This time last year the financial world was tumbling around our ears, as Lehman Brothers and AIG became high profile casualties of the credit crisis. But one year on, the world as we know it has not vanished. Rumours of the death of capitalism appear to have been exaggerated.
It is time for some perspective. The causes of the financial crisis are now well known. Among them: years of low interest rates, the boom in mortgage lending, lowering of lending standards, growth in leverage, and the property price boom.
To those rather abstract causes may be added more human ones. Many people were making money from the bubble, including those who happily sold $100,000 mortgages to creditors obviously unable to meet the repayments, as well as the bankers who bundled those mortgages together and added leverage to satisfy the aggressive return expectations of their fund manager clients. Over-reliance on rating agencies was also a factor: before the crash, mortgage debt was very highly rated. Before the crash, mortgage debt was generally seen as non-risky.
Looking deeper, crashes may be an inevitable part of capitalism. Once you allow a free investment market, bubbles and crashes may be unavoidable. Investors speculate, and sometimes speculations run away into self-reinforcing bubbles. Prices escalate, and people begin to believe in a free lunch. Eventually, as in 1929 or 2008, the bubble bursts. This does not mean there will not also be periods of relative tranquility.
Not only economists, but also entomologists have studied the phenomena of herding. In one experiment, ants were placed equidistant between two identical food sources. The scientists wanted to know how many ants would eat from one source and how many from the other.
You might guess the result would be about 50%-50%, but it was not. After a time, 80% of the ants ate from one food source while only 20% used the other. The ants were communicating with each other as to where to go, and the majority opinion became self-reinforcing. Give the ants more time, and sometimes there is a flip, with the 80%-20% split inverting to 20%-80%. The behaviour of bulls and bears in the financial markets can be modelled in an analogous way. Of course, humans, unlike ants, also try to predict what the majority opinion will be.
Have an enjoyable Monte Carlo, and many more to come.