Black swans and dark matter

There’s been a lot of talk about the idea that the GFC (the in-group shorthand for ‘global financial crisis’) is an example of a ‘black swan’, that is, an event that would be treated as impossible on the basis of induction from past experience, and hence that could not be encompassed by formal models of the kind used by risk managers. All this talk has of course been great for Nicholas Taleb who has a book with this title. It’s good in a lot of ways, but I found it ultimately insufferable in the continuous repetition of the message that only Taleb was smart enough to see all this. ( To be fair, Taleb predicted a global financial crisis, and didn’t simply claim it in retrospect as an unpredictable Black Swan).

I spend a lot of my time working on how to think about unforeseen contingencies and I’m not at all convinced that the GFC should be described in this way. Of course, the models used by the risk managers in investment banks didn’t include this as a possibility; if they had, the implication would have been that all sorts of much-desired deals should not go ahead. But as I pointed out a while ago, very simple models based on well-established principles predicted that the bubble economy would end badly.

The crisis then, involved something more like dark matter, the ‘missing’ matter in the universe that must exist if it is to work as it does, but can’t at presented be detected. Given that risk can’t easily be made to disappear*, it was obvious that the risk associated with lending of all kinds (most obviously, mortages offered to people with no capacity to repay) was being borne by someone, and probably someone who was unaware of it.

The big problem for the Cassandras (and we were certainly both correct and disregarded) was that it was easy to see that the bubble could not continue and much harder to foresee how it would end – it’s one thing to say that dark matter must exist and another to work out what it is really like. Like Brad and Brad, I expected that the problems would emerge first in the form of a run on the US dollar, given that holders of US dollar assets were receiving very little compensation for the obvious risk of large capital losses. In fact, the US dollar actually rose in the early stages of the meltdown, though it has been falling more recently.

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Rudd misread the weather

My opinion columns at the Fin appear to have emerged from behind the paywall. I guess that says they aren’t vital enough that people will pay to read them (especially since they can get much the same opinions here) but maybe that having this material available will attract readers to the Fin site and sell advertising. Anyway, here’s my latest

The end of PPPs

I wrote a piece for the Centre for Policy Development on Public Private Partnerships which was also picked up by the Canberra Times. My favorite bit

The British government, which has nationalised or bailed out large parts of the banking sector is now suggesting that banks may be forced to lend to private investors in public projects under the Private Finance Initiative. In effect, the government will be lending money to itself, while paying the costs of a series of complex transactions (some of them highly vulnerable to exploitation) along the way.


That’s the new target interest rate announced by the US Federal Reserve today (with a margin of up to 25 basis points). It’s also, following the $50 billion Madoff fraud and the increasingly widespread suspicion that the entire bailout scheme has been operated to promote the interests of Goldman Sachs at the expense of its competitors and the general public, an upper bound for the credibility of the global financial system. And it’s a pretty good estimate of the probability that we’re going to avoid a recession worse than any since the Great Depression.

Without a household name like Citigroup or GS going bust, it’s hard to convey the seriousness of the latest news in an environment where we are already inured to financial cataclysms. But it seems pretty clear that the last couple of days spell the end for both hedge funds (many of which have lost a fortune with Madoff and all of which are subject to invidious comparisons with his decades-long Ponzi scheme) and money market funds, which can’t possibly cover their costs while paying positive net returns, given a funds rate of 0.25 per cent.

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