Edited by James R. Barth, Chen Lin and Clas Wihlborg
Chapter 20: The Policy Conundrum of Financial Market Complexity
Hilton L. Root Your own best footstep may unleash the very cascade that carries you away, and neither you nor anyone else can predict which grain will unleash the tiny or the cataclysmic alteration. (Kauffman, 1993) 20.1 ECONOMICS AND THE SAND PILE A pile of sand. What could be a less likely metaphor for a global financial system that contains close to $200 trillion in assets worldwide? Yet an avalanche in that sand pile caused a colossal financial meltdown that destroyed at least 15 percent of national wealth in the United States alone.1 Which grain of sand triggered the avalanche? We cannot know with certainty where it was or why it moved. Conventional risk models used by economists are poor at determining which set or category of transactions pushed the markets into a system-wide free fall, and they fail completely at expressing the market in collapse. Because financial instruments such as mortgages, bonds and derivatives operate in several markets at the same time, they are subject not only to the internal dynamics inherent in those particular markets, but to interactive risks as well, emanating from the wider financial system. In fact, trading those financial instruments might have originated the interactive risks – they reflect correlations across activities and markets when losses in one area affect losses in another. The solutions are much harder to find than when discrete sectors or markets are affected. The operative rule for policymakers who resort to social science is that one must know the cause of...
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