Are active and vibrant financial markets safe too?

Atlanta Fed hosted this annual conference on financial markets.

Came across this interesting paper (ppt here) by Prof. Joseph Stiglitz. In the usual Stiglitz spirit and appraoch, he crticises this whole rise of active and vibrant markets:

Capital markets are sensitive to quick changes in sentiments. Sometimes those changes are related to real changes in the economy, or more accurately, to new information about potential changes in the economy in the future—the discovery of large amounts of gas, unanticipated changes in monetary policy, the break-out of war, the breaking of a bubble. In many cases, these events or the new news had been partially anticipated. It was possible that war would break out. But the break-out of a war changes what was a possibility, or even something that had a high likelihood of occurring, into a certainty.

But often, those changes in sentiments are related to perceptions, to beliefs, which can spread across the investment community, with little relationship to underlying fundamentals. Rob Shiller and others have documented that much of the variation in stock market prices cannot be explained by changes in fundamentals, or news about changes in fundamentals2. There was nothing so dramatic unveiled in October 1987 that could come any way near accounting for the wiping out of a quarter of the value of the stock market. There were no changes in the fundamentals that could account for the wiping out of a trillion dollars of stock market value in the flash crash of May, 2010.

Keynes talked about these changes in sentiments in terms of animal spirits. Using a context that today would be viewed as politically incorrect, he focused on the market as a beauty contest, where the objective was not to ascertain the “fundamentals,” but rather to assess what others were thinking. Modern research in psychology, sociology, and social psychology has begun to explore how each of our beliefs are shaped by those around us; there can be contagion—spirits of optimism and pessimism can spread.

The paper looks at two issues:

In this paper, I provide a brief, mainly theoretical, survey of some of the key issues. I begin (in section I) with a brief reference to two basic theoretical propositions, which should frame discussions in this area: there is no presumption that unfettered markets lead to (Pareto) efficient outcomes, or even that movements towards “better” markets lead to welfare improvements.

Section II. focuses on a well-studied context–that of capital market liberalization–where there is now a broad consensus that unfettered markets are welfare decreasing.

Nice bit..

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