Hysteresis in Price Efficiency and the Economics of Slow-moving Capital
Will arbitrage capital flow into markets experiencing shocks, mitigating adverse effects on price efficiency? Not necessarily. In a dynamic model with privately informed capital constrained arbitrageurs, Jungsuk Han, Associate Professor at SSE, James Dow, Professor at the London Business School and Francesco Sangiorgi, Associate Professor at Frankfurt School of Finance & Management show how price efficiency plays a dual role, determining both the profitability of new arbitrage and the ability to close existing positions profitably.
In traditional models, when capital is available investors will engage in arbitrage activities forcing price equal to fundamental value and market efficiency is restored. Hence once a bad shock to the economy is removed the system should go back to normal. Conventional models, however, fall short in explaining the ubiquitous phenomena of slow-moving capital. Jungsuk Han from SSE and his co-authors explain that even though capital is available it does not necessarily translate into market efficiency. They argue that the amount of “active capital”, which they define as capital ready and willing to be deployed, is more important than the amount of capital itself. An increase or a decrease in active capital can have a persistent effect, creating a strong path dependency, or hysteresis. With better understanding of their proposed model, Han underscores that it can be used for signaling appropriate government intervention and protecting welfare at a relatively low cost.
The Feedback Loop
With path dependency or hysteresis, the economy can be trapped into a persistent low efficiency regime. The key driving force is the feedback between active capital and price efficiency. When mispricing increases due to a bad shock, arbitrageurs’ existing positions take a longer time to realize profits. This makes active capital more scarce as those arbitrageurs have to wait longer with their positions. If so, arbitrageurs with available capital abstain from exploiting arbitrage opportunities knowing that the investment horizon will be lengthened. Consequently, this leads to a negative cycle of further mispricing, which in turn reduces active capital even more. With capital trapped in existing positions, more and more investors avoid investing. Hence, mispricing persists due to the negative feedback loop, creating a low price efficiency regime.
Covid-19 and Slow-moving Capital
When considering bad shocks, Covid-19 is a good example. People expect the economy to be on a negative trajectory and consequently investors are discouraged to invest in mispricing because the investment horizon is prolonged. Capital starts getting locked in, and the resulting negative feedback effect leads to slow-moving capital. That is why, Han explains, capital is important, but what is even more important is active capital, which measures how much capital is immediately willing to flow into the market.
Government Measures: A Multiplier Effect
The feedback loop, however, also works in reverse. As capital becomes more available it resolves inefficiency in the market and the market becomes more efficient. As the market becomes more efficient, it increases the availability of capital by freeing up capital already engaged in investments. This opens up for ways in which the government can stimulate a multiplier effect by allowing a bit more liquidity, for example by providing more capital to arbitrageurs in the form of liquidity injections to financial institutions. Such measures can have a powerful effect by shifting expectations about future inefficiency, which in turn shortens the investment horizon and makes investors more likely to engage in arbitrage.
Proxy Measures for Active Capital to Improve Policy Intervention
Based on that, the model can be extended for empirical guidance on how to have proxy measures for active capital and use cross sectional differences of mispricing across markets. Having an idea about active capital in the market can improve policy intervention by signaling when the level of efficiency slips below a critical mass. Jungsuk Han underscores that this does not necessarily imply that liquidity always has to be supported, since markets can recover on their own most of the time. In more severe shocks, however, that will change the course of the market and create hysteresis dependence the government should get in and provide support. Above all, in any kind of financial- or liquidity crisis, if the government can support financial institutions with liquidity it will ease market inefficiency and help avoiding persisting inefficiency, as well as retain welfare of the economy at a relatively small cost.