The Black Swan – spotted in Queenstown New Zealand

Black Swan – Glenorchy NZ

In December 2014, then-President Barack Obama warned that the United States needed to prepare for an upcoming pandemic. This came a soon after the Ebola outbreak had threatened to spread worldwide. People knew of pandemics and their impact from history but Covid-19 took a lot of us by surprise. This can be seen as a ‘Black Swan’ event – an event or discovery whose existence was not predictable from the available data, and whose effect on society or the markets yields surprising and unexpected results. Just because all the data says that there are only white swans does not prove that Black Swans do not exist. Philosophers debated that they didn’t exist until explorers found a Black Swan in Australia. It was quite ironic that yesterday, whilst holidaying in Queenstown (South Island NZ), I saw a Black Swan – see photo. It immediately reminded me of Nassim Nicholas Taleb book ‘The Black Swan’ (2007). The book describes a black swan as a highly improbable event with three principal characteristics:

  1. its unpredictability;
  2. its massive impact; and
  3. after it has happened, our desire to make appear less random and more predictable than it was.

The GFC unquestionably meet the criteria as a Black Swan. No one saw it coming and no one knows how it is going to end. The same can be said about Covid-19. This unexpected and hard-to-predict event was not within the range of normal expectations. However it will result in a major economic contraction on a global basis.

Economist Hyman Minsky once wrote a thesis about economic stability – more applicable to the GFC Black Swan event.
“If you have a wonderful, stable world and, better yet, it is growing nicely and nothing is going wrong, you are likely as the years go by to take more risk. As time passes the cost of taking risk gets less and less because interest rates come down. You can imagine that people will get carried away into thinking such conditions are permanent and take on record levels of debt. They think conditions will always be good. And then all it takes is one small event to create instability.”

10 years on and the financial system is still fragile

Nassim Taleb of “Black Swan” fame has a new book out entitled “Skin in the Game”. Below is an interview with John Solman of PBS ‘Making Sense’. In this he argues:

  • a financial system works only if the people who are running it have a stake in the outcome.
  • a society should be built around risk and reward – if you make good decisions you do well but if something goes wrong you are penalised.
  • Currently profit is privatised and loss is socialised, where the taxpayer only has a downside and will never have the benefit of what’s going on.
  • The financial system is at risk if people can make money transferring risk to others and aren’t penalised. Dangerous, unfair and immoral
  • The Federal Reserve tried to cure debt with debt, transferring debt from one to the other, from the private to the public.
  • The system loaded — laden with debt and with pseudo experts will collapse eventually.

How we can predict the next financial crisis

Two delusions characterized the Great Crash of 2007-2008 which wiped $5 trillion off global GDP and $30 trillion off world stock markets, according to risk analyst Didier Sornette, author of ‘Why Stock Markets Crash: Critical Events in Complex Financial Systems’.

1. It could never happen: we had supposedly entered the age of “economic moderation” buttressed by never-ending growth, low unemployment and low financial volatility otherwise known as the ‘Goldilocks economy’—not too hot, not too cold, but just right.

2. We couldn’t possibly have seen the Crash coming: it was a rare ‘Black Swan’ event, an unpredictable outlier, a freak wave of economic destruction.

While the first myth has been comprehensively debunked, the second myth persists among economists, central bankers and policymakers around the world, the French economist told TEDGlobal 2013 conference in Edinburgh. We were somehow helpless in the face of “the wrath of the Gods…there was no responsibility.” See the TED Talk below – well worth a look.

Markets after disasters

From The Economist Daily Chart series. An interesting picture of how local stockmarkets reacted to the aftermath of a national disaster.

2011 Japan Earthquake – The Nikkei 225 – 17.5%↓
2001 USA Terrorist attacks – S&P 500 -11.6%↓
1995 Kobe Earthquake – Nikkei 225 – 7.6%↓

However while this earthquake was, to a certain extent, a forseen event – remember Japan has a history of earthquakes – the damage to the nuclear power station was not. Some commentators have likened this to a Black Swan – see previous posting: 2011 Black Swans. The Black Swan has three characteristics:
1. its unpredictability;
2. its massive impact; and
3. after it has happened, our desire to make appear less random and more predictable than it was.

One wonders if this disaster has given the US Federal Reserve a key reason to undertake further Quantitative Easing 3 (QE3)?

2011 Black Swans

A few days have past since my last post – had another spell at the beach with family before heading back to Auckland. Anyway Bernard Hickey wrote a nice piece on the NZ Herald website today with regard to Black Swans.

No doubt you would have come across the book entitled “The Black Swan” (2007) by Nassim Nicholas Taleb. He describes a black swan as highly improbable event with three principal characteristics:
1. its unpredictability;
2. its massive impact; and
3. after it has happened, our desire to make appear less random and more predictable than it was.

Nassim Nicholas Taleb could see the banking crisis being realized, and this quote from “The Black Swan” explains partly the rationale for the current environment. Remember it was written when the world was awash with cheap credit and leaders were content with what was happening.

“So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crises less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur I shiver at the thought.” Page 225-226

2011 – Black Swans

Hickey mentions the following in his piece:
* Irish Politics – with a likely change of government there is the probablity that holders of Irish bonds will suffer losses and subsequently put pressure on UK and German banks
* Chinese inflation – with pressure on prices there could be social unrest as lower income groups grapple with the cost of living
* Aussie house prices – already depressed in Queensland, Sydney and Perth this could mean lower volume of imports from NZ
* Higher oil prices – conflicts in the Middle East could lead to supply pressures
* Kiwis stop spending – still a lot of debt around and deleveraging.

A couple of my predictions for 2011

* US Fed goes for QE3 – Quantitative Easing No. 3 – as the banks once again get into trouble
* Gold hits US$1,700 an ounce as investors run for cover
* Reserve Bank of New Zealand maintain their expansionary stance and don’t increase interest rates until September
* Ireland win the Rugby World Cup