Eu: Professor Casti, Professor Persaud, thank you for your time. What can we do about financial bubbles?

Casti: Well, my background, unlike you guys, is not finance, but mathematical modeling and social behavior. But as far as bubbles are concerned, I believe if you live in an environment where people freely trade back and forth and prices are set by supply and demand, bubbles are inevitable. What you can do to mitigate them is a different question. I am not sure it is a good idea to try to mitigate them. I was hoping to gain insight from you in this regard.

Persaud: Well, cycles are natural, and we are not good at calibrating bubbles, so attempts to eliminate them would be difficult. This is not to say we shouldn’t do something. They can be extremely damaging and have huge social and economic consequences. You can see the effects of the Asian financial crisis, for example, in the infant mortality rates of Indonesia and Thailand.

Eu: So policy-makers have a legitimate role in limiting the scale, frequency and impact of crises?

Persaud: Yes, however, recent regulatory trends have made crises more frequent and intense. The reason is that the trend of removing government and replacing it with the market has upset the balance. At the heart of financial regulations now are market prices, which inevitably amplify a crisis.

Eu: Why should we try to mitigate bubbles?

Persaud: This is the 85th major financial crisis, so we have a lot of data. What happens is that public debt levels double, unemployment rates double and there is a huge impact on poverty and inequality. How should we respond? It is not so much about eliminating bubbles, as about moderating their excesses. The principal problem is what is referred to as “macroprudential.” There used to be a philosophical view that we could make the financial system safe by making individual firms safe. That, in my view, was always flawed.

Eu: John, in your opening remarks you asked if it makes sense to mitigate bubbles. Would you explain that?

Casti: From the viewpoint of a system theorist, it is possible to construct systems in which every component functions perfectly, but the global system still crashes. This occurs when components have an anticipatory bias. In other words, when decisions are not just taken on the basis of the past and current situation, but in anticipation of what the future will be. So, the idea of making sure every firm in the economy is behaving as it should provides no guarantee that the system as a whole will behave as it should.

Persaud: Yes, that is my point.

Casti: The second system-theoretic point relates to the difficulty in calibrating cycles. As a consequence it is unclear exactly when you should act. I agree with Avinash, you don’t want a situation where things fly into the stratosphere, which is what happened recently. On the other hand, as far as regulation goes, history has not been kind to the measures of intervention.

Eu: A lot of macroprudential measures presuppose our ability to measure and identify the right signals. Avinash, is there a simple, realistic way to solve these problems in complex systems?

Persaud: I am confident there is. The problem is that the measure of risk in financial systems was market prices. And in the middle of a boom, for all kinds of reasons, the markets don’t see the risks. So back in 2006, the banks’ models were telling them that they didn’t have enough risk because their measured risks had collapsed. They were running more capital than required. Of course this is unprofitable, so stock markets whipped institutions running excess capital. The problem is that market measures of risk were pro-cyclical.

Eu: What prevents the implementation of counter-cyclical systems?

Persaud: Our ability is largely politically, not technically, constrained. No one has an interest in bursting a bubble: not politicians, central bank governors or regulators. So you need a rule-based system that leans against the wind.

Casti: Can you see such a system realistically implemented in the near future?

Persaud: The Basel Committee has made a framework proposal and suggests such a system could be in place within two years. So, yes, we could soon have a slightly more counter-cyclical system, though how counter-cyclical remains to be seen. Don’t forget, most crises from 1950 to 1980 were significantly less impactful than those in the 1990s. That’s because we were using, inadvertently, systems that were more counter-cyclical.

Eu: Can we simplify the world to a set of rules that catch such problems? What could the Swiss government, as an example, have done better to prevent UBS getting into trouble?

Persaud: In a boom the assets of banks, such as UBS or Northern Rock, grow well above traditional growth rates. At that point, the regulator needs to require the banks to put aside more capital. Now what actually happened was that banks put aside less capital because they were concentrated in an area where the market said risks were low. If you read the auditor report you see UBS was adhering to the practice of using market prices for risk. That was their problem.

Casti: Would you say that the measures people were using for characterizing risk were out of balance?

Persaud: Yes, the models assumed independent behavior and not strategic behavior. What happened is that the world standardized on the same risk models. This led to homogeneity of behavior, which made the degree of risks far greater than the models could predict. As a result, the system became extremely fragile. The fundamental problem is the way we measure risk: if we measure risk incorrectly, then limiting bank bonus to the risk or limiting capital to the risk is not enough to avoid a future crisis.

Casti: Even if you had a better measure of risk than, say, Black-Scholes turned out to be, then it still would not change this problem. If everyone is doing basically the same thing at the same time, you exacerbate whatever risk there is.

Persaud: That’s why you need regulators to intervene in a counter-cyclical way. The markets can’t do it.

Eu: Is the regime that you are imagining one where all the regulators use the same measures requiring the same or similar behavior?

Persaud: People who talk about global regulation miss the point. The one area where we actually had global regulation was banking. Now, we don’t need to globally agree on macroprudential intervention. We have to agree on principles which define intervention. Even today, in the mother of all recessions, every country is at a different stage in the cycle, so you couldn’t have a common intervention even if you wanted.

Casti: May I return to Doug’s question about complexity? You asked, “Are some systems too complex for us to get a handle on?” This issue has also been raised in the context of ecological networks: What is the relationship between the complexity of the system and its ability to absorb changes and continue to function in the light of disturbances. The general conclusion is that there is a kind of sweet spot to complexity. Ideally the system should be like Goldilocks’ porridge: not too simple, not too complex, but just right. At that level of complexity you get the kind of structures Avinash is suggesting.

Eu: What are the issues stemming from the recent crisis that we need to think about?

Persaud: I think this crisis will cast a shadow for many years. One lesson is that there is not one thing called “risk.” The reality is we have different types of risk. We have credit risk, which is different from liquidity risk, which is different from interest rate risk. The way you see these risks as different will dictate how you hedge them. Another lesson is the importance of liquidity risk. Liquidity risk opens an opportunity for pension funds as they have a unique capacity for liquidity risk in the way that banks with short-term funding do not.

Eu: John, we’ll let you have the last word.

Casti: I agree about the long-term ramifications, but financial networks are not the entire global system. Many trends are converging now and major shifts in the political and ecological structure, even shifts in social values, are occurring. I think we are experiencing the early stages of something that may end up, in the historical perspective, looking like the Great, Great Depression. I think the situation will be negative for a considerable period of time.

Published by PROJECT M in November 2009