More Black Swans?

I have arguedthat the best way to think of “black swan” events is as developments that, even though low-probability, can in fact be contemplated ahead of time.  Even if they are the sort of thing that has never happened before within an analyst’s memory, similar things may have happened before in the distant past or in other countries.

What current possible shocks have probabilities that, even if fairly low, are high enough to warrant thinking about now?  Some have been discussed ad infinitum, others hardly at all.

  • Most widely discussed is the danger of a break-up of the euro. Considered unthinkable a short time ago, the probability that one or more euro members will drop out is now well above 50%. Currency unions have disintegrated before.
  • Another is the possibility of a hard landing in China, analogous to the crisis that hit Korea and other East Asian markets in 1997.
  • An oil crisis in the Mideast is the classic black swan event. Each one catches us by surprise: 1956, 1973, 1979, and 1990 (among others). Oil prices can rise for lots of reasons, not just crises in the Mideast, and have done so in recent years. But the most likely crisis scenarios currently stem from either military conflict with Iran or instability in some Arab government. The threatened loss of supply to world markets typically shows up as a sharp increase in demand for oil inventories and thus in prices.
  • The most worrisome financial threat is a crash of currently over-priced bond markets. In theory such a crash could be precipitated by inflation (particularly commodity-induced inflation as in 1973 or 1979). But this seems unlikely. More likely triggers are (i) a breakdown in the eurozone or (ii) political dysfunction in Washington. A default in Greece or some other Mediterranean country could trigger a global debt crisis any time. The evidence of extreme dysfunction in US politics is already there for all to see, in the attempts by some politicians to repeat the macroeconomic policy mistakes of 1937 and in the debt-ceiling show-down of August 2011 (which led S&P to downgrade US government credit rating from AAA to AA). The obvious crunch date comes after the American election, as the “fiscal cliff” approaches in the last two months of this year. In theory, fears of what will happen January 1 should lead investors to start dumping bonds now. But it is still considered a sign of sophistication in financial markets to opine that, precisely because the consequences of going over the cliff would be so bad, the politicians will again find a last-minute way to avoid it. In truth, the fact that we haven’t gone over the cliff before does not necessarily mean we won’t this time. Perhaps observers think that a clear result in the election, one way or the other, would help settle things. A true black swan in the mix would be a repeat in November of the disputed 2000 presidential election; there has been no reform in the meantime to assure people that their votes will be counted or that a disputed outcome would be resolved by independent institutions rather than by interested political appointees.
  • Scariest on the list is a terrorist attack with weapons of mass destruction. When politicians have used the specter of a September 11 repeat to scare the American public into supporting unhelpful policy responses, the mistake has been in the unhelpful policy responses, not in the “scare” part. There is long-standing gap between the probability of a nuclear event as perceived by terrorism experts and the probability as perceived by the public. Admittedly the probability is lower now that Osama bin Laden is dead.
  • Last on this 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 of necessity be exhausted eventually. But the disbelievers are just as faulty in their reasoning that because a global climate disaster has not happened in the past it can’t happen in the future.

Have a nice vacation.

Black Swans of August

Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacationin 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.

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.”  Enough saidGreece’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.

Perspective on the Latest Employment Numbers

The BLS this morning reported U.S. job gains of 163,000 in July, which is good news.  But the jobs data had been disappointing over the preceding three spring months.  Before that, during the winter months, employment growth was strong.

In terms of perceptions and politics, pundits will say that today’s report is good news for Obama’s re-election prospects, just as they said the spring jobs numbers were bad news for the President.  But my interest is in economics and reality, rather than perceptions and politics.   From a longer-term perspective, a few important facts have not been adequately discussed.

  • 1. The rate of job growth over the last two years, 137,000 jobs per month, inadequate as it is, has actually been substantially greater than the rate of job growth during the George W. Bush Administration (101,000 per month) even if one excludes the two Bush recessions that occurred in the first and last years of his administration, respectively.   The Obama Administration looks even better if one confines the numbers to private sector employment, since the government has been shedding jobs under Obama and was growing rapidly under Bush. Of course this is still nothing like the sort of progress we would ideally want to see – say, the 237,000 jobs that were created month in and month out on average during the 8 years of the Clinton Administration. And the number of long-term unemployed remains worryingly high. But the situation is a big improvement over the economy that Obama inherited three years ago.
  • 2. An unemployment rate of 8.3% shows that the economy is still in unsatisfactory shape.   (The July numbers show a rise from 8.21 to 8.25, which the BLS labelled “essentially unchanged” in the first sentence of its release.)   Unemployment remains higher than what the Obama Administration hoped we would have by now at the time it took office in January 2009.  Most of the difference can be explained by the fact that the level of economic activity in January 2009 – as a result of the free-fall in the last part of 2008 – was much worse than was realized at the time. The subsequent downward revision by the Commerce Department in the official 2008 GDP growth statistics can explain why the level of the economy is disappointing 3 ½ years later, more than can the rate of growth over the intervening period. After all, those horrendous 2008 rates of decline in GDP and employment turned around during the six months following the day Obama took office.
  • 3. Most private-sector and independent economists agree that the Obama fiscal stimulus made a positive difference; that (together with TARP and monetary easing by the Fed, unpopular as they are in some circles) it helps explain the mid-2009 economic turnaround; and that it helps explain the moderate growth that followed (2 ½% growth p.a. in the 2nd half of 2009 plus 2010). One good explanation for the disappointingly slow rate of growth in output and employment since the end of 2010 is that the fiscal stimulus has been withdrawn and the government sector has been contracting. (Since the November 2010 election, there have been enough Republicans in Congress to block the American Jobs Act and every action that Obama proposes.) One can see this in the composition of both GDP and employment. Today’s jobs report (another 9,000 jobs cut in state, local, and federal governments) continues the pattern that has held throughout the recovery: jobs and output in manufacturing and the rest of the private sector have been expanding, partially offset by contraction in the public sector.