Wednesday, 7 October 2009

Feedback in Financial Markets

In a previous post, I mentioned that bubbles were characterized by – indeed, defined by – positive feedback. This idea, and more generally, the importance of feedback in driving market dynamics, deserves a lot more ink. Here’s a first installment.

Classical economics is often concerned with analyzing various equilibrium outcomes (“comparative statics”). These outcomes are usually generated or maintained by some sort of negative feedback. The simplest example is that of security prices. Under the efficient markets hypothesis, each security has a fair price reflecting its ‘fundamental value’; furthermore, this fundamental value is known to market participants in aggregate. If the actual market price drops below this value, people step in to buy the security; if the price rises above it, people step in to sell. As a result of this negative feedback, the market price equilibriates to its natural or fundamental value.

Unfortunately markets do not always tend to equilibrium. Negative feedback is not always the dominant mechanism at work. And fundamental value is not always well defined. Bubbles provide a clear example of each of these counterfactuals.

In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise?

The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation.

But one doesn’t have to invoke irrationality to explain positive feedback. Positive feedback can arise quite naturally when rational traders encounter flawed institutional mechanisms, as my previous post makes clear. Short-term incentives, asymmetric outcomes, incomplete information and firm-wide pay structures could all lead to perfectly rational actors taking actions which lead to positive feedback and hence bubbles.

Both of these are what I would call ‘technical’ explanations, in that they depend on trader behavior (which has various causes) to move market prices away from some underlying fundamental value. But there is another, and to my mind more interesting, form of positive feedback in which the fundamental values themselves change.

Consider this example from the FX markets. A currency strengthens. This acts like a tightening of monetary policy. Hence inflation expectations diminish. Hence the currency strengthens further. The initial move has thus changed the underlying fundamentals so as to justify itself; it has become a self-fulfilling prophecy.

Or consider this example from the equity markets (private email from my friend WB):
Markets prices impact fundamentals. If Amazon's stock price goes up as it did in 1999-2000, it makes it that much easier to raise capital either from debt markets or from equity markets. If Amazon raises more money it can invest more and make improvements which make the future look that much brighter. That pushes up prices even higher. That's not a negative feedback cycle. In fact it's downright positive feedback. This can go on for a very long time, but then one day the reality just doesn't offer as much as was priced in and we have an enormous collapse which again acts in a positive feedback way. So in the end over medium horizons, markets can be mean-averting or create trends while in the longer term picture they are mean-reverting.
Or, closer to home, consider this example from the real estate markets (lifted from Wikipedia):
Lenders began to make more money available to more people in the 1990s to buy houses. More people bought houses with this larger amount of money, thus increasing the prices of these houses. Lenders looked at their balance sheets which not only showed that they had made more loans, but that their equity backing the loans—the value of the houses, had gone up (because more money was chasing the same amount of housing, relatively). Thus they lent out more money because their balance sheets looked good, and prices went up more, and they lent more.
Of course, the conditions required to foster a ‘fundamental’ positive feedback loop don’t arise very often, but when they do, the outcome is dramatic.

The final word belongs to George Soros, who treats feedback as a special case of his larger socio-economic theory, ‘reflexivity’. Soros’ book The Alchemy of Finance contains many more examples of ‘fundamental bubbles’; rather than quote them all, I’ll leave you with two short excerpts from this 1994 speech:
I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy

...

For instance, in a freely-fluctuating currency market, a change in exchange rates has the capacity to affect the so-called fundamentals which are supposed to determine exchange rates, such as the rate of inflation in the countries concerned; so that any divergence from a theoretical equilibrium has the capacity to validate itself. This self-validating capacity encourages trend-following speculation, and trend-following speculation generates divergences from whatever may be considered the theoretical equilibrium. The circular reasoning is complete. The outcome is that freely-fluctuating currency markets tend to produce excessive fluctuations and trend-following speculation tends to be justified.
And there you have it, straight from the greatest trader of the twentieth century. Further comment would be superfluous.

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