Experimental Economics: How We Can Build Better Financial Markets: How We Can Build Better Financial Markets - Softcover

Miller, Ross M.

Softcover

ISBN 10: 0471706256 ISBN 13: 9780471706250

Publisher: John Wiley &Sons, 2018

Synopsis

In a little more than thirty years, the field of experimental economics has gone from obscurity to international recognition with the presentation of the 2002 Nobel Prize in Economics to Vernon L. Smith, who took a classroom exercise he saw as a Harvard graduate student and turned it into one of the hottest areas in economics. Experimental Economics is an engaging and accessible introduction to the field by Ross M. Miller, one of Professor Smith?s first student collaborators and a pioneer in the application of experimental methods to financial markets. His book uses a series of experimental case studies to examine what makes markets work, what can cause them to break, and how experimental methods can be used to repair them.

Order your copy of this dramatic and fun-to-read exploration of the ideas shaping the future of the global economy today.

About this title

About the Author

ROSS M. MILLER teaches finance at the State University of New York at Albany and heads an international risk management consultancy with a client list that includes GE, Bank of America, Barclays, and MBIA. Previously, he was a senior vice president and director of research at National Westminster Bank. Miller is coauthor of the international bestseller What Went Wrong at Enron (Wiley).

From the Back Cover

Praise for Experimental Economics

"The best account of all of the new developments [in economics] moves far beyond Peter Bernstein's two classic volumes, Capital Ideas and Against the Gods."
?David Warsh, Boston Globe

"This is a remarkable book that weaves the deep scientific roots of modern finance and modern financial institutions with humorous perspective and considerable wisdom. Few understand the pervasive and complex economic principles that govern our world of finance. Few are aware of the academic and scientific origins of financial practices and market instruments that are commonplace today. Ross Miller uses his experience and talents acquired as an experimental economist to help us understand a world that is contradictory, potentially dangerous, and paradoxical. He entertains us while doing it."
?Charles R. Plott, Edward S. Harkness Professor of Economics and Political Science, California Institute of Technology

"Dramatic new ways for buying and selling?spectrum auctions, e-commerce, derivatives?are the economics profession's contribution to the Information Revolution. This book explains how many of these innovations began with simple experiments at Caltech. The style is a refreshing combination?dramatic and fun to read, but also historically and scientifically accurate. So I can send one to my Dad, a salesman, and another to my girlfriend, a patent attorney."
?Colin Camerer, Rea and Lela Axline Professor of Business Economics, California Institute of Technology

"[Experimental Economics] is a provocative summary of recent decades of economic research. The investor who wants to know the theory behind the markets in which he trades, the economist who has been out of the academic mainstream for many years, and the interested general reader can spend many evenings mulling over the revolution in economics that has occurred since Smith's assumptions of market perfection were challenged. Mr. Miller makes mathematical finance relevant and sometimes even poignant. His book is a marvel of combining anecdote with theory all without so much as a single partial differential equation."
?Andrew Allentuck, Globe and Mail (Toronto)

Excerpt. © Reprinted by permission. All rights reserved.

Experimental Economics

How We Can Build Better Financial MarketsBy Ross M. Miller

John Wiley & Sons

Copyright © 2005 Ross M. Miller
All right reserved.
ISBN: 9780471706250

Chapter One

Wind Tunnel Markets

On a typical Monday, the floor of the New York Stock Exchange is a beehive of activity from the opening bell at 9:30 in the morning until the closing gavel at four in the afternoon. October 27, 1997, however, was not a typical Monday. For exactly 30 minutes and 5 seconds-from 2:35:55 P.M. until 3:06:00 P.M.-all trading stopped. Traders who would normally be milling from post to post, gesturing madly to get the attention of one of the specialists who maintain the order books for each stock, prepared for trading to resume. On a few previous occasions, the entire exchange had shut down for a computer or power outage or to help members deal with a snowstorm; trading halts in individual stocks pending important news are an everyday occurrence. Now, for the first time in history, the government had brought the New York Stock Exchange to a complete standstill.

The day had started out as just another in a string of bad days when news of financial woes in Asia weighed on the U.S. markets. The problems had begun in July with the devaluation of Thailand's currency-the baht-and, with each passing day, it seemed like the crisis had spread so far through Asia's other emerging economies that its impact would eventually be felt in the United States. On Friday, the Dow Jones Industrial Average had closed a tad above 7700, down from 8200 a month earlier, but still up 200 percent from the beginning of its latest climb in 1990.This had been a most impressive run for the market. The Dow continued lower on Monday, declining steadily throughout the morning to fall below 7550 shortly before noon. The market then attempted to stage a rally, making it feebly back to 7600 at the stroke of noon. As this rally faltered, panic began to spread through the market.

