From what I understand, this week’s near meltdown of the stock market most likely came not from fat fingers, but from a computer program gone awry. In trying to figure out exactly what happened, I decided to start from the beginning. Economists, correct me if I’m missing something.
1. In order to get anything done in society, people need money in advance. This is called “raising capital.”
2. Some people are willing to lend money to people who have ideas for doing things. Say, for example, a guy comes up with an idea to build a better mousetrap and form a company to sell it to the mouse-hating public. Say he doesn’t have enough money to do this. He needs to find someone who has some extra money willing to take a flyer on his mousetrap idea. The guy with the extra money is called an “investor.” In exchange for lending his money and taking a risk on the mousetrap, he asks for a return on his investment. This is called “profit.”
3. So then a group of other people came up with a way to bring the guy with the mousetrap idea together with the guy with the extra money. This place is called the “stock market.” People doing the matchmaking are called “brokers,” and they sell “stocks,” which are “shares” in ownership in companies. This way of doing things is called “capitalism,” because it’s based on raising capital so that things can get done in society.
4. Now say that the mousetrap company wants to expand. It issues more shares in the company, luring more people to buy stock in it (these are called “shareholders”). To sweeten the deal, it promises shareholders not merely a long-term profit (to be reaped after many years of the company continuing to grow) but regular quarterly payments (“dividends”). My dad, during his retirement, especially liked this part.
5. The stock market itself, meanwhile, grew bigger and bigger and bigger. Eventually, it grew so big that it became bigger than many businesses like the mousetrap company.
6. Meanwhile, it turned out that trading stocks was a whole ton of fun. It wasn’t just profitable (making money every time a deal was sealed). It was thrilling. Exhilarating. People wanted to trade stocks, and trading stocks took on a life of its own.
7. At first, brokers and investors kept an eye on the mousetrap, and how good an idea it was, and on how well the mousetrap company was doing. The mousetrap company issued glowing quarterly reports.
8. Next came two really big changes. First, some companies got super-big, which led them to buy other companies. It became hard to follow the companies within companies within companies, and which ones were actually doing well. Accountants came up with some complicated accounting to explain this. Second, technology increased the speed of trades. Buying and selling stocks started happening at such a dazzling pace that people couldn’t really pay attention to the actual performance of companies. Moreover, people learned that to make money, all that was required was buying and selling a stock really fast—flipping it. Since no one was interested in buying and holding shares in companies any longer, companies stopped paying dividends.
9. Trading kept on getting faster and faster, moving to a dizzying pace. It became nothing but a way to seize a momentary opportunity to grab a quick profit and run. Soon mousetraps and the company that produced them turned into background noise.
10. Meanwhile, computer programs were invented that could focus entirely on trading transactions. These paid no attention whatsoever to mousetraps or the company that produced them. Investors could use these trading programs without the help of brokers, conducting trades in nanoseconds. Investors went berserk, buying and selling and selling and buying, mindlessly reaping profits merely by conducting transactions. Oh, I almost forgot. The computer programs contained internal directions to buy and sell based on abstract algorithms that bear no relation to anything real (like a mousetrap and mousetrap company).
11. Since the computer programs are made by computer-science people, and are super-complex, no one really understands them. External regulation (i.e., stepping in to stop a trading program that has a glitch in it) is no longer possible. There just plain isn’t enough time, in between nanosecond transactions, to halt a trade that’s already happening.
12. Now comes the spooky, science-fiction part. Trading now becomes exactly like a monster. Created in the laboratory of capitalism, trading has gotten loose. It’s running around the lab, wreaking havoc on everything. It doesn’t care one bit about mousetraps or mousetrap companies or the lab in which it’s running around or even the people who created it in the first place.
13. Companies everywhere now find it hard to get capital (the monster is hogging it all, tossing it around in the lab). The mousetrap company, for example, folded a long time ago, sending its workers home to fend for themselves.