Commodity Futures Trading Commission issued a joint statement that said, in part: “We are scrutinizing the extent to which disparate trading conventions and rules across various markets may have contributed to the spike in volatility.”

But it seems the whole system is built to unstable. Instead, we should be asking ourselves why so few recognized how unstable the system is, and why we’ve done so little about it.

If the answer is that the markets are too complicated to understand—let alone manage—then that’s useful, too. Then perhaps we need to make them simpler, so we can control them in some way. Perhaps we can build in systems to slow down swings, or make it more resilient. It’s just an intuition—I don’t know exactly how you’d do this—but the fact that hardly anyone seems to be talking in these terms makes me worried.

The New York Times article floats one possibility like this, for building in resilience by controlling computer trading. It points out that “only when traders began to manually respond to the sharp drop did the market seem to turn around, said the official, who spoke on the condition of anonymity because the investigation was not complete.”

Duncan L. Niederauer, chief executive of NYSE Euronext, blamed the “computers for continuing trading while the market was in free fall.”

“These computers go out and just find the next bid they can find,” he said on CNBC.

“Mr. Niederauer acknowledged the need to introduce circuit-breakers along the lines of those already in place on the Big Board, and his views were echoed by some chief executives of the new exchanges,” the article says.

But I get the impression that these circuit breakers—along with other fixes and regulations being considered—are tinkering with the details, rather than looking for fundamental flaws in how the markets work.


books I've read on failure & grace

The World Without Us
The Last Oil Shock: A Survival Guide to the Imminent Extinction of Petroleum Man
A Paradise Built in Hell: The Extraordinary Communities That Arise in Disaster
Hell and High Water: Global Warming--the Solution and the Politics--and What We Should Do
The Worst Hard Time: The Untold Story of Those Who Survived the Great American Dust Bowl
The Tipping Point
Three Cups of Tea: One Man's Mission to Promote Peace... One School at a Time
The Upside of Down: Catastrophe, Creativity and the Renewal of Civilization
Out of Poverty: What Works When Traditional Approaches Fail
The Little Ice Age: How Climate Made History, 1300-1850
Confessions of an Eco-Sinner: Tracking Down the Sources of My Stuff
Deep Economy: The Wealth of Communities and the Durable Future
The Geography of Bliss: One Grump's Search for the Happiest Places in the World

Mason's favorite books »