Tuesday, August 28, 2007

Bipolar Financial Markets

The debate between the efficient markets approach to finance, with its fully rational optimisers, trading, signal-extracting and forecasting away, and the behavioural finance approach, with its boundedly rational (or plain stupid), rule-of-thumb-bound, heuristic-addicted emoticons is pointless. It’s clear that financial markets are BPCE: bipolar- conditionally efficient.

The term bipolar is a wimpish medical euphemism for manic-depressive. Those familiar with manic-depressive illness, whether first-hand or second-hand, will agree that bipolar, with its Scott of the Antarctic connotations, doesn’t do it justice, but that manic-depressive does: Himmelhoch jauchzend - zu Tode betrübt. There are other medical euphemism that have crossed the boundary of the ridiculous. Many years ago at Yale University I found myself searching for the mental health unit (on behalf of a friend, of course!). I could not find anything resembling it, until some helpful soul pointed me to the Mental Hygiene Department. Mental hygiene!? Visions of people flossing their frontal lobes crossed my mind. What were they thinking when they came up with that term?

Back to BPCE financial markets. I don’t mean to imply that those who operate in financial markets are bipolar to a greater degree than those in any other profession, from Amish ministers to zoologists. But if one were to model the aggregate behaviour of financial markets as representing the actions of a representative agent, the choice could only be a heroically bipolar Ayn Randian figure.

An even keel is just an ephemeral, transitional state of affairs between the depth of depression and the height of mania. The mood swings can be triggered by external fundamental events, by sun spots, or be intrinsic – like the rich dynamics of non-linear differential and difference equation systems.

Unfortunately, this is where the analogy breaks down. Manic-depressive illness can in many cases be treated. Where, however, is the financial market lithium that will forestall the succession of waves of irrational exuberance and irrational despondency, the alternation of manias, panics and paralysis we have witnessed in financial markets at least since the tulip bulb mania of the 17th century Dutch Republic? Would it not be wonderful if we could have a pharmacological substitute our current inadequate prudential regulation and supervision of financial markets? A slightly more downbeat version of Aldous Huxley’s Soma perhaps?

© Willem H. Buiter 2007

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