THE BLOG
08/16/2010 10:46 am ET | Updated May 25, 2011

Gordon Gekko on Steriods: How Wall Street Computers Amplify Risk

Nouriel Roubini recently wrote an article at Project Syndicate called "Gordon Gekko Reborn" in which he argues that it's pointless and naive to expect that people on Wall Street won't be driven by greed. Gordon Gekko, of course, was the now legendary character (loosely based on inside trader Ivan Bosky) in the 1987 film Wall Street.

Roubini points out that financial markets have always had a "greed is good" mentality:

But were the traders and bankers of the sub-prime saga more greedy, arrogant, and immoral than the Gekkos of the 1980's? Not really, because greed and amorality in financial markets have been common throughout the ages.

While it is certainly true that human nature--and the propensity toward excessive greed--has not changed, there is something that most definitely has changed. The technology that can be wielded by Wall Street players has accelerated dramatically. The computers that sit on Wall Street desks today are at least 2000 (yes, two thousand) times faster than the machines that were in use in 1987 when the film was released.

That dramatic increase in computational speed, and also in memory capacity, has been accompanied by similar advances in communications technology and by significant progress in software. To see the role that technology now plays on Wall Street, it's necessary to look no further than the subprime meltdown and the ensuring global crisis.

If subprime loan programs had existed twenty or thirty years ago, it would, of course, have been possible for those borrowers to default in large numbers, just as they began to do in 2007. In earlier years, however, there would have been little or no danger that a mortgage crisis localized in the United States would have grown into the global financial calamity that befell us in 2008. The reason that disaster did occur has a great deal to do with computer technology.

The derivatives and securities, such as collatorized debt obligations (CDOs), that nearly brought the global financial system down would have been impossible to create without the use of advanced computers. And if these exotic financial instruments had not been created and distributed to banks and other institutions throughout the world, the subprime meltdown might have been a relatively minor crisis without the disastrous consequences that we continue to endure.

Even the relatively primitive computer technology available in 1987 was already beginning to have a significant impact on markets. As Wall Street begins, the date "1985" appears on the screen; that was necessary because the stock market crashed a staggering 20 percent on October 19, 1987--just before the movie was released. There was really no specific news event or other factor that might have explained the sudden market plunge. Many of the people involved in quantitative technologies on Wall Street at the time believe that the crash may have been precipitated by computer programs that traded autonomously in the hope of providing "portfolio insurance" for big investors.

In recent months, a lot of attention has been focused on "flash trading," a technique that uses extraordinarily fast computers to execute trades in tiny fractions of a second. There is also evidence to suggest that Wall Street firms are increasingly using software algorithms incorporating artificial intelligence to trade at speeds incomprehensible to any human being.

The point of all this is not that we should somehow try to halt technical progress, but that we have to recognize the implications of accelerating information technology. As Roubini points out, human nature doesn't change. But technology does change--and it will continue to advance at an accelerating rate. The people on Wall Street will not hesitate to use that technology to exploit new opportunities. The overall effect will be to amplify risk and potentially introduce new--and quite possibility completely unanticipated--systemic threats.

The pace of technical progress on Wall Street makes it critical that regulations are flexible and enforce the spirit of the law, rather than attempting to anticipate the details of the next crisis. As Roubini says, the only effective counterweight to excessive greed is genuine fear of loss--and I think that probably has to be not just corporate loss but personal financial loss for top executives.

One effective way to make a future crisis less likely would be to impose an automatic special tax (in addition to normal corporate taxes) on any institution that receives a bailout from the government. The tax should capture a substantial fraction of profits and should be imposed automatically upon the institution's return to profitability.

If the taxpayers step in and rescue a private firm from an existential threat, then I think it is entirely reasonable that the taxpayers should share in the future profitability of that firm--perhaps for many years to come. One can argue, for example, that firms like Goldman Sachs exist today only because the government intervened. In other words, all the future profits that will accrue to both shareholders and executives would not have existed without that taxpayer assistance. If you doubt that, check out the profits currently being generated by Lehman Brothers.

In addition to a special, supplementary tax on firms that receive bailouts, I would suggest that the CEO and top executives of the firm also be subject to a substantial and automatic retroactive tax on compensation received during the time leading up to the crisis. This would dissuade executives from allowing their firms to assume excessive risks in order to generate huge bonuses for themselves.

The Federal Reserve could be given the authority to impose a bailout--and the associated special taxes--unilaterally on firms in cases where a significant risk to the entire financial system exists. That would prevent firms from holding the system hostage in the event of a crisis.

My guess is that these two new taxes would dramatically change the way Wall Street firms are run. If a CEO knows in advance that his or her compensation could be subject to an onerous retroactive tax, I think we can be reasonably certain that the firm would do everything in its power to properly evaluate and minimize risk. The CEO and other executives would have a very personal interest in making that happen.

Would that result in more caution on Wall Street and perhaps less financial innovation? Perhaps it would, and that might well be a very good thing. What we need is not exotic new securities but innovation in areas like clean energy or in ways to control health care costs. The role of the financial system should be to maintain relative stability and to support investment and innovation in the real economy--and government regulation should reflect that.

For more thoughts on how advancing technology may have contributed to the financial crisis, please also see this post.

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Martin Ford is the author of The Lights in the Tunnel: Automation, Accelerating Technology and the Economy of the Future (available from Amazon or as a FREE PDF download) and has a blog at econfuture.wordpress.com .