Financial Market (In)Stability: Lessons from the Chernobyl Disaster

In one of the most brilliant and climactic scenes of the HBO Miniseries Chernobyl, the protagonist Valery Legasov uses red and blue cards to explain to the courtroom, and the TV viewer, how a nuclear reactor works and the flaw in the reactor at Chernobyl that led to its 1986 explosion.  If you haven’t seen the show or don’t recall this scene, it’s useful to watch a brief snippet of it before continuing:

The key idea is that there are components that heat up the reactor, such as the fission reaction, and components that cool the reactor, such as water. Legasov describes the battle between these cold and hot elements as “the invisible dance that powers entire cities without smoke or flame, and it is beautiful––when things are normal.” When something causes this system to move away from balance, there are dampening (or negative feedback) channels that bring it back to equilibrium, and amplifying (or positive feedback) channels that push it farther away from equilibrium. Making sure the dampening channels are stronger than the amplifying ones makes for a safe and stable reactor. Unfortunately, the type of nuclear reactor used at Chernobyl had a design flaw (among many) called a positive void coefficient, which created a positive feedback loop, leading to the nuclear reaction going out of control and exploding.

So what, you may ask, does any of this have to do with finance? Well, financial markets such as the stock market can similarly be thought of as battles between “hot” and “cold”, buyers and sellers, optimists and pessimists. In a stable system, these two forces are in balance, and the price of the asset is anchored to its fundamental value. When the market is out of kilter and the price is “too hot” or “too cold”, there are negative feedback mechanisms that bring it back in balance, and positive feedback mechanisms that throw it further out of balance. If the latter forces are stronger than the former, the price will keep going out of control until a crash occurs. Because such crashes have historically been extremely harmful to the real economy, it is critical for policymakers to ensure that the balance of power tilts in favor of the negative feedback channels.

So what are the key feedback channels in financial markets? A free-floating market price is the key dampener, as higher prices generally discourage buyers and encourage sellers. Arbitrageurs, such as hedge funds, are an important source of stability, as they are constantly searching for mispricing and trading in the opposite direction, for example by short-selling securities that they believe to be overpriced. Issuers, such as firms in the stock market, or governments in the Treasury and municipal bond markets, can sell new securities when they are overpriced and buy back securities when they are underpriced. Finally, the government, including fiscal and monetary authorities, can get involved if financial asset prices move too far away from fundamentals, by “taking away the punch bowl” when the party gets too out of control.

On the other side of the ledger are positive feedback mechanisms that are sources of instability. The key group here are investors whose demand is not price-sensitive, and who do not understand the relationship between price and (future) returns. In the academic literature, these have been traditionally called noise traders because they trade on irrelevant “noise” rather than actual data. However, noise traders, as they were originally conceived, would not directly dampen nor amplify price effects as their trading is random. More recent studies have focused on investors with adaptive expectations, i.e., investors who think asset prices will continue to move in the same direction as they have moved recently. Empirical studies provide strong evidence for the prevalence of such “return-chasing” investors, who prefer assets with higher prices because they believe that the prices will keep going up. The media exacerbates the return-chasing behavior of investors by focusing attention on the most extreme outliers. Readers are attracted to stories about big changes, big winner, and big losers; no one is interested in stories about non-events.

In recent years, but especially in the last fourteen months, we’ve seen some extreme, and I would argue unhealthy, behavior in various asset markets, from commodities to residential real estate, from Tesla stock to GameStop stock, from Bitcoin to Dogecoin. I would argue that this instability is a result of worrisome structural changes to both dampening and amplifying mechanisms, which have shifted the balance toward the latter.

In damaging the dampening mechanisms that create stability, one of the most harmful episodes in a long time was the “GameStop” fiasco. To recap, a large number of hedge funds shorted GameStop stock, betting that its price would decline. In a clear-cut case of market manipulation, the wallstreetbets subreddit, with millions of users, was used to organize a large-scale purchase of GameStop shares, leading to a massive short squeeze and total losses for the short sellers in the tens of billions of dollars. The media cheered all of this on, describing the episoode favorably as the “little guy” finally giving the big evil hedge funds what they deserve. While hedge funds, especially those that focus on short selling, are viewed unfavorably, they are an important force for stability, preventing prices from “overheating” (to use the Chernobyl language), and the threat of social media-driven price manipulation as happened with GameStop is likely to significantly curtail their activity.

The government, both the Federal Reserve and the fiscal authorities, have also moved from promoting stability to ignoring or even worsening financial instability. Ever since the taper tantrums of the early 2010s, the Federal Reserve has been scared of asset markets, leading to the widespread notion of the “Powell put”, i.e., that Federal Reserve Chair Jay Powell would always stop doling out the medicine and instead give out candy if the market started crying. At the start of the Covid pandemic in March 2020, the Fed properly supported financial markets and the economy, but more recently decided they would keep the extremely supportive measures in place for considerably longer, even as the unemployment rate fell to around 6%, real GDP growth exceeded 6% in the first quarter of 2021, and prices of various asset classes went into “frothy” territory.

Similarly, Congress provided large-scale stimulus in 2020 when much of the economy was shut down but then passed a $1.9 trillion relief and stimulus package in March 2021 when the economy was opening up, throwing more fuel onto a fire that was starting to potentially burn out of control. While the intentions behind all these relief measures were noble, to propel economic growth and help struggling people find jobs and see wage gains, the unintended consequences from financial market bubbles (and crashes) for the real economy would be severe.

Finally, the ranks of the main amplifying force, the less-sophisticated return-chasing investors, have grown dramatically, especially over the last fourteen months. People with little understanding of the functioning of financial markets, but with nothing to do due to lockdowns, opened brokerage accounts and started day-trading. They were attracted to “hot” disruptive investments like cryptocurrencies or the stocks that are in the portfolio of the ARK Innovation ETF, and often take their cues from social media. While higher stock market participation is terrific for long-term building of wealth and should be encouraged, the day-to-day trading behavior of these investors has contributed to market instability.

So what can be done to restore balance to the “nuclear reactors” of finance? Several remedies come to mind. More aggressive scrutiny by regulators of market manipulation to ensure that arbitrageurs can safely make bets. Use of monetary policy to correct frothy financial markets and set investor expectations that the Fed will remove the punch bowl in the future when it’s necessary even if it’s not popular. Improving financial education and literacy so that new people invest in ways that are better for themselves and for financial stability. More responsible media coverage that focuses on explaining rather than sensationalizing ongoing market phenomena. (Yeah, that last one is definitely not happening)

Stable financial markets are critical in ensuring economic stability and growth. In recent years, the mechanisms of stability have gotten degraded while those of instability have strengthened. Unless we reverse these trends, we are likely to be facing an increasing number of financial Chernobyls.