By one o'clock, the Dow had fallen to 7500 and the minds of traders on the floor, as well as those around the globe, undoubtedly focused on a market regulation that had never come into play before-the circuit breakers. This regulation required that all trading in U.S. stocks be automatically suspended for 30 minutes as soon as the Dow Jones Industrial Average declined 350 points from its previous close. Designed as a time out mechanism for the market, the circuit breakers forced traders to go back to their corners-providing them with the chance to reflect on their actions. This time could also provide the opportunity for a savior to step in and bail out the market. But, most important of all, the inventors of the circuit breakers hoped that their mere existence-even if they were never triggered-would reassure the market that a safety net was in place to catch a falling market, thereby nipping panic in the bud.

As two o'clock approached, it was clear that the circuit breakers overhanging the market had not allayed the panic; instead they had helped to fuel it. Disconcerted by the prospect of being locked into their positions when the market was shut down, many traders dumped stock while they still could. The very presence of the 350-point circuit breaker contributed to its being tripped soon after the half hour with the Dow just above 7360. Indeed, many traders believed that the circuit breakers had acted like a magnet. Instead of breaking the market's fall, each circuit breaker pulled the market down to it.

During their maiden voyage into market limbo, traders had time to contemplate something even more ominous-the next circuit breaker. If the Dow fell another 200 points, placing it down 550 points for the day, a second circuit breaker would be triggered-this one suspending trade for a full hour. Given that the first circuit breaker would not be lifted until after three o'clock and the market was scheduled to shut down at four o'clock, the tripping of the second circuit breaker would shut down the market for the day. This second circuit breaker proved to be an even stronger magnet than the first.

After mulling over the second circuit breaker, traders continued to sell like there was no tomorrow when the market reopened. For those traders whose capital would be wiped out by margin calls, forcing the liquidation of their positions at tremendous losses, there would indeed be no tomorrow. The anticipated plunge in the market tripped the second circuit breaker in just 24 minutes. The circuit breaker would have been tripped immediately except that the loss in each of the 30 stocks that made up the Dow would not register on the Average until buyers and sellers could agree upon a price at which to trade. With the market verging on mayhem, it took several minutes for most stocks to resume trading. As each Dow stock opened, the Average fell several more points to reflect its new, lower price. Because the market was now moving downward by leaps, the Dow overshot the second circuit breaker; trading halted for the day after the Dow had fallen 554 points to close at 7161.

Monday, October 27, 1997, quickly made a name for itself; indeed, it made several names for itself, the most popular of which was Blue Monday, which is how this book will refer to it. One name that was not available was Black Monday-it had already been taken by the record-breaking crash 10 years earlier on October 19, 1987. That plunge was so terrifying that the circuit breakers that were triggered on Blue Monday were instituted in an effort to prevent a replay of Black Monday's events.

After the market's early close at 3:30 P.M., the president of the New York Stock Exchange met with the press and proclaimed that the circuit breakers had worked as intended. Nonetheless, they were soon modified so that a 10 percent decline in the market rather than any specific point move would trigger them. In the future, changes in the settings for the circuit breakers would be largely automatic and would require only token administrative action. (The circuit breaker limits had only been minimally adjusted prior to Blue Monday.) Had the upgraded circuit breakers been in place on Blue Monday, it is doubtful that they would have been triggered at all. The only good thing that came out of the early close of the market was that it reset the circuit breakers. On the next day, another 350-point decline in the Dow would be needed to trip the first circuit breaker.

The market opened for trading on Tuesday the 28th with considerable fear. U.S. stocks had traded sharply lower overnight on the Tokyo, London, and world's other stock exchanges, but not low enough to make the tripping of the first circuit breaker a fait accompli. After an immediate decline of nearly 200 more points to clear out the so-called weak hands in the market-mostly traders receiving margin calls-the market abruptly reversed course. By the end of the day, it had rocketed up 334 points, recouping much of Monday's loss. Figure 1.1 shows the swiftness of both the decline and the subsequent recovery. Although few people felt the need to tag Tuesday with a name, Happy Tuesday was a common choice.

Despite making banner headlines in newspapers and magazines around the world, Blue Monday has become little more than a footnote to financial history. The great bull market of the 1990s stampeded back to life, with the Dow topping 10,000 in less than two years. Monday did set a record for the largest daily point decline in the Dow; however, viewed in relative terms, the 7.2 percent decline was only the twelfth-worst percentage decline at the time. In addition, the rise in the Dow and the trading volume for the next day's rebound both set records. But all these records were quickly and repeatedly eclipsed as the U.S. stock market continued to grow in value and volatility.

The aftermath of Blue Monday and Happy Tuesday is as important as what happened to the market on those days. The change in circuit breakers most likely took the market from one bad system to another, but at least the new circuit breakers would take much longer to trigger. Even if we ignore the fact that any type of circuit breaker is likely to be counterproductive regardless of how it is structured, as technology stocks continued their unprecedented climb, the Dow was becoming less representative of the dangerously volatile part of the market. Indeed, on several occasions in 2000 and 2001, the Dow would move strongly higher on many days where the Nasdaq and S&P (Standard & Poor's) averages plummeted. The Dow had become a safe haven for the rest of the market and so investors could sustain enormous losses without their being reflected in the Dow.

