10 October 2008

Chaos and Control

Maybe it's appropriate to remember the two opposed espionage organizations in the old TV series, "Get Smart," when one thinks of the financial markets. But what we have here is an attempt by regulatory organizations around the world to control the the global financial chaos. Many of the measures the regulators take will be helpful. But none of them will "work" in the strict sense of that word, because the event loop of the markets moves faster than the control loop of the regulators. That's what control theory says.

To make that more concrete, let me give you an example: Suppose I give you a Maserati, but I have rigged it so that its brakes, accelerator, and steering won't react to anything you do for fifteen seconds after you do it. You wouldn't last fifteen seconds trying to drive a car that powerful before wrecking it. Unless you were suicidal, there is no chance you would get into that car.

But many of us got into the stock, real estate, or financial markets. (Because over the long run all other investments fail to keep up with inflation. See the Motley Fool for details.)

The stock and credit markets move on a time scale of minutes (due to programmed trading among other things) while the Federal Reserve, the SEC, the Treasury and other regulatory agencies move on a time scale of weeks. In the strict control theory sense, the markets are out of control and have been out of control for about two decades. The only hope for the regulators to get on top of things is to slow down the event loop of the markets to a human pace - to place an indefinite moratorium on both naked short selling and programmed trading.

But that itself might have unforeseen consequences. As I said here and there, nobody really knows how the markets really work, because nobody has really tried to do a rigorous stability analysis of the markets, backed up by, say a detailed and large agent-based simulation.

So buckle your seatbelts, it's going to be a bumpy ride.

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