Monday, April 21, 2014
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A Flock of Black Swans

CAMBRIDGE – Throughout history, major political and economic shocks have often occurred in August, when leaders have gone on vacation believing that world affairs are quiet. Consider World War I’s outbreak in 1914, the Nazi-Soviet pact in 1939, the Sputnik launch in 1957, the Berlin Wall in 1961, and the failed coup in Moscow of 1991. Then there was the Nixon shock of 1971 (when the American president took the dollar off the gold standard and imposed wage, price, and trade controls), the 1982 international debt crisis in Mexico, the 1992 crisis in the European Exchange Rate Mechanism, and the 2007 subprime mortgage crisis in the United States.

Many of these shocks constituted events that had previously been considered unthinkable. They were not even on the radar screen. Such developments have been called “black swans” – events of inconceivably tiny probability.

But, in my view, “black swan” should refer to something else: an event that is considered virtually impossible by those whose frame of reference is limited in time and geographical area, but not by those who consider other countries and other decades or centuries.

The origin of the black swan metaphor was the belief that all swans are white, a conclusion that a nineteenth-century Englishman might have reached based on a lifetime of personal observation and David Hume’s principle of induction. But ornithologists already knew that black swans existed in Australia, having discovered them in 1697.  They should not have been viewed as “unthinkable.”

Before September 11, 2001, some experts warned that foreign terrorists might try to blow up American office buildings. Those in power did not take these warnings seriously.  After all, “it had never happened before.” Many Americans did not know the history of terrorist events in other countries and other decades.

Likewise, until 2006, most Americans based their economic behavior on the assumption that nominal housing prices, even if they slowed, would not fall, because they had not done so before – within living memory in the US. They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940’s. Needless to say, many indebted homeowners and leveraged bank executives would have made very different decisions had they thought that there was a non-negligible chance of an outright decline in prices.

From 2004 to 2006, financial markets perceived market risk as very low. This was most apparent in the implicit volatilities in options prices such as the VIX. But it was also manifest in junk-bond spreads, sovereign spreads, and many other financial prices. One reason for this historic mispricing of risk is that traders’ models went back only a few years, or at most a few decades (the period of the late “Great Moderation”). Traders should have gone back much further – or better yet, formed judgments based on a more comprehensive assessment of what risks might confront the world economy.

Starting in August 2007, supposedly singular black swans begin to multiply quickly. “Big banks don’t fail?” No comment. “Governments of advanced countries don’t default?” Enough said.

Debt troubles in Greece, especially, should not have surprised anyone, least of all northern Europeans. But, even when the Greek crisis erupted, leaders in Brussels and Frankfurt failed to recognize it as a close cousin of the Argentine crisis of 2001-2002, the Mexican crisis of 1994, and many others in history, including among European countries.

Nowadays, a eurozone breakup has become one of the most widely discussed possible shocks. Considered unthinkable just a short time ago, the probability that one or more euro members will drop out is now well above 50%. A hard landing in China and other emerging markets is another possibility.

An oil crisis in the Mideast is the classic black-swan event. Each one catches us by surprise: 1956, 1973, 1979, 1990. Oil prices can rise for many other reasons, as they have in recent years. But the most likely crisis scenarios currently stem from either military conflict with Iran or instability in some Arab country. The threat of a supply shock typically fuels a sharp increase in demand for oil inventories – and thus in prices.

The most worrisome financial threat is that currently over-priced bond markets will crash. In theory, inflation (particularly commodity-induced inflation, as in 1973 or 1979) could precipitate a collapse. But this seems unlikely. Default in some euro countries or political dysfunction in the US is a much more likely trigger.

Evidence of extreme dysfunction in US politics is already plain to see, reaching a low in 2011 during the debt-ceiling showdown (also in August), which cost America its AAA sovereign rating from Standard & Poor’s. In theory, as the “fiscal cliff” set for January 1, 2013, approaches, fearful investors should start dumping bonds now. But investors still believe that politicians, aware of the dire consequences of going over the cliff, will again find a last-minute way to avoid it.

Perhaps observers believe that a clear result in November’s elections, one way or the other, would help to settle things. A true black swan – low probability, but high enough to think about – would be a repeat of the disputed 2000 presidential election. There has been no reform since then to ensure that people’s votes will be counted or that a disputed outcome will not be resolved by political appointees.

Scariest on the black-swan list is a terrorist attack with weapons of mass destruction. There is a long-standing gap between terrorism experts’ perception of the probability of a nuclear event and the probability as perceived by the public. (Admittedly, the risk is lower now that Osama bin Laden is dead.)

Last on the list is an unprecedented climate disaster. Environmentalists sometimes underestimate the benefits of technological and economic progress when they reason that a finite supply of resources must imply their eventual exhaustion. But it is equally mistaken to believe that a true climate disaster cannot happen simply because one has not already occurred.

