However, the violence of the responses to what seemed to be relatively mild imbalances in southeast Asia in 1997 and throughout the global economy in August and September of 1998 have raised the possibility of a discontinuous adjustment process. Almost all the time investors adopt strategies that seek profit only in a relatively long- term context, fostering the propensity for convergence toward equilibrium that ordinarily characterizes financial markets. Risk aversion accordingly rises dramatically and deliberative trading strategies are replaced by rising fear-induced disengagement. Yield spreads on relatively risky assets widen dramatically. In the more extreme manifestation, the inability to differentiate among degrees of risk drives trading strategies to ever more liquid instruments.
Strategies become so tentative that traders want the capacity to reverse decisions at minimum cost.
History tells us that sharp reversals in confidence happen abruptly, most often with little advance notice. They are self-reinforcing processes that can compress into a very short time period. I defy anyone to distinguish a speculative price pattern for 1999 from one for 1899 if the charts specify neither the dates nor the levels of the prices. If this paradigm turns out to be the appropriate representation of the way our economy and our financial markets will work in the future, it has significant implications for risk management. Probability distributions estimated largely, or exclusively, over cycles excluding periods of panic will underestimate the probability of extreme price movements because they fail to capture a secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic.