Tuesday, October 25, 2011

Are free markets in information flows good for stability?

Chris Dillow has an interesting post where he compares the role played by information cascades in triggering off stock market sell-offs and riots. In this context, in a recent paper Klaus Adam and Albert Marcet show that even a very small information cascade can generate significant asset price volatility. Can the same model of information cascades be extended to explain rioting?

Extending the same logic to social and political systems, there could be a strong argument that the latest communication technologies and information dissemination channels, which remove information market frictions, reduce their stability. In the circumstances, a familiar debate, similar to that between advocates of laissez faire and those favoring a more nuanced acceptance of free-markets, appears inevitable.

Laissez faire advocates would welcome the proliferation of these technologies as contributing to increasing the efficiency of information flows. They would argue that it will help people make more informed decisions and thereby reduce distortions and prejudices that are commonplace in social, political and economic markets. Is this assessment correct? Is unrestricted information flows and social networking platforms an unqualified good? Do market failures in financial and economic systems carry any relevance for information markets?

There are a few observations on this.

1. Information markets are vulnerable to atleast some of the same failures that characterize financial markets. Mere availability of information does not guarantee efficiency in decision making. As is the case with financial markets, thanks to the cognitive biases of human beings, the manner in which the information is presented or made available has important bearing on their individual response.

2. Social and economic systems straddle a fine line between stability and chaos. Unrestricted information flows often end up unsettling the delicate balance in such systems and chaos ensues. Without going into the merits of whether the delicate balance was sub-optimal or inefficient, it is often the case that stability is the casualty when the information market is unshackled. This assumes importance since socio-political stability is critical for any economic growth and development. The instability that followed the break up of countries like Yugoslavia is an example of this.

3. This brings us to an issue of whether some form of information latency is desirable for social and political stability. For example, in a highly heterogeneous society, democracy and the formal norms of democratic governance cannot be readily transplanted without having in place several other institutionalized checks and balances. Conventional norms of majority rule can be destabilizing in these countries, as evidenced by the civil wars in the aftermath of democratic elections held in a few African countries in the nineties.

4. As information flows unhindered and the communication channels become more active, the probability of even small events upsetting the balance is greater. Even small, often insignificant information flows, as the work of Klaus Adam and Albert Marcet shows, have the potential to generate considerable instability. A sharp increase in the quantity and velocity of information flows, as is happening now, significantly increases the probability of such dynamics being triggered off. This increases the social or political riskiness associated with traditionally unstable societies. This also means that instability mitigating institutional systems assume much greater significance in these countries.

5. Always-on and many-to-many communication channels like social networking sites amplifies the impact of free information flows. In all respects, these channels are much more disruptive of stability that mere information flows. Further, their stability creating aspects, most often end up being crowded out by the stability disrupting aspect. After all, do we not more often come across examples of an information flood clarifying issues instead of complicating them?

None of this is an argument in favor of placing restrictions on information flows and social networking sites. Far from it. It is only a note of caution and a pointer to possible triggers that can upset the stability of social, political and economic systems. It therefore becomes important that such information technology developments be accompanied by policies that mitigate the market failures that arise out of them.

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