The images in this post are my own; one I generated from actual NASDAQ values over the last 25 years, the other I generated using a computational stock market model I coded in R. See if you can tell which is which. The model is not meant to predict actual prices—which is largely a fool's errand—but to model the overall behavior. Judge for yourself whether you think I succeeded.
If you study markets at all, even on a quite superficial level, one of the first things you'll notice is that they are unstable. Take the stock market, for example; 1929 and 2008 were the most prominent examples of recessions—depressions, really—but the US has gone through stock market crashes and following recessions dozens of times. Eight of the last nine recessions, by the way, were under Republican Presidents. Indeed, just about every economic indicator, from wages to stock market returns, fares better under Democrat Presidents.
But it isn't just the stock market; commodities like gold and oil also show great volatility, and perhaps even more worrisome, so does the price of real estate. Some prices are more stable, like food; but this may have a lot to do with our subsidy policy. Even more exotic "goods" like Bitcoin can exhibit massive volatility. (Bitcoin actually rose in price by a factor of 6 in one month, November 2013; this amounts to hyperdeflation, indeed a mind-bogglingly high annualized deflation rate of 99.999,999,95%. Or if we use logarithms, the "Platonic percent change" as Miles Kimball calls it would be -934. For comparison, the deflation in the Great Depression was about -30%, which in percent logarithm is -35.)
This raises a deep and surprisingly complex question: Why are markets unstable?
I can think of three basic explanations, the third of which is what I believe to be true. The first two, however, are the ones usually used by neoclassical economists.
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They aren't, actually; they just look that way.
On this theory, markets are actually quite stable, and automatically correct themselves, but they appear unstable because the rest of the world is so unstable and markets have to adjust to keep up. On this view, market prices are still exactly where they should be—the efficient market hypothesis—given the state of the world; it's just that the world is a mess. "Don't blame the markets! The markets are fine; it's everything else's fault."
This is actually pretty weird if you think about it; it basically requires that the economy be somehow divorced from the rest of the world, so that things like technological changes, political upheavals or disease epidemics which obviously can have economic effects nonetheless are not in any way allowed to have economic causes. "We didn't invent new computers because of government funding or patent incentives; we did it, uh, just because. Africa isn't suffering from HIV because of poverty or tyranny or public ignorance; it's just... something that happened."
This is basically the underlying view of Real Business Cycle theory, on which recessions are caused by what are called real shocks, meaning events that disrupt the functioning of the real economy—the actual physical production of goods and services, as opposed to the financial economy which deals with money and debt and prices. I can think of two recessions that may be best explained this way: The 1973-1975 recession was caused by OPEC policy, and the 2001 recession was at least exacerbated by 9/11. Here we have actual unexpected events—both involving the Middle East, it's worth noting—that clearly disrupted the actual production of real goods and services. But try as I might I can't seem to find such real shocks in 1929 or 2008, and yet we had far worse market collapses in those years. And what I do find is some very bad financial events—involving price bubbles, huge amounts of debt, and surging income inequality. As Krugman brilliantly explains, when the bubble pops, deflation emerges, and the result is a debt-deflation depression. That sure looks like market instability to me.
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It's the government's fault for meddling so much.
On this account, markets would be stable, but taxes and regulations get in the way and prevent the market from correcting itself. This theory was in vogue during the Herbert Hoover Administration—I think you remember how that went—and saw a resurgence among conservatives and Libertarians during the 2008 depression as well. One of its most common applications of this idea is austerity, in which cuts to government spending and balanced budgets alleged to increase economic growth, even though there is basically no evidence—or even theory in any real sense—to actually back this up. Even the standard neoclassical IS-LM model clearly says that budget deficits are beneficial in a recession, and most economists oppose austerity during recessions for that reason—but policymakers ignore this advice. The nadir of austerity had to be Rogart-Reinhoff, a world-famous paper arguing that debt above 90% of GDP causes a sudden drop in economic growth—a paper that was literally based upon spreadsheet errors.
While most economists are smart enough to realize that austerity is bad in a recession, they still generally ascribe to the overall notion that markets would be stable and efficient if the government would just stop getting in the way. It is a near-consensus among economists that capital taxes should be minimal or even zero; fortunately folks like Piketty are challenging this notion, pointing out how capital income and investment aren't the same thing, and failing to tax capital leads to ever-growing concentration of wealth. Minimum wage was universally regarded as nothing but harmful—until David Card actually tested it empirically and found it not to be. Even today many economists still stick to their guns despite this empirical evidence. (The argument in that particular post would be hilarious if it weren't so aggravating: "I insist that the labor demand curve is downward-sloping!" Uh, yeah, nobody ever said otherwise. We said that labor markets are too complex to be accurately described by just a supply and demand curve with no further constraints. Or actually the aggregate labor demand curve might not be downward-sloping, because it's a dark secret in economics that there is no law requiring the aggregate demand curve to be downward-sloping even if every particular demand curve is, unless you assume that people are identical—which of course they aren't.)
Don't get me wrong; there definitely are ways that the government can intervene in the economy which are harmful—like subsidizing oil, or giving no-bid contracts to defense contractors, or creating regulations that protect oligopolies against competition. In several countries governments have printed far too much money and triggered bouts of hyperinflation (though the perennial panic about this in the US seems a bit odd, given that we have never had anything of the sort). Even certain kinds of well-intentioned policies can lead to bad results; I'm ambivalent about employment protection legislation, for instance, because while it does keep people from being fired it can also keep them from being hired in the first place. A lot of social welfare policies don't help the people they are really supposed to, or can create weird perverse incentives if the benefits cut off suddenly as income reaches a certain threshold. (Suppose you can get a welfare benefit of $500 as long as your income is less than $800. Now suppose that you are making $700. You'll get the benefit, and have a total income of $1200. But now if you're offered a raise or could take on more hours to raise your income to $800, you don't want to, because then it would be just $800; the benefits would no longer apply. This is one of the great benefits of a basic income; a basic income cannot create any perverse incentives due to substitution effect whatsoever, because everyone gets it no matter what.) There are such things as bad government interventions. But there are also such things as good government interventions, yet somehow this gets left out in most discussions of economics.
