Black Swans of August

Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet. Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961. Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007. Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable.

The phrase “black swans” has come to be used to mean a very unlikely event of this sort. Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time. This is nonsense. If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong. This is like the case when “hundred-year floods” turn up every few years.

A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it. A still better interpretation is that statistical distributions have “fat tails,” in technical terms. But it would be nice to get beyond the Jurassic Park lesson (”don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events.

What does “black swan” really mean? In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries.

Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

1. “All swans are white.” The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction. But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697. A 19th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books. It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event. A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.

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2. “Terrorists don’t blow up big office buildings.” Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings. These warnings were not taken seriously by those in power at the time. Many Americans did not know the history of terrorist events taking place in other countries and in other decades.

3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall. After all, “they never had before,” which meant that they had not fallen in living memory in the United States. They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s. Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.

4. “Volatilities are low.” During the years 2004-06, financial markets perceived market risk as very low. This was most nakedly visible 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 of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”). They should have gone back much farther - or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.

5. “Big banks don’t fail.” ”Governments of advanced countries don’t default.” ”European governments don’t default.” Enoughsaid. Greece’s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans. The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk. Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.

My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.

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