Tulipomania DotCom Reader
hedging by traders on the Chicago Board Options Exchange, for example, forms a significant part of the volume of trading on the New York Stock Exchange. Larger, more liquid markets make it easier and cheaper to buy and sell financial assets, and so the continuous revisability of portfolios becomes a more realistic approximation to reality. The key general point was made fifty years ago, not by an economist, but by a sociologist, Robert K. Merton, father of the finance theorist: beliefs about social institutions are a constitutive part of those institutions, not simply an external description of them. Merton's first example - in retrospect a poignant one - of what he called 'self-fulfilling prophecy' was a run on a bank: a rumour that a bank is about to fail causes depositors to seek to withdraw their funds, making what was actually a sound financial institution unsound. Alone among the commentators on LTCM, Dunbar notes Merton's article, but even he does not explore its full significance. To do so, we must free ourselves from the assumption that a self-fulfilling prophecy is necessarily pathological. In some cases it is: Merton gave the example of the racist belief that black workers were strike-breakers, which was used to justify their exclusion from trade unions, and often left them in the position of having to take whatever work was available. In other cases, however probably the vast majority - self-validating belief is perfectly rational. In the case of money, for example, the widely-shared belief that dollar bills will continue to be exchangeable for goods and services makes them usable for such purchases (that it is beliefs that ultimately constitute money becomes plain when those beliefs become precarious, as in times of social collapse or hyper-inflation). More generally, as Barnes has pointed out, all stable social institutions are underpinned by self-validating beliefs, and that is no criticism of the institutions or the beliefs: it is what constitutes their stability. As markets and financial institutions change, the relationship between the assumptions of finance theory and 'reality' (even in very particular areas) does not remain static: it evolves. The dominant tendency, over the last thirty years, of what Robert C. Merton calls the 'financial innovation spiral' has been to increase the truth of finance theory's typical assumptions. Markets have become more efficient and more liquid, new products have made them more complete, arbitrageurs on the look-out for inefficiencies have become smarter, more thorough and more determined, transaction costs have decreased radically, and the ease with which positions can be adjusted has typically increased considerably. Within this primary pattern, however, are many secondary complexities: the interconnections of institutions, beliefs and actions do not always promote stability. That, perhaps, is what gave the summer and autumn months of 1998 their dreadful significance for LTCM. The fund's market positions were varied, but a common theme underlay many of them. Using extensive statistical databases and theoretical reasoning, the firm identified pairs of financial assets the prices of which ought to have been closely related, which should over the long run converge, but which for contingent reasons had diverged: perhaps one was temporarily somewhat easier to trade than the other, and therefore more popular, or perhaps institutions had a particular need for one rather than the other. The fund would then buy the underpriced, less popular asset, and borrow and sell the overpriced, more popular one. The close relation between the two assets would mean that general market changes such as a rise or fall in interest rates would affect the prices of each nearly equally, and long-run convergence between their prices would create a small but low-risk profit for LTCM. The partnership knew perfectly well that over the short and medium term prices might diverge further, but the risks and the
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