The other fallout from Blue Monday was that the SEC, almost a year after the incident, produced a report indicating that the system worked while grudgingly admitting that the circuit breakers likely contributed to the rapid decline through their magnet effect rather than abating it. Still, they gave the overall concept of circuit breakers a clean bill of health even though they had provided no hard evidence to support this conclusion.

Step into the Wind Tunnel

It is instructive to compare the collapse of a market with its counterpart in the physical world. Although Wall Street ends at the East River, those wishing to continue across need only look to the north and there, less than half a mile away, is that monumental feat of engineering-the Brooklyn Bridge. This legendary structure of the nineteenth century, frequently sold to the unsuspecting and the subject of the first Ken Burns documentary, gave the world a glimpse of what might be possible in the twentieth century. But the frenzy of bridge construction that the Brooklyn Bridge inspired had to be reconsidered when engineers eventually pushed the limits of the physical world.

As engineerng failures go, the 1940 collapse of the Tacoma Narrows Bridge ranks among the most visually arresting. When it was unveiled in June 1940, the bridge was the third-longest suspension bridge in the world. It did not stay open for long, however, because the bridge's inclination to sway violently in the wind soon became apparent and so all traffic was banned from its roadway. This penchant for twisting in the wind was so pronounced that it earned the bridge its sobriquet-Galloping Gertie.

On November 7, 1940, Galloping Gertie did more than just sway; hit with a brisk 42-mile-per-hour wind, the bridge galloped into the waters of Puget Sound below. The popular reason given for the collapse was that the sustained gales caused the bridge to resonate (like a tuning fork) until it shook itself to bits. Such problems with bridges have been known since ancient times; indeed, soldiers have long been trained to break step when marching across a bridge to prevent it from resonating with their collective footsteps.

It is fortunate both that no one was injured in the collapse and that a camera crew was present to capture the event on film. This amazing footage has become the classic example of an engineering blunder; indeed, many engineering students must have the pleasure of viewing it several times in the course of their education as an object lesson.

Although the collapse of the Tacoma Narrows Bridge was a multimillion-dollar embarrassment, it led to improvements in bridge design that have helped prevent any further wind-induced collapses. The key improvement, which is now standard engineering practice, was to test the aerodynamic properties of the bridge during the design process by placing a model of the bridge in a wind tunnel. (Engineers at the University of Washington had already started wind tunnel testing of a modified bridge; however, Gertie collapsed before any of their fixes could be applied to the bridge.) Using powerful fans to create a sustained breeze, the wind tunnel provides a controlled, simulated environment in which to subject a bridge to the conditions that it could encounter out in the "real world," only on a much smaller scale. The wind tunnel works because the tendency for a bridge to resonate in the wind is approximately the same at both the small scale of the model and the large scale of reality.

As long as the scale-model bridge captures the essential aerodynamic features of the real bridge, what we learn from placing the model in the wind tunnel can be applied to the bridge in its natural setting because the same physical laws apply to both. For the purposes of wind tunnel testing, the model bridge does not have to be an exact replica of the proposed bridge. Only those salient features that contribute significantly to the aerodynamic properties of the bridge need to be included in the model. In addition, many of the finer details of the bridge, such as the electrical and drainage systems, can be omitted. Finally, because even scale-model bridges are costly, wind-tunnel tests are designed not to destroy the model, only stress it. This type of testing is far more convenient and cost effective than building the real bridge and hoping that the right gust of wind comes along to provide an adequate test of stability prior to its opening.

In general, the type of model that we should construct is dictated by what we expect to learn from it. A wind tunnel model is likely to be very different from an architect's display model, where physical appearance rather than structural stability is the reason for building the model.

Luckily for those of us who cross bridges, the government did not just issue a report saying that despite Gertie's collapse, suspension bridges were fundamentally safe, and then suggest some minor changes in their construction. Without testing a bridge before constructing it, one could only guess as to whether any recommended changes in engineering specifications would have the desired result. Although wind tunnel testing, like any simulation procedure, has its limitations, it provides an inexpensive way to avoid costly, and even life-threatening, mistakes.

It is natural to wonder why, if wind tunnels and related simulation methods work so well in the physical world, something like them cannot be used for markets, which after all provide a bridge between buyers and sellers. The economic cost of a crash in a major financial market can be trillions of dollars and the human cost is immeasurable. With that much on the line, it would seem that something well beyond a standard bureaucratic response is appropriate.

One need not spin conspiracy theories in order to find a reason why experimentation has taken so long to appear on the radar screens of many economists (and has yet to appear on the screens of some). For the bridge, the transition from blueprint to model and then on to the real world is quite smooth. The universality of physical law ensures that the basic properties of the blueprint bridge are manifested in the model. Only occasionally will the nuances of the physical reality of the model differ significantly from the idealized world of physics.



Continues...

Excerpted from Experimental Economicsby Ross M. Miller Copyright © 2005 by Ross M. Miller. Excerpted by permission.
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Edition details

• Publisher: John Wiley &Sons
• Publication date: 2018
• Language: English
• ISBN 10: 0471706256
• ISBN 13: 9780471706250
• Binding: Paperback
• Number of pages: 338