Over the past few weeks, a number of
events have rolled and rollicked the media sphere.
Some of them relate to markets, and yet others to
the world of media (as in, journalists becoming
the news rather than simply reporting on it) and
lastly even to wars. All through though there is a
common theme - one involving
otherwise-knowledgeable and experienced people
quite simply falling into the kinds of traps that
would have been unimaginable barely a few weeks or
months ago.
Look at the following events,
all hailing from the past few weeks:
The tumult at News Corporation, a large media
conglomerate overseen and managed by the
redoubtable Rupert Murdoch that is now facing
unheard-of conniptions in both the UK and the US
on the heels of a ill-managed media scandal
(Credibility).
Moody's downgraded both Portugal and Ireland
by multiple notches into speculative grade
territory (ie the bonds are no longer
eligible for many investors)
on fears that the countries would find it hard to
refinance themselves in the markets (Confidence).
A decision by 30 countries led by Italy to
recognize a rebel alliance as the official
government of Libya, as the march towards Tripoli
appeared unhindered with the Muammar Gaddafi
forces seemingly in disarray both on and off the
battlefield (Conflict).
For all the major
actors in the dramas above - Murdoch, European
Union politicians and Colonel Gaddafi - the key
question is whether the events may have been
predictable and/or controllable but for the
apparent avalanche of events towards the close?
Let me explain. This article isn't about
any individual per se but taking the experience of
Murdoch, the very notion that a mere scandal at
one of his newspapers around his far-flung empire
that contributed less than 5% of group profits
would lead him down the path of groveling
full-page apologies in the United Kingdom while
confronting the increased threat of full-blown
investigations on both sides of the Atlantic would
have appeared not just fanciful but positively
fantastic a few weeks ago.
Or consider the
other example. A few months ago, would Gaddafi -
who survived aerial bombardment by former US
president Ronald Reagan - have even envisaged the
situation of a few al-Qaeda rebels gathering
enough momentum to bring down his government? And
yet, here he is at the precise juncture, with the
more galling prospect of Western European
countries supporting the very same people who
would otherwise have been their enemies as well as
his.
As for the market aspects of this
discussion, I have previously laid down the simple
principles of how crises are precipitated - see
also my previous article on the subject Bank
folks can't count (Asia Times Online, June 14,
2011) - by a mixture of indulgence, innocence and
(lack of) integrity. Simple lies have a habit of
ballooning over a period to the point where they
simply crowd out everything else and demand to be
handled with pure truth rather than more lies.
By a country mile, every crisis we have
seen in recent times, ranging from the sudden
collapse of triple-A rated US mortgage securities
in 2007, to the collapse of various US
institutions (Bear Stearns, Lehman Brothers, AIG
etc) in 2008, and the European sovereign debt
crisis of 2010 onwards, has followed the same
script: A rapid build up of problems that are
ignored by most people until some folks start
asking questions only to be met initially with
strong denials and worse. Soon though the doubters
get the upper hand and before you know it,
establishment figures are shaken out and chaos
reigns supreme. Seen that movie before?
It
is in the crux of market crises that Murdoch and
Gaddafi may have found the seeds of their own
failures of management. Specifically, the focus of
management had always been on looking at the
exceptions and handling them aggressively without
paying sufficient attention to the recursive
behavioral feedback loop of those actions.
Think about that phrase for a second -
recursive behavioral feedback loop. In the case of
the good colonel in Libya, the idea was to use the
heavy hand of the state to control all
visible dissent to authority, for example
as manifested in a tribal leader demanding free
and fair elections instead of an embellished
monarchy in the guise of a popular government.
The net result wasn't so much that all
tribal leaders fell into the colonel's line but
that - as events over the past 12 weeks show - the
tribal leaders no longer led anyone. In
effect, what was played out in the colonel's Libya
was the age-old communist joke about Soviet
factories - we pretend to pay the workers and in
return the workers pretend to make things. The
leaders were no longer in charge of their tribes
and the colonel simply didn't have the means to
finding out who was in charge - ironically because
of the lack of free and fair elections that would
have otherwise shown up the real leaders.
