On Isaac Newton and the need to regulate the financial markets

Yesterday CNN.com published my op-ed. in which I told the story of Isaac Newton’s catastrophic losses in the stock market during the South Sea Bubble of 1720.  That piece is a distillation of a section in my book, Newton and the Counterfeiter (AmazonPowells,Barnes and NobleIndiebound) in which I discuss, inter alia, Newton’s role in the formation of what have become our modern ideas about money, finance and banking

For me, the moral of Newton’s catastrophic brush with stock market gyrations is that regulation of the financial markets is essential.  Slightly expanding — my account in the CNN piece — this is so because human emotional responses in the midst of a money mania make even the most seemingly expert brains prey to belief in the impossible.

This is not a new thought, and examining it in detail is a staple of behaviorial economics.

Its connection to a justification of financial regulation is that this known deviation from the ideal view of markets made by rational actors with equal access to information is (a) exploited by the unscrupulous — and in fact there was fraud as well as simple delusion implicated in the South Sea Bubble — and (b) is simply an easy-to-spot example of a whole spate of real-world departures from the ideal markets of myth and beginning economics courses.

So far this seemed to me almost too banal to mention.  But the comment thread to the piece reminded me why it’s important to pound this drum. And that’s because those who don’t know, or don’t wish to know, about the gap between aspiration and experience* keep on coming back for more.  This comment on my piece is typical of one (I think a minority, but not by that much) reaction to what I wrote:

Claiming Newton should have known better is disingenuous. Just because he was of above-average intelligence does not give him the ability to know the unknowable. Fraudulent behavior is hidden precisely because it offers no benefit if everyone knows its fraud. Additional regulation on fraud is unnecessary — it’s already illegal — and additional regulation on non-fraudulent transactions is also unnecessary as it only adds cost and makes the transactions less efficient, as the author points out. Attempting to regulate the risk out of investments is folly — the only difference between a casino and the stock market is the odds.

This truly is a statement within a dream.  In this writer’s pleasing fantasy, no fraud may be detected or deterred by a regulatory body other than that of the local sherriff.  And no transaction that does not involve outright fraud can possibly distort the market.

What’s impressive about this commitment to assumptions-not-in-evidence is that it was written yesterday, Wed. July 29, 2009 — just five days after this piece appeared in The New York Times.  This fine piece of MSM economics reporting (see — there really is good stuff out there) — documented the apparently legal use of very fast computers by leading Wall St. firms (Goldman Sachs, anyone!) to front run, and thus cheat other investors in the markets.  Money graf:

High-frequency traders often confound other investors by issuing and then canceling orders almost simultaneously. Loopholes in market rules give high-speed investors an early glance at how others are trading. And their computers can essentially bully slower investors into giving up profits — and then disappear before anyone even knows they were there.

The cost adding, inefficiency, and theft in the markets affected by these trading technologies (which is to say the same markets where I and everyone else with a 401k live) is not driven by regulation, but by its absence or lack of enforcement.

As Newton used to say at the end of his proofs in the Principia, Q.E.D.

Image:  South Sea Bubble card reproduced in the 1841/1852 editions of Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, LL. D.

Explore posts in the same categories: bad behavior, deceit, Economic follies, Policy, Stupidity

One Comment on “On Isaac Newton and the need to regulate the financial markets”

  1. BCC Says:

    Excellent post and excellent piece on CNN.com.

    I do have to say that reading the comments on most any article on a high-volume news site (CNN, ABC, boston.com…) does make me despair about the human condition a little bit.

    Is it really that hard or undesirable to construct an argument that is based on both a reasonably verifiable starting premise, and internally consistent logic?

    I know that humans are not as rational as we like to think, but our collective willingness to honor our own internal “truths” over data and logic to the contrary is generally disheartening…


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