A Demon of Our Own Design

"What’s wonderful about Rick is that he was an engineer and…you remember the 1987 market crash that was about portfolio insurance? Well, Rick was running one of the biggest portfolio insurance desks and he tells this great story. He had a 30 billion dollar business and a young salesman came into his office and said: ‘I’d like to get this straight. The whole principle of this, the way you’re providing portfolio insurance for your clients, is that if the market falls you will start to sell stock futures? Right?’ Rick says: ‘Right.’ And the kid says: ‘And if the market falls fast you sell them fast? And every other bank will do the same thing? Right?’ And Bookstaber says: ‘Right.’ So the kid made a bet that the market would crash and hasn’t had to work since. I don’t know and, even if the story has a slight fictional twist, it’s the real tale. That’s what really happened. And how in God’s name could they not see that? They were very bright folks. So what Bookstaber does is he steps back and looks at the whole theory of economics that drives modern markets. The underlying principle is that markets are a naturally equalising, optimising machine. Of course. But this is the current theory. And Rick is a actual engineer, so how does an engineer build a complex system? They try to build it so that it will correct anything that goes wrong. You assume random events always happen and they always amplify. So, if you’re building an internet system you do not want rapid perfect data transmission – you always have firewalls, etcetera, etcetera. But the Chicago school rational market model has been foisting the opposite idea on us. When Greenspan was on his campaign against regulation he would say that what is wrong with regulation is that you are stifling innovation, you are slowing down market signals. Rick would say that’s exactly what you should do. The whole notion that there is some kind of perfect machine there is utter nonsense."