This theory may even be worse than the previous one; it is largely at a loss to explain market instability, because government policies simply don't change like that. On purpose, in fact, government policies are designed to phase in over time in order to avoid causing disruption. Indeed, the only major exception I can think of was the shock therapy policies in former Communist countries, which was designed by these same economists who think markets are perfect. They were so convinced that market instability is caused by government action they decided to prove it by doing it. They radically restructured the economy almost overnight in order to make it more "free market", and the results have been, shall we say, mixed. I'm not saying the Soviet Union was a great place to live, but Putin's Russia honestly doesn't seem a whole lot better. Richer, I guess, even for the average person; that's not nothing.
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Human beings are limited.
Given the topic of my first post, it shouldn't surprise you too much that this is the theory I believe. Human beings are often irrational, we have limited access to information, and we make mistakes. The theorems that would ensure perfect market stability depend on remarkably strong assumptions: Not only do human beings have to be perfectly rational, they also need to bear no transaction costs and have access to perfect information. Even a small amount of uncertainty or a small transaction cost can prevent markets from attaining efficiency. Indeed, strictly speaking uncertainty makes efficient market prices impossible—though under some circumstances we can at least get reasonably close to efficiency.
Those graphs above (if you're still not sure which is which, I'll give you a hint: my market model has a sort of "warmup" phase in which it behaves oddly until it has run for about a dozen cycles; the NASDAQ doesn't do that) are based on agents who are operating under asymmetric information—each one knows what they are willing to pay for the stock, but not what everyone else is—and limited rationality—a certain portion of the agents don't actually have good growth forecasts, they just follow the crowd (herd behavior). I also included some random shocks—making it a little bit like RBC theory—but there are three things to keep in mind about that: First, the shocks are much smaller than the market oscillations—there is an amplification effect. Second, the shocks aren't real shocks; they're shocks to expectations. People randomly become more or less optimistic, and it has no actual connection to any real production (for the model includes none). Third, even with shocks, a model with perfect rationality and perfect information just makes the price behave like a nice normal distribution, while the real distribution is not at all normal; like a real-world market, it is fat-tailed. Nothing in the code is fat-tailed; the shocks are nice convenient normal distributions. Instead, the fat-tailed result comes from the herd behavior of the agents.
It's actually a bit odd that this behavioral theory of market instability is so unpopular among economists; its assumptions are obviously true, for one thing—people aren't totally rational and don't have anything remotely like perfect information. Second, its implications are hardly dire; basically it says that we need regulations to protect the stability of markets, not that we should get rid of markets altogether. In fact even those food subsidies might be doing something useful, since a stable price of food seems like a good thing to have. This is if anything less radical than what the mainstream theory would say; whereas in option 1 we are basically hopeless and in option 2 we need to pull out all the stops and get rid of huge amounts of regulations, in option 3 we just need to rethink some of our current regulations and institute some better ones.
Unfortunately, option 3 is not the one that most economists seem to believe—that would be option 2. Option 2 was in fact how we got the madness that was the Commodity Futures Modernization Act of 2000, in which they actually made a regulation against regulations—a law against making laws. "We don't need to regulate the quadrillion-dollar (yes you read that correctly, with a Q; $700 trillion is a low estimate) market that is over-the-counter derivatives! Markets are inherently stable, and we could only get in the way!" This, above all, is what caused the 2008 depression. Don't ever let anyone tell you it was poor people buying houses they couldn't afford (how dare they!) or the government forcing banks to sell those houses (Fannie Mae and Freddie Mac entered the subprime market later than most private banks); the core reason why we had a financial crisis was that collateralized debt obligations (CDOs),a form of these unregulated derivatives,created a fundamental shift in the nature of how loans are made. Normally a loan that is made must be kept by the bank that makes it, so they have a strong incentive not to make loans they don't expect to be repaid. But with CDOs, that is no longer the case. Instead, banks have an incentive to make as many loans as they can, with interest rates as high as they can, in order to repackage and sell those loans to other banks—who may not have the faintest idea what they are buying. One could say those other banks have a responsibility not to buy what they don't understand, but human beings are irrational, and those high interest rates create high returns, which are so very enticing. Moreover, maybe it wasn't all that irrational, since when the whole thing came crashing down, what did we do? We swept in and bailed out all the failing banks. It was heads they win, tails we lose. There was also a lot of corruption in the credit rating system, since credit rating agencies (why are they for-profit companies!?) were paid—in effect, bribed—to artificially elevate the ratings of new derivatives to make them seem safe even when they plainly weren't. This ultimately comes down to human limitations as well; because we are in a state of uncertainty, we need some mechanism for dealing with that uncertainty, and we thought we could trust credit rating agencies to do that—but we can't.
Fortunately, I think a lot of people are coming around, seeing the flaws in options 1 and 2 and beginning to consider the possibility of option 3. Maybe it is the market that's broken, not the government, not some mysterious outside force (when RBC theory came out it was satirized as "recessions are caused by sunspots"; I think this is quite apt, since that's the sort of outside unpredictable force you need for it to work). Maybe it's broken because we are broken, or rather because we are not the perfect beings that we would need to be in order to have a perfect market. But if we understand why the market is broken, maybe we can fix it! Maybe we can figure out where our limitations lie and what effect they have on the market systems we devise. That is what I hope to see, and what, in some small way, I hope to be contributing to right now.
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