Suppose you went into the street and hit passersby with some breaking news: “Listen,” you say, “derivatives and other exotic financial products can sometimes make financial markets less stable and more prone to crises. What do you think about that?”
Those with any grasp of what you were talking about would say, “Are you kidding? We already know that. All that stuff is mostly used for gambling and speculation.”
In the world of academia, it’s no joke. The idea that derivatives might not make markets safer and more efficient is a relative novelty that is being pursued by a small group of economists. One standout is Alp Simsek, a young assistant professor of economics at the Massachusetts Institute of Technology.
The standard theoretical story in economics claims that derivatives and other financial products – including the infamous collateralized debt obligations that fueled the housing bubble and the credit-default swaps that afflicted insurance giant American International Group Inc. – make markets more “complete.” By allowing participants great flexibility in crafting positions, they lead to better risk-sharing, lower transaction costs and better information for all.
The story has strong appeal to those who make their money selling financial products. It reached perhaps its apotheosis in 2005, when the economists Robert Merton and Zvi Bodie published a paper celebrating “vast improvements in our understanding of how to use the new financial technologies to manage risk” and claiming that further financial innovation could only lead to a progressive “spiraling” of markets toward the theoretical limit of perfect efficiency.
William Brock, Cars Hommes and Florian Wagener demonstrated in 2009 that we should in general expect more derivatives to make markets less stable: Through the very act of reducing the risk of some strategies, they invite more vigorous gambling on others. About the same time, a group of physicists showed that the theoretical ideal of complete markets should actually be inherently unstable because, in approaching this limit, tiny shocks to the economy come to demand huge changes in investors’ portfolios.
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