I read this Piece by James Hamilton and ask if maybe he makes the proposition too complicated. The major factor behind much of the market moves within a basically stable Market comes from the mathematical purchasing systems engaged today. They are basically a Traders’ mechanism, designed to detect the slightest changes in Price; as consequence, they always cut in at the same time and in the same direction, and in themselves generate the expected Market move. This directional pull basically destroyed the real operation of the Market, and acts as a parasitic force preying on the Investment funds in the Market. Any Investor must depend on long-term trends, or enter into the field of mechanical Trading themselves, the alternative being loss of investment capital. The real Question becomes what this does to long-term Investment, especially with the artificial drain of funds to Profits-Taking?
The above paragraph leads naturally into this Post by David Beckworth. The Great Moderation was accompanied by the beginning of model Trading. The asymmetric policy of the Fed was very important to the smoothing of the growth of GDP, but not the whole Answer for the Great Moderation. There had to be an additional shift in the award of Profits from growth, and this was accomplished with the mathematical model Trading which quickly adapted to fringe Trading. The relative delays in Stock price growth by Profits-Taking ensured that growth would be accomplished by heavy borrowing and Stock dilution. The Fed policy was dictated by protection of the heavy borrowing, bringing a degree of safety to Lending; a practice which was finally overborne, as it’s construction became more risky.
There are Those who contest Beckworth’s and my contention. They believe there has been no sign of a change in market formation in the period of the Great Moderation. Their essential thesis states that the new financial instruments are not the cause of the current Recession. I believe that this is wrong, that both the new instruments and Fed policy reaction to these instruments led to the Recession. This occurred because the Fed underwrote the financial practices adopted, until they became so extreme that the Fed could no longer go along; whereas the CDSs immediately began to fail. The worst impact was probably the allowance of these Swaps to be used as Reserve limits. The whole thing is a mess, and there has still been little effort expended on forestalling many of these practices because of Bank opposition to losing these high-Profit loan entities. lgl