December 5, 2011

I have been asked to provide a guide to our scientific results that motivated my statement in support of Occupy Wall Street. [1]

Here is a summary:

Our research over the past few years has been directed at understanding the stability and instability of our economic system.[2-5] When an economic system is robust it can function under a variety of stresses, and when it is not robust even minor perturbations cause cascading failures and dislocation of its essential function. We have seen evidence of such dislocation in the financial system failures, and in government financial and economic rescue actions that only provide temporary and insufficient results.[6] Identifying the underlying reasons for instability of the economic system and how they may be corrected motivates our work.

Our results show that government policy decisions, often in deregulation but also in regulation, have undermined the ability of our economic system to function and made it highly susceptible to crises. The economic system is an essential part of the functioning of our society. When functioning properly its action enables both basic survival and many other opportunities for us, individually and collectively. The need for its functional reliability should be apparent, and should not be assumed. Similar to other systems with emergent behaviors, economic activity depends on a framework in which it can function successfully. Our analysis is designed to identify key aspects of the framework that enable economic activity, and without which systemic failure is likely. In each case we identify the nature of the systemic dysfunction associated with regulatory changes.

We have brought our concerns about regulatory actions that destabilized the economic system to regulators, in some cases directly, as in a presentation on stock market regulations we gave at the Division of Markets of the Securities and Exchange Commission (SEC).[4] Many others also strongly advocated to the SEC the reversal of recent deregulatory actions.[7] However, the SEC, under lobbying pressure from hedge funds, chose to institute a watered down version of previous regulations.[8,9] Our analysis, reported to the SEC, showed that the watered down version would be ineffective.[4] Similarly, other acts of regulation and deregulation have been carried out under the influence of corporate interests. A conclusion of our studies has been that changes in regulation have undermined the very stability of our economic system.

Our research has identified three areas of regulatory activity that have played a major role in the global financial, economic and food crises. The references were provided in my original comment [1] and are described in brief here:

Banking deregulation:

The repeal of the Glass-Steagall Act of 1934 by the Gramm-Leach-Bliley Act in 1999 allowed the creation of the "too big to fail" banks. A lobbying effort by Citigroup to achieve this legislation is a matter of public record.[10-12] The increased vulnerability of the economy due to this deregulation has been widely discussed [6] and is analyzed in our paper "Networks of Economic Market Interdependence and Systemic Risk."[3] In particular, the banks facilitated the propagation of the mortgage crisis to the economy as a whole. We conclude that reinstating banking regulation that separates domains of banking activity would inhibit cascading economic failures and play an important role in restoring economic stability.

Commodity futures deregulation:

Our research shows that rapid increases in food and other commodity prices during this past decade have their basis in deregulation of the commodities markets. This is described in our paper "The Food Crises: A Quantitative Model of Food Prices Including Speculators and Ethanol Conversion."[5] The repeal of the Commodity Exchange Act of 1936 by the Commodity Futures Modernization Act of 2000 removed limits on trading. These trading limits were established in order to limit the impact of speculation. Their repeal enabled rapid growth in commodity index funds and contributed to the volume of speculative activity that resulted in bubbles and crashes that disrupt supply and demand economics in these systems. When supply and demand are not in equilibrium, the effectiveness and even stability of the economic system are undermined. The increases in food prices have resulted in a global food crisis, causing widespread suffering and major food riots. The Commodity Futures Trading Commission is currently in process of reinstating position limits, and the primary corporation meeting with them is Goldman Sachs, which also manages the largest commodity index fund.[13]

Other work has analyzed the role of the agricultural industry in influencing regulations that promote ethanol production,[14] the second major cause of price increases.[5]

Stock market deregulation:

The repeal by the SEC in July 2007 of the "uptick rule" of 1938 eliminated its intended role in stabilizing the stock markets against the rapid selling of borrowed shares, whether for illegal intentional manipulation or otherwise. Our research provided a scientific analysis of the impact of the uptick rule [4,15-17] and motivated Congressman Barney Frank in advocating its reinstatement to the SEC.[18] Despite overwhelming public and professional support for reinstatement of the uptick rule, the SEC listened to industry advocates, especially hedge funds, who claimed that the uptick rule was not beneficial.[8,9] In March of this year the SEC implemented a rule that is only in effect if a stock's price decreases by 10% in a single day. Our analysis shows that this rule does not have the same stabilizing effect as the original uptick rule. The "flash crash" on May 6, 2010 and mini flash crashes manifest market dysfunction,[19,20] and they are consistent with our analysis of the consequences of this deregulation.

There are several other examples of regulatory activity and its consequences that are still to be described in publications. Each of these is connected with influence of corporations on regulators.

Our scientific findings have implications for the overall wellbeing of society. The economic crisis has caused widespread problems. Where catastrophic outcomes result from policy choices, we have a responsibility to identify the implications of the policies and advocate for better alternatives. In sum, I believe that the call for reduced influence of corporations by Occupy Wall Street [21] is a statement of economic necessity in the context of poorly considered decisions by government under the influence of special interests. The Occupy Wall Street movement is developing its identity and considering potential courses of action. Our research shows this is a good time to constructively engage in social change.