Financial analyst and author Nassim Taleb demonstrated that suppressing market volatility in the short-run leads to much more violent bursts of dislocation and chaos in the long run.
Taleb learned many of his ideas from mathematician Benoit Mandelbrot (who discovered fractals). As Scientific American noted in 2008:
One of those long-time market watchers is fractal pioneer Benoit Mandelbrot. In 1999, Scientific American published an article by Mandelbrot that showed how fractal geometry can model market volatility, while revealing the intrinsic deficiencies of a cornerstone of finance called modern portfolio theory (for which there has been awarded more than one Nobel Prize in Economics).
Mandelbrot, 83, contends that portfolio theory, which tries to maximize return for a given level of risk, treats extreme events (like, say, yesterday’s market shockers) with “benign neglect: it regards large market shifts as too unlikely to matter or as impossible to take into account.” The faulty assumption of modern portfolio theorists, in Mandelbrot’s view, is that price changes do not drift far from the mean when observing daily ups and downs—so extreme events are exceedingly rare. “Typhoons, in effect, are defined out of existence,” he wrote.
Similarly, Graham Giller – from Oxford University in experimental elementary particle physics, then strategy researcher and portfolio manager for Morgan Stanley – writes today:
The Greenspan [and Bernanke] era monetary policy has altered the distribution of changes in interest rates in a way that exchanges a reduction in day-to-day ‘normal’ variability for a considerably higher (perhaps catastrophically higher as we are finding out this week) likelihood of extreme shocks.
I first made the attached chart in 2004 after attending a lecture by Benoit Mandelbrot, and reading his “Fractals and Scaling in Finance.”
So a narrative for what the Greenspan era monetary policy has done to the distribution of changes in rates is to exchange a decreased daily variability for a higher (perhaps catastrophically higher as we have found out) likelihood for extreme shocks. [And nothing has changed under Bernanke.]
The whole enterprise of bond portfolio risk management is intrinsically unreliable.
It is this constant papering-over of the day-to-day cracks (and business cycle) that is supposedly so beneficial for our society (and central planners) as a whole that creates a building tension as the underlying causes grow larger and larger and are never purged until in one fell swoop, the market mechanism finds a way.
Of course, Taleb, Mandelbrot and Giller’s analysis of volatility means that the Fed and other central planners’ attempts to prop up some asset prices or drive some indicators down as a way to reduce volatility could well lead to a more explosive crash of the entire financial system.