On Markets and Complexity

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TR: So what do you make of the current crisis?

RM: Anything I or anyone else tells you about it has got to be speculation, because the pathology hasn't been done. We really don't have all the data, and so very good stories we come up with now may not turn out to be the accurate explanation. And certainly I don't have the access that many other people who are in this have. But I would point out a couple of things that are structural that fit this. You'll hear in this case as in the past, "Look at all this financial innovation or financial engineering--it's caused too much complexity, and now the system has run off the tracks." To that I would say, structurally, one would expect that in the case of a successful innovation, the infrastructure to support it properly will lag behind. Why is that? It's because if you have 100 innovations, maybe 2 of them will be successful. So it is not practical to build a full infrastructure--regulatory, educational, et cetera--for all 100 innovations. Innovations are going to run ahead of the infrastructure. That, we have to recognize, is structural. It's not about bad people, it's not about incompetent people, it's not about greedy people. It's not about having a market system or a nonmarket system. Whether the problems are addressed by external regulation or a combination of that along with internal regulation--whatever set of ways, we have to be prepared when innovations come in to have some degree of oversight modulation. If you do too much of that and you stifle innovation, that's not good. If you do none at all, that's not good either. So there's something in between. Sometimes we don't do enough of it, or the growth of innovation is too quick, but the point is that there is a reason why you will typically find that financial crises are often connected with what are perceived as new things, big changes--innovations.

TR: Okay. So when you overhear people say, "The market is more complex today," what do you most want to tell them?

RM: Yes, the markets are more complex today than they were five or ten years ago. On the whole, I believe that complexity is a reflection on improvements in the system that made possible greater complexity within an acceptable risk range. The benefits came from performing the functions of the financial system either more efficiently or [from] performing more of them. That said, complexity also raises the specter of risks that can cause a crisis in which you don't fully understand what's happening, because you're in a new environment where the structures are different from what they were ten years ago. There's a psychological reason for that. We tend to be much more comfortable doing something familiar than we are with doing something new, even if the risk is the same in both cases. I'm not saying that bad things haven't happened. But if you take a horizon of, say, ten years, on the whole, the system is structurally better, but we probably have had a mismatch between the infrastructural growth and the growth of the innovations such that we find ourselves in a situation that is very costly and expensive and unnerving.

TR: Back in 1973, when you had enhanced the Black-Scholes model for the pricing of a stock option, did you have any idea about the growth of complexity that was going to unleash?

RM: Well, I couldn't have anticipated the enormous growth. But we did recognize, even back then, that its applicability went far beyond options. Also, it was coincident with the 1970s, when the world got turned upside down. You had the breakdown of Bretton Woods [the international agreement, set up in 1944, that created rules and institutions for international trade, and which pegged currencies to gold], so you suddenly had all these currencies floating; you had interest rates in double digits in the United States, which probably hadn't been seen since the Civil War; you had inflation rates in double digits; you had the stock market between 1973 and the end of 1974 fall by 50 percent, which was a greater fall than had been seen since the Great Depression; and you had the oil shocks. All of this created a high need for the development of risk sharing. So the futures market and the options market were all created back then. It was a response to need. It wasn't about capability, it was about need. You can have all the technology in the world, you can have all the great models in the world, and if there isn't a perceived need, it doesn't get adopted.