I grew up in southern California which means that everything I ever needed to know I learned on the 405. Driving in traffic serves as a useful metaphor for a lot of life and it wasn’t until this morning that I made the connection and started to understand what Simon Johnson has been talking about all this time in blog posts like What Is Finance Really?
The parallels are clear between financial markets and driving in traffic. Arbitrage is the controlling force. For example, on the freeways arbitrage equalizes the traveling time across lanes, the commuters version of the efficient markets hypothesis.
You don’t have to have spent much time on the freeways to understand why arbitrage is not always efficient. An individual driver can get where he is going faster by changing lanes, but since there is a fixed capacity on the road this is always at the expense of somebody else. In equilibrium the total distance traveled by all is the same as if everybody were required to stay in their lanes. The arbitrage turns out to be a pure social loss due to the increased frequency of accidents.
Addendum: Calculated Exuberance has a nice take.
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September 6, 2009 at 9:17 am
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September 6, 2009 at 11:49 am
Kevin Dick
Unless there is an accident, stall, or debris blocking your lane ahead.
And just like in finance, you never know whether that’s the case ahead of you.
September 6, 2009 at 12:22 pm
James Kibler
I like this analogy quite a bit. However, I don’t think the conclusion (that arbitrage turns out to be a pure social loss) follows, at least if you use the most widely accepted definition of arbitrage. The act of weaving in and out of traffic is by definition not arbitrage, because the gain is accompanied by additional risk. It could very well be a pure social loss.
The statement “since there is a fixed capacity on the road this is always at the expense of someone else” only holds under the condition that the road is being used exactly at capacity. To see this, consider the arbitrage of changing from a lane with three cars in it to a lane with 0 cars in it. It is hard to say that this move, which is a true arbitrage, occurs at the cost of the two drivers still in the original lane.
Under the full capacity condition distance traveled in a particular amount of time might be the same if you restricted drivers to a single lane. I wonder at what point does this capacity condition exist in the process of valuing financial assets? Perhaps in very efficient markets?
The point that this post might really be making is that in some (efficient) markets arbitrage opportunities don’t exist. In these cases, excessive risky behavior probably is a pure social loss. The crux of this question is at what point do markets become so efficient that trading is ‘excessively risky’?
September 6, 2009 at 8:13 pm
Thorfinn
There remain arbitrage opportunities on freeways because there is no leverage. Carrying the analogy further; if ‘managers’ could offer to lead many cars in exchange for a fee, you would see many arbitrage opportunities clear.
Even in this market, arbitrage can be valuable. For one, it always increases the average speed. If you have two lanes, one slow and one fast, turning them into two medium speed lanes will always increase the average speed.
Arbitrage also decreases the variance in speed across lanes, which makes travel time more predictable. This allows people to better plan their trips, etc.
In this market, arbitrage will be efficient even if cars switch lanes randomly over time. Because cars spend more time in the slower lanes, they will gradually equilibriate to the optimal solution.
Carrying the analogy even further, the highway (stock) market experiences booms and busts correlated with datytime commuting (business cycle). You also get traffic waves (booms, panics, manias) that can’t be fixed by individual car arbitrage, and can persist indefinitely.
I discuss this a little more on my blog.