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Market Failure: Interdependence in Action

CAMBRIDGE, Mass.--October 3, 2008--Today we wake up to a remarkable uncertainty: market crash or market recovery. How is it that the seemingly unstoppable economic engine of the US is so susceptible to uncertainty and failure? Professor Yaneer Bar-Yam, president of the New England Complex Systems Institute, says a lack of understanding about complex systems is to blame. Professor Bar-Yam claims regulators such as the Federal Reserve, the SEC, and Congress have failed to account for the increasingly strong connections among people and organizations.

"The source for these problems is in ignoring interdependence," states Bar-Yam. "Investors make decisions by considering the risk of each investment separately and adding together the total risk. But if things are connected to each other, it can be dangerous to evaluate them independently."

Professor Bar-Yam argues that if the SEC and other regulatory organizations had taken into account the interdependent connections of our complex economic system, they might have predicted the damaging behavior leading to this crash.

He explains, "Much of the economy works through positive feedback--if people buy more, more workers are hired, who in turn work more and earn more money to buy more goods. The problem with positive feedback loops is that they can run in the opposite direction: if people buy less, fewer workers are needed, which means lower earnings and less buying. What stabilizes these loops has to do with the many different ways and places people work, buy and sell, and interact with the market. More variety creates greater stability."

Danger arises when too many people are doing the same thing--as when too many investors buy certain stocks creating a stock market bubble; or when too many invest in mortgage-backed securities, leading to the bubble we have just experienced.

A more specific example is the case of short sellers--the recent focus of the SEC's regulations. "The SEC supports policies enabling short selling because, among other things, they can help weed out the weak corporations and avoid market bubbles...When there is an overabundance of short sellers, however, they can kill off one company after another."

Professor Bar-Yam, who has done extensive research in predator/prey behavior, explains that the actions of short sellers can be understood by considering the positive and negative roles of predators: "Having a few predators to eliminate the weak and sick animals may be good for the herd, but too many and you have an extinction. In the current panicky conditions, the SEC has realized there is a problem and restricted shorting financial stocks. So what should we expect the short sellers to do? Are they going to stop selling? No. They go elsewhere and short-sell non-financial stocks, increasing the risk to the rest of the market. Protecting some of the herd makes the rest more vulnerable to predation."

Recognizing dependencies will lead to better regulation and a more stable market. When free markets become "too free," the predators can run wild. To combat this excess, Professor Bar-Yam suggests a simple guiding notion: "Moderation has always been considered a personal virtue," he states. "Today we see that moderation is also an essential economic principle. What is bad for markets is when one player, or a coordinated group, controls the movement of prices. Regulations can restrict the extent of short selling, or rapid buying, rather than forbid or allow it."

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