Stable Instability
By Daniel O'Connor of Integral Ventures, LLC
The latest commentary from Stephen Roach of Morgan Stanley points to the foreboding similarities between the market conditions of 2005 and those of 2000, both the objective indicators of excess and the subjective indicators of denial:
On this fifth anniversary of NASDAQ 5000, there is an eerie sense of déjà vu. Unlike the excesses in equities five years ago, today’s bubble is more of an interest-rate and currency phenomenon — complete with extraordinary compressions of interest-rate spreads in notoriously risky asset classes such as emerging-market debt, high-yield securities, and a broad array of credit instruments. In my view, these bubbles are joined at the hip, with today’s excesses very much an outgrowth of the post-equity-bubble defense tactics of America’s Federal Reserve. Excess liquidity and extraordinarily low real interest rates are indeed the “candy” of the current profusion of carry trades.
There’s another important similarity with the heady days of early 2000 — one that pertains more to the psyche of the markets. Emboldened by a recent outbreak of Goldilocks-type conditions in the macro space — namely, new hopes of inflationless growth — investors are becoming more and more combative at my rebalancing presentations. “You don’t get it,” they increasingly lecture me, “we live in a newly symbiotic world.” After all, they go on to say, as long as Asian central banks and their infinitely potent printing presses keep financing the excesses of the American consumer, why worry? "It’s in everyone’s best interest that this continues,” is the punch line I hear all too often these days. And, of course, that’s pretty much the way it has worked out so far, with the major nations of the world having managed to cope just fine with all the stresses and strains I seem so concerned about. I am getting challenged more and more these days as to why I believe imbalances will ever come to a head. Motive is not my concern. I certainly concede that it is in everyone’s best interests to put off the day of reckoning. The big question is, Can they?
He then suggests that this apparent stability in markets may be masking a growing instability in the global economy, one that will eventually manifest in a dramatic rebalancing of markets.
The answer lies in what can be called the “paradox of stability” — the possibility that a seemingly tranquil status quo is, in fact, masking a dangerous build-up of tensions. That is a clear risk today, in my view. While it is possible and, for some, even easy to draw comfort from the appearance of a new symbiosis between debtor (America) and creditor nations (mainly in Asia), there is a worrisome undercurrent of tensions now building. Such signs are evident on the real side of the global economy, its financial underpinnings, and also in the political arena. Ironically, this confluence of forces could well be reaching a critical mass just when investors have mistakenly concluded that this new symbiosis — code words for yet another New Paradigm — is rewriting time-honored macro rules.
This paradoxical arrangement of what I would call Stable Instability can be framed in terms of the Market Learning theory I presented in a series of book excerpts. Without rehashing the thesis, I will simply reiterate one of the basic models through this illustration:
Single-Loop Market Learning
In the language of Market Learning, our global economic conditions may be driven in part by Single-Loop Market Learning in which a temporary excess of positive feedback from market results repeatedly confirms the validity of previous exchange strategies and encourages the continuation of these same exchange strategies, thus forming a self-reinforcing dynamic. What negative feedback there is, is merely used to fine-tune the existing exchange strategies.
This is most apparent in rising asset prices that tend to rise all the more so as people believe they will continue to rise, and it is all the more interesting when the underlying exchange strategies being confirmed and encouraged involve the extensive use of increasingly-easy-to-acquire debt financing to purchase these assets (e.g., housing and mortgages). Moreover, when we consider the mutual causality between the trends in asset prices, debt balances, income levels, interest rates, saving rates, current account balances, and currency exchange rates, just to name a few, we begin to appreciate how self-reinforcing dynamics in selected markets within the global economy may indicate parallel self-reinforcing dynamics throughout all the related markets.
Double-Loop Market Learning
As for Double-Loop Market Learning, which involves the reflective evaluation of alternative exchange strategies in light of all the information available for consideration, it is possible that this may be impaired by a temporary absence of negative feedback that appears to confirm the virtue of the current exchange strategy, even among those who are well aware of alternatives.
This is most easily illustrated by recognizing that most of us do not perceive the need to rethink our exchange strategies as long as we are getting the results we want. Because most people appreciate a certain continuity in market prices, any such pattern, even one that may be based on continuous growth in money and credit, can offer the illusion of stability, for a time. Moreover, even if we are not getting the market results we want and we recognize the need for something new, our efforts to redesign our exchange strategies may be limited by our capacity to envision alternatives or by the means available to us in pursuing alternatives. In the market, values only count if they manifest in exchanges that establish actual prices, which are part of the market results that can inform the next round of Market Learning for everyone. Finally, there are those major players in the markets who may be well aware of the temporary nature of the current configuration of relatively stable prices and believe it to be in their best interest to publicly promote its continuity, while privately betting on a hedge that will capitalize on the eventual second-order change in the markets. Whether by deliberate deception or sincere mistake, even the experts will generally promote the status quo exchange strategies right up until the moment when it becomes obvious to a critical mass of market participants-with-means that the status quo must change.
Therefore, it is possible to conceive of a situation in which the apparent stability of exchange strategies and market results actually masks a growing instability that will eventually manifest in dramatic negative feedback indicating the need for entirely new exchange strategies to produce the market results people desire--a second-order change in markets. The question is, why? Why would people continue to make market decisions that, in hindsight at least, turn out to have been unsustainable, foolish, and in some cases manipulative?
