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     Jul 20, 2011

Murdoch, Moody's and Mandelbrot
By Chan Akya

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.

    (Copyright 2011 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

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