Wednesday, July 29, 2009

Regulation and Speculative Bubbles

Thomas Levenson writes today on a piece about Isaac Newton's losses during the South Sea bubble of 1720. From the article:

Newton had been an active trader in the new stock market for years before the bubble year of 1720. He made his first investment in the South Sea issue early, in 1713, and held it for several years, marking a modest paper profit. He held on through early 1720, as the company pursued a new and increasingly risky banking deal -- and as insiders began to talk up the (as it turned out, fictitious) trading profits the company expected from another venture.

That got the desired result, a sudden leap in stock prices. Starting at £128 in January, the price for South Sea securities rose to £175 in February and then £330 in March. Newton kept his head -- at first. He sold in April, content with his (quite spectacular) gains to date. But then, between April and June, share prices tripled, reaching over £1,000 ... which is precisely when he could stand it no longer. Having "lost" two thirds of his potential gain, Newton bought again at the very top, and bought more after a slight decline in July.

The South Sea stock price held up through August 1720, and then in September, the gap between the possible income from all the purchased debt and the returns promised to investors became too obvious to ignore.

The bubble burst, and South Sea share prices collapsed to roughly their pre-bubble level. Newton's losses totaled as much as £20,000, between $4 million and $5 million in 21st century terms.

OK so far: it's a story of how Newton, one of the great geniuses of all time, made a poor bet on the stock market. But Levenson somehow translates this into an urgent need for financial regulation:

Here's why this story matters now. Of all people, Newton should have known better. He had, after all, invented the mathematics that could expose the impossibility of the South Sea Company's promise of returns to be paid to an everlasting stream of new investors. And yet, even he could not resist the prospect of infinite returns on his money.

Hence, the obligation to regulate. There is plenty of recent academic research that confirms that bubbles -- including the ones we've just endured -- are not unique disasters, but the predictable consequences of human behavior in the context of implausible rewards. What Newton's experience tells us is that this has been true since the beginning of modern markets -- and that mere intelligence, even genius, doesn't help.

This is misguided. The most obvious reason why is that regulators are also people. If a genius of Newton's caliber cannot recognize a speculative bubble, why does Levenson think
some regulator can? Historical evidence indicates that regulators aren't good at preventing speculative bubbles: they have existed for centuries, despite regulation. It's easy to see bubbles in hindsight, but not so easy at the time. The NASDAQ has risen over 50% since March 6, 2009. Is that a bubble? Or just a recovery?

We don't know, of course. So rational people diversify their investments: they don't put all their eggs in one basket. They don't invest everything in one stock, or in a NASDAQ index fund, or even just in U.S. equities or bonds. They might lose in one area, even lose big, but hopefully other investments will cushion the blow. But this is just common sense investing, not something that should be regulated. We don't regulate to prevent people from wasting their money on fast cars and hot women, either.

Back to Newton, who might have bought a fast car if they had existed but would have had no interest in hot women:

The catastrophe did not sink [Newton]; he had made other, more cautious investments, including a significant stake in the East India Company, and when he died in 1727, his estate was valued at £30,000.

So Newton was rationally diversified. That makes Levenson's argument even more confusing: his exemplar of the suckered genius was actually just betting some mad money on a long shot. It didn't work out, but he wasn't ruined. How can that possibly form the basis of an argument for regulation?

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