Systemic Risk, Multiple Equilibriums, and Market Dynamics: What You Need to Know and Why

Using an array of real-life examples—including the current sovereign debt crisis in the eurozone—the authors analyze the underlying dynamics of the periodic bouts of systemic path dependence that affect not only financial markets (their functioning and stability, investment returns, and volatility) but also investment strategy itself. Their analysis explains how sudden shifts in expectations can morph into particularly disruptive multiple-equilibrium dynamics and points to possible implications for market outcomes, market equilibriums, and policy responses.With too many advanced economies confronting the twin dilemmas of too much debt and too little growth—and with systemically important emerging countries navigating the tricky middle-income developmental transition—today’s global economy poses unusual challenges for traditional concepts of policy responses, asset allocation, and risk management. It is also slowly changing the way investors think about correlations, volatility, guidelines, and benchmarks.These changes can be particularly pronounced in situations where markets transition from a mean-reverting paradigm to one of multiple equilibriums and path dependency. In today’s world, expectations play a major role in economic and market outcomes.On the negative side, we saw the phenomenon unfold dramatically in the 2008 financial crisis, and Europe has been experiencing it more recently. Moreover, it was central to many of the historic bubbles and bank runs that are still the subject of analysis and fascination. On the positive side, it has characterized the beneficial breakout phase in several emerging economies. We also saw it in the market reactions to circuit breakers imposed by decisive policy actions on the part of some advanced countries in 2009.In these circumstances, successful investors (as well as policymakers, researchers, and opinion leaders) must extend well beyond their conventional understanding of fundamentals, historic risk premiums, correlations, and relative value. They have no alternative but to try to understand the expectation formation process itself, including agent signaling and feedback loops incorporating economic outcomes and incentive structures. Without such understanding, continuous success in meeting objectives becomes even harder—especially in a world that will continue to delever and where policymakers are still in full experimentation mode.Both theory and the experience of the last few years suggest that investors must also enhance their analyses of policymakers’ reaction function. Indeed, this is an important input into assessments of correlations, volatility, returns, and risk.For policymakers, the need for a better design and use of ex ante and ex post circuit breakers is clear. The former prevent the evolution of structures that amplify feedback loops. The latter are better suited to break the serial contamination of expectations, the real economy, and market linkages, thereby interrupting the often disruptive dynamic that leads to a sequence of bad equilibriums.