CFE Analysis | Finance

Professor Faust on Derivatives and Economic Instabilityb

In the mid-1990s as the open interest in some financial derivatives began to explode, Prof. Faust (Director of the Center but then at the Fed), was involved in several meetings where various experts argued that derivatives could not contribute to instability–derivatives only allow risk to be allocated to those who could bear it most efficiently. Ah, those were simpler times.

Prof. Faust teamed with David Bowman at the Fed to write a paper giving simple examples of how derivatives could lead to instability.

The key idea is that if the open interest became very large relative to the value of underlying real assets, then surprise price changes in the underlying could trigger massive shifts of wealth that could put the economy in a whole new—and potentially bad—equilibrium. In absence of the derivatives, such wealth shifts and price changes could not occur.

These simple examples don’t even approximate the complexity of the recent crisis, but some aspects of the crisis have the flavor of the Faust-Bowman examples. The paper, published in the Journal of Political Economy is entitled, `Options, Sunspots, and the Creation of Uncertainty.’