The analogy isn't difficult to draw out
from the Greek experience - they were told that a
certain ratio (in this case, debt/gross domestic
product) was required to be part of the eurozone
and so simply fudged the statistics to make it
into the zone. Once in there and allowed to borrow
far off the market rates - a deliberate construct
of the eurozone to encourage greater investing of
savings locally rather than in the US or emerging
markets - the Greeks simply dug themselves into a
grand hole.
Their vision of infallibility
was fueled by the needs of the French and German
banks to avoid showing losses on their holdings
and hence the merry charade continued until free
market forces started taking them apart, bond by
bond.
Mandelbrot figured it right In the case of the financial markets, the
failures of risk management were laid at the door
of the mathematical tool referred to as the
"standard normal" distribution, that describes the
likely ambit of oscillating market prices; this
was used to construct the maximum daily losses
that could be suffered by having exposure to
certain market instruments (or a balance sheet
stuck to the gills with them, like US investment
banks have).
The key problem once everyone
went past the dense math associated with the
subject was that the basic premise was simply
wrong. It turned out that the Gaussian
distribution was an artefact not so much of the
data but of the requirements of risk management
that any model have finite variance: thus using
the model generated by data that would have shown
a non-normal distribution was simply unacceptable.
The square peg (statistical risk models)
simply had to be fit inside the round hole (market
data on price variance) and everyone had to
pretend that there were no gaps between the two.
That was it.
French-American mathematician
Benoit Mandelbrot challenged the idiocy by
suggesting the use of other distributions with
different scale parameters; they did not
contradict risk management's use of statistical
models but merely explained the rules of
escalating the probabilities associated with
extreme events whenever one arose. This idea -
cutely referred to as fractal geometry in books by
Nicholas Nassim Taleb (Fooled by
Randomness, Black Swan) - was central
to the experience of the survivors of the
financial crisis like Goldman Sachs, Deutsche Bank
and Paulson & Co.
Faced with
exceptions, rather than fit their business
management around the problematic data, these
institutions simply started operating on the basis
that their risk models were potentially wrong and
accordingly decided to cut the risks which could
no longer be explained by their models. That some
of them then decided to go one better and position
themselves against those in the market that still
believed in the old practices of risk management
is of course another matter altogether.
I
have a different ax to grind here, away from the
Saudis and the Americans: Keynesians have much to
answer for, given the simple lack of data that
supports their various interventionist approaches
over the past three years.
The lack of
data has been dismissed as artefacts of time, just
like excessive variance in market data was once
described in terms of freak behavior rather than
as a precedent to a crisis. In the US, despite
trillions in stimulus monies, there are simply no
recoveries in either housing or employment to
speak of; without either (or more comfortably
both) there are no grounds for calling an economic
recovery.
As the stock markets finally
take cognizance of the new reality, a positively
scary moment beckons when major indices may
retrace more than 25% in a matter of weeks - with
the speed of the decline accelerating because of
the sheer lack of preparedness.
So what
are the lessons for the "survivors" of various
crises points around the world - be it the Saudi
state or America with its muddling approach to the
debt crisis? Already, we have news that Moody's
(along with other rating agencies including Fitch)
issued an official warning on a potential
downgrade of the US triple-A rating given the
ongoing confusion around the debt limit that has
been stuck in political negotiations between the
two major parties in the US Congress and the
president.
This appears for all intent and
purposes like the first phase of the European debt
crisis some three years ago - not a lot of time in
the world of credit. Given the experience of
various neighboring states ranging from Yemen and
Bahrain to Egypt and Libya in handling domestic
revolts against authority, it would be similarly
foolish for Saudi authorities to consider their
problems behind them.
Rather, as Murdoch
noticed to his alarm just over a week ago, it
merely takes one blog post (in this case by the
Guardian newspaper) to set off a chain of events
that turn the implausible to the merely
inevitable.
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