Market Learning Impediments
Part of the reason why is to be found in that little box labeled "Values" in the Market Learning illustration--a catch-all term used to denote the subjective dimension of the market. Behavioral economists and their colleagues in the fields of psychology and neurology have identified no shortage of cognitive biases and heuristics--from Herbert Simon's bounded rationality to Daniel Kahneman's and Amos Tversky's framing, overconfidence, and risk aversion to the latest findings on time-inconsistency, fairness, trust-building, and political decision making--that help explain why people engage in something other than perfectly rational behavior. I have taken my economics research to a deeper level by including such complementary schools of thought as Chris Argyris's theories of action, Jurgen Habermas's communicative competence, and Ken Wilber's integral perspectives, which collectively explain the psychological, sociological, and developmental dynamics that both strengthen and weaken self-awareness and social learning.
All have been incorporated into the Market Learning theory to yield a more complete understanding of the many ways people see the market, design their exchange strategies, produce market results, and learn from their market experiences. Moreover, all these complementary theories provide insights into the many ways people can systematically fail to learn from their market experiences, which is surely a big part of the reason why imbalances develop. If these many theories of decision making, communication, and development are valid, then what I am defining as conscious Double-Loop Market Learning is a rare occurrence for the vast majority of people. When it does occur, it is typically precipitated by a crisis that disrupts the seeming stability of a long-running cycle of inherently unstable positive feedback.
Impediments Beyond the Market
That said, there is another major reason why hundreds of millions of people may be encouraged to settle into exchange strategies that generate seemingly stable market results while secretly destabilizing the global economy. The reason is that governments are constantly intervening in what would otherwise be a self-organizing market, striving to engineer market results that would not otherwise exist because of the natural tendency for markets to produce negative feedback that would likely preclude these results. As the following model suggests, the "Results" that market participants are using as the basis for their Market Learning include prices that have been directly manipulated and indirectly influenced by the policy interventions of state actors.
In doing so, state actors may be participating in the creation of the positive feedback loops that drive the growing instability, while interrupting the negative feedback loops that might otherwise re-establish a more sustainable balance. Nowhere is this more apparent than in the monetary policies of our central banks, which seem to prescribe more money and credit as the universal elixir for whatever ails the global economy. For example, as the Federal Reserve's inflationary monetary policy creates pressure for dollar devaluation, Chinese and Japanese central banks buy more, not fewer, dollar-denominated bonds as a way of devaluing their own currencies in relation to the dollar and thereby promoting export growth to the American consumers, who are thereby, thanks to lower long-term interest rates, all the more able to borrow against their appreciating homes to fund continued consumption of imports from Japan and China. If that isn't a self-reinforcing dynamic, I don't know what is.
The critical point is that it wouldn't happen like this in a pure market economy. By definition, everything the state does to move the market creates conditions that would otherwise not exist and tensions that may very well accumulate in the form of the global imbalances Stephen Roach has been tracking for years. Thus, state interventions, regardless of their normative and positive justifications, will tend to distort both Single-Loop and Double-Loop Market Learning. Acknowledging this fact does not necessarily have to imply a negative judgment against all state intervention in the market. After all, it is certainly worth considering the possibility that centralized State Learning is, in some economic situations, superior to decentralized Market Learning. Nevertheless, such an acknowledgment does highlight some important considerations for people on both sides of the political economic debate.
The Stable Instability of Market Learning
If the recent trends in dollar exchange rates, interest rates, debt balances, home prices, household income and saving, government deficits, and the current account deficit--to name just a few--are being driven by a certain more-or-less coordinated, multi-state intervention policy designed, in the most general of terms, to move the global economy away from some other pattern of results that would reflect the distributed intelligence of market participants, then who is to say that the tension between what has been and what would have been, absent the state interventions, does not still reside in the minds of market participants?
Who is to say that market participants will not eventually, one by one, little by little, slowly spreading, eventually tipping, and finally surging, turn the global economy on the axis of Double-Loop Market Learning?
While central bankers, economists, and other knowledgeable observers may successfully justify, in the midst of a policy dialogue, this more-or-less coordinated, multi-state intervention policy--this proto-global-Keynesianism--on both ethical and empirical grounds, this is of little consequence in the larger and more powerful evolutionary dialogue of the market itself. In all its distributed intelligence and ignorance, as the case may be, the impersonal market doesn't much care about the political virtues of the economic philosophy being used to control it. Nor, I suspect, do you care much about aligning yourself with other people's political and economic philosophies as you struggle at the margin to buy, sell, work, earn, borrow, spend, and invest.
Finally, because market participants are largely unaware of the specific impacts of the state interventions into the markets in which they participate, they have a very difficult time with both Single-Loop and Double-Loop Market Learning. No matter how mindful they may be in their market participation, they are still basing all their decisions on distorted information, the specific distortions in which are unknowable. So, to a certain extent, it's like a well-designed computer spreadsheet model whose outputs are nevertheless suspect due to faulty inputs: "garbage in, garbage out." You and I, whether we like it or not, are to some extent unwitting participants in whatever stable instability might be developing.
It is for these reasons that I am also concerned about the stable instability I think I see in the global economy and the American economy. Because as smart and powerful as the people at the center of the dialogue are, if their political and economic philosophies do not reflect sufficient respect for the distributed intelligence and collective power of the market's evolutionary forces, then their policies are likely to lead to a very chaotic and painful period of long-overdue Market Learning. If this should happen, then we can be sure that it will trigger a new era of State Learning and Social Learning, with potentially ominous consequences for libertarians and egalitarians alike.
© 2005 by Daniel J. O'Connor. All Rights Reserved.
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