Don't rely on markets to stabilize themselves. Photographer: Tim Boyle/Bloomberg News Photographer: Tim Boyle/Bloomberg News
Don't rely on markets to stabilize themselves. Photographer: Tim Boyle/Bloomberg News Photographer: Tim Boyle/Bloomberg News

Once again, it is Adam Smith versus John Maynard Keynes and Hyman Minsky in the financial marketplace. Smith is winning so far, but his further prospects depend less on his theory of self-enlightened individual behavior in the private sector than on the efficacy of guardrails that governments and central banks put in place.

According to Smith, the collective good is best served by the atomized behavior of rational individuals driven by self-interest. In maximizing their own needs, individuals also maximize the collective objective – a process that has self-reinforcing dynamics.

This seems to be playing out in markets today. By being willing to underwrite ever greater investment risks and pursuing higher returns in virtually any market segment, investors are also improving the likelihood that we'll see a broad economic recovery and a smooth normalization in monetary policy. In turn, the much-hoped-for prospects of the latter encourage investors to take on even more risks at ever more elevated prices and lower yields.

What is happening today is starting to look eerily reminiscent of what transpired in the middle of the last decade. The “Great Moderation” that seemed to prevail at that time was so reassuring and captivating that many people thought of it as a “Goldilocks” scenario -- not too hot and not too cold. Of course, that was before important insights from Keynes and Minsky began playing out, first in financial markets and then the broader economy.

Keynes reminds us that excessive herd behavior often takes over markets, leading to unsustainable outcomes. In insights that have been confirmed since, he observed: “worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Minsky went further in demonstrating how stability ends up breeding instability.

Contrary to Smith, Keynes and Minsky suggest that, in certain circumstances, what appears rational and beneficial for the individual may not be so for society as a whole. At some point, financial stability becomes too much of a good thing, because it encourages excessive and ultimately irresponsible risk taking by individuals and institutions. In the process, the economic system and, therefore, collective interest are threatened.

While we would all like to believe that enlightened self-interest will automatically stop the current Adam Smith phase from morphing into Hyman Minsky’s, we would be foolish to do so. Misaligned financial incentives, classic principal-agent problems and hubris all tend to get into the way. So does the unwillingness, or inability, of investors to lower their return objectives in response to market valuations that may already be too high. Instead, investors increase their leverage and risk tolerance.

Rather than act in self-correcting fashion and risk being too early, many market participants are waiting for overwhelming evidence of a sustained turn in the market – even though by the time that happens it is unreasonable to expect they will all be able to exit in a timely or orderly fashion. So investors continue to circle around the punch bowl at the risk party and only their hosts, the public sector, can play the role of the sober adult. Yet most governments today have fewer tools at their disposal to perform that function effectively.

Unlike many past periods of market exuberance, the current one is not associated with a booming global economy. Instead, growth remains sluggish, even after many years of exceptional monetary stimulus. As a result, neither higher interest rates nor tighter fiscal policy can be used to reduce the risks of financial instability; and what would be gained on that front would probably be offset by the detrimental impact on an already-sluggish economic performance. Instead, governments and central banks must rely on two other tools: thorough regulatory and supervisory regimes, and the related ability to offset excessive risk-taking through the tactical use of macro-prudential measures.

The prospects for Adam Smith in this contest depend on the proper use of these two tools, rather than on timely course adjustments by the private sector. I doubt that his disciples -- who believe the invisible hand of the marketplace and self-interested behavior of individuals will always move the economy in a robust direction -- will find this reality reassuring. They certainly shouldn’t.

To contact the writer of this article: Mohamed A. El-Erian at M.El-Erian@bloomberg.net.

To contact the editor responsible for this article: Timothy L. O'Brien at tobrien46@bloomberg.net.