Have a nice vacation.

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  1. CommentedKen Peterson

    Thank you for saving me a lot of work. I've been ineptly scratching out, paragraph by paragraph, a list of "never in a million years" things.

    Only one thing is Absolutely Certain: no one will see it coming.

    Some things, of course, are truly absurd: Ebola with a mosquito vector... Ridiculous...

  2. CommentedNicklas Sundström

    Just to add one more to the list, and closer to my own heart: The risk of a serious influenca epidemic, i.e. highly contagious and high mortality >2,5-5%

    The H1N1/09 was a rehearsal or reminder of the danger that is ever present, and it is, as far as I see it, only a matter of time. And given enough time we might have the resources, knowledge and technology be able to forestall it, or we might have developed better general defences against it, and we are certainly in a much better position now then 5 years ago.

    But the truth is, if it were to begin this afternoon in a small village in southern China and then spread to Hong Kong, matching or surpassing the deathrate of the spanish flu, we face a truly formidable challange.

    And just finishing the last pages of Gibbons remarkable Decline and Fall, it is not inconceivable to conclude that the philosophical Black species seems to emulate the preference of their living counterparts, and do indeed fly together.

    Not only with themselves, but accompanied by human hubris, arrogance, short sightedness and folly.

  3. CommentedMargaret Bowker

    I'm a writer so I hope you will forgive my love of imagery conjuring up the scenario of a flock of black swans flying across the sky in Roubini's 'perfect storm.' But seriously, the policy makers need a very good grip for the rest of the year so that the unforseen becomes the planned for and the likely e.g. Greece etc, the presently in hand.

  4. CommentedRichard Conway

    I agree that black swans will come faster and have more devestating consequences. Why?

    First, the global nature of our interactions has increased the size of what can go wrong. It also means that the effect in one place can be felt across the world with little delay. Undoubtedly the internet has helped in this process.

    Secondly, with regard to the financial markets, the structures currently in place can only result in a Ponzi style collapse. For example, here in the UK, the Bank of England is predicting no growth, yet the FTSE 100 continues to rise. This clearly will result in a shock to the system. The black swan element of this is not that it will happen, but when it will happen.

    Thirdly, the electoral systems that we have in place results in our elected leaders looking to their re-election as well as dealing with current issues. There appears to be a culture of "no failure on my watch". This leads to the propping up of failing systems. Whereas early collapse of a system such as the banking system would result in mayhem, it would be less than letting the system continue from crisis to crisis and a larger collapse ensue. The early collapse is political suicide.

    Many events that we comment as being Black Swans can be predicted. What we cannot predict is when. For example, Rome was "too big to fail", but fail it did. No civilisation has not failed. Our Western world is looking particularly fragile at the moment. Will it fail in the next 5 years, 20 years, 100 years? We can build enough scenarios for each of these, but one thing we can say is that history has taught us to look at the underlying issues not the immediate issues.

  5. CommentedPieter Keesen

    Kale Popper's concept of falsifiability is what the metaphore of the black swan pertains to. The degree of certainty prescribed by the method of falsifiability pertains to physics, and drawing conclusions form empirical data from experiments. What the black swan idea is not about is predicting the future, especially not future events in politics and finance.
    In terms of risk management, the spectrum of equations is between low probability with catastrophic consequences, and high probability associated with mild or hardly any consequence. This is the trade of bankers, politicians, military professionals, medical doctors, lawyers, etc. So let's keep it professional people, and not lose ourselves in an excersise of free association. To remind mr. Frankel; Karl Popper also wrote "The poverty of historicism". I advise you to read this book and refrain from scaring people with coincidences.

  6. CommentedZsolt Hermann

    It is a scary but factual article.
    We could add that apart from a possible mass scale economical disaster all the other probable events stem from the same source: We are stubbornly trying to force a system on our global, integral, natural, living world system that is unnatural and unsustainable.
    The longer we keep on repeating the mantra of "constant growth", "return to growth", "emerging markets", the longer we keep pumping virtual money into institutions that are obsolete and are only serving a dead system the more we create a self fulfilling prophecy about an unpredictable and volatile collapse.
    We have became so blind that we ignore the most obvious facts happening day after day in Europe, US, China and everywhere else, we read day after day how much all the political leaders, financial and economic experts are putting their hands up in defeat. We are changing governments, banks, we point fingers to the weakest links, but still do not want to accept what is wrong.
    We are all sitting on the sinking boat, we still do not want to acknowledge how much we depend on each other and only by working for the whole can we succeed. The only thing we agree on is to keep our rotten socio-economic system unchanged.
    At the moment we are looking straight at a black swan and we say it is white.