A very good article on the Real World Economic Review

May 6th -- Signals from a very brief but emblematic catastrophe on Wall Street

ABSTRACT

This essay begins by looking closely at the underlying structural causes of the discontinuity that appeared in the behavior of the U.S. stock market at 2:40pm in the afternoon of 6th May 2010, because the emblematic “catastrophic” aspect of the collapse of equity prices, and their subsequent equally abrupt rebound, renders these events potentially informative about things that can happen in a wider array of dynamical systems or processes – including those with consequences about which there is cause for serious concern. What transpired in those 7 minutes is viewed as being best understood as a hitherto unrecognized “emergent property” of structural conditions in the U.S. national stock market that all the actors in the story collectively had allowed to come into existence largely unremarked upon, through an historical process that was viewed generally as benign and therefore left to follow its own course of evolution unimpeded. The deeper significance of the events of May 6th lies in the attention it directs to the difference between a society being able to create and deploy technical “codes” enabling greatly enhanced connectivity for “exchange networks” - the condition of “hyper-connectivity” among an increasing number of its decentralized sub-systems, and a society that also provides timely mutually compatible institutional regulations and administrative rules for the coherent governance of computer-mediated transactions among “community-like” organizations of human agents. Regulating mechanisms operating to damp volatility and stabilize systems in which there is beneficial positive feedback are considered, as are a variety of circumstances in which their absence results in dysfunction dynamic behavior. It is suggested that in view of the growing dependence of contemporary society upon on-line human-machine organizations for the performance of vital social and economic functions, continuing to focus resources and creative imagination upon accomplishing the former, while neglecting the latter form of “progress” is a recipe for embarking upon dangerous trajectories that will be characterized by rising systemic hazards of catastrophic events of the non-transient kind.

.
.
.
.
.
.
.
.
.
.
Closing reflections on the fraying nexus between financial instability and real economic growth in the 21st century

The excesses of the recent financial boom in the West and the ensuing global credit crises are not really new developments in the history of market economies, as Reinhart and Rogoff, and others before them have noticed.26 One aspect, however, may be seen to be a signal of novel things to come, while manifesting the familiar susceptibility of capitalist systems to this form of macro-instability. Nothing about that should be regarded as paradoxical: the discontinuous advent of novelties such as speciation in biological evolution is rooted in the continuity of mutant organisms’ genetic endowments with that of their ancestors.

What we have recently experienced in the confined, high-frequency dynamical behavior of the U.S. national stock market on 6th May, and also in the property-finance-and-derivatives boom and crisis, are resultants of innovations that have affected and thereby disrupted both the sphere of technical affordances and the sphere of institutionalized regulatory structures. The synchronicity of the latter disruptions in each case, and in still others, is not entirely accidental.

Rapid advances in digital technologies, accelerated by the “connection-less” architecture of the Internet have enormously expanded possibilities of effecting conditions of hyper-connectivity in specific forms of transactions among human agents and machines (‘things’). That modern society’s augmented facilities in these respects have tended to outrun its capabilities for creating networked communities (in the particular sense of the term that has been invoked here) is neither a mere coincidence nor the product of concurrent independent processes one of which inherently moves at a slower pace than the other. Technological innovations engender positive private forces that contribute that the observed lag response in “governance,” as has already been noticed. The business models of the operators of new electronic stock exchanges, like those of the small high-frequency trading firms that flocked into the national stock market, were aligned with and so worked to perpetuate the condition of high price volatility that normally is found in “thin” unregulated markets.

Thus, proximate reasons for the absence of mechanisms that would slow trading on the satellite electronic exchanges (paralleling the mandated cross-exchange “circuit breaker” regulations) can be found in the institutional consequences of the technical novelties that were driving alterations in the NMS’s structure. Much of the volume of trading came to lie beyond the established ambit of the regulatory agencies, even though the registered equity and equity futures exchanges remained in other respects well within the jurisdictions of the SEC and the CFTC. Therefore, even if one leaves out of the picture the growing importance in the NMS of the unregistered “dark pools”, there is a striking parallel between this aspect of the genesis of the May 6th “market break” and the failed regulatory supervision of the “shadow banking” system that had expanded quickly following the Glass-Steagall Act’s repeal and the introduction of loosely regulated innovative financial instruments such as the CDOs and CDSs.

The riskiness of the CDOs would have been difficult for the rating agencies to establish accurately, even had they stronger incentives to do so, because the underlying packages of variegated mortgages were not like the usual assets against which corporate and government debentures conventionally were issued. As for the CDSs, they constituted a form of insurance that deviated from conventional insurance contracts sufficiently for the firms writing them to make the case that they really were not insurance of the kind that called for the issuers to hold capital commensurate with the obligations they represented. Freed from the restraints that would otherwise have been placed upon their use within the regulatory jurisdiction of both the SEC and State commissions responsible for regulating the insurance industry, these devices for increasing “leverage” multiplied until they represented obligations far greater than even the most optimistic valuations of the assets they ostensibly were supposed to be insuring.

Situations of this sort occur repeatedly, in large part because established governance procedures and regulatory structures affecting transportation, communication or other network industries, and the contractual networks of banking and finance, historically have tended to be specified with reference to specific, widely-deployed technical or legal modes of transaction. They pertain not to generic functions, but specifically to the uses of railways, airplanes, and motor trucks, or telegraphy, telephones, radio and television systems, and to specific types of businesses (deposit banks, investment banks, and mutual saving associations) or to particular, classes of financial securities and contractual agreements. Legislative statutes addressing problems encountered with particular practices, especially technical practices, thus tend to confine themselves to dealing with the identified specific context of perceived dysfunctional outcomes. Rarely does social “rule-writing” for these domains tackle the generic goal, aiming to establish procedures that would achieve and maintain acceptable standards of performance for larger classes of socio-technical systems – including those who imminent emergence can be envisaged.
.
.
.
.
.
.