Sand piles, Earthquakes and Minksy Instability

Complex Systems

The understanding of complex systems has been greatly increased since the 1980s except in economics!  For some reason, economists refuse to adopt this science as it's not in their best interest (except Minsky).

If you build a sand-pile many times, you find it will fail under different heights.  It's impossible to predict the height at which it will fail.  However, you can say some things about complex systems.  There's no typical size but there is an expected wait time.

From earthquake studies:

1) Large earthquakes tend to cluster together in time and that the longer you wait without seeing one, the longer you will probably have to wait. So calm periods last a while and the first earthquake means more are coming.  Calm follows calm and storm follows storm.

2) The sizes of failure are observed as a power law like the Richter scale.

Impossible to predict when, but if you've waited a long time...chances are it will be large.  Think of a fault that is locked.  If it is locked for a long time, the pressure and fingers of instability grow large. Periods of instability are shorter but are more violent/volatile than periods of stability.

How Does a Market Break?

Unfortunately we don't know how quickly a market will fall.  Will the market fall quickly or gently?  The technical analysts (using charts) claim they can bail out before the collapse.  They can't guarantee this however.

Alas, we are not able to predict "transitions" into crises or contagions. p271 The Black Swan

I make a best guess (around recessions), but always keep at least 50% in treasuries just in case (80-90% before recessions). While easier said than done, investors need to worry more about errors of co-mission (losses) than errors of omission (missed opportunities) - there's always another bus.

Some possible charts...

Minsky Instability and Asset Bubbles

From John Mauldin's Newsletter:

First, Nobel laureate Hyman Minsky points out that stability leads to instability. The longer a given condition or trend persists, the more dramatic the correction when the trend fails. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. 

My comment-

It's otherwise known as "mal-investment". Of course, periodic recessions relieve the pressure and re-stabilize the arrangement.  Unfortunately, the FED has been fighting the deflationary forces with too much vigor.  Consequently, they manage mild recessions instead of relieving the mal-investment.  They've been lucky with globalization having a downward pressure on wages and inflation.  Consequently, credit has flowed into asset bubbles instead of CPI.  This arrangement has allowed them to continue their policy of unprecedented credit creation.  Ultimately, the debt/GDP ratio will build to unsustainable proportions. 

I wish I knew the day or year when the sand pile fails.  All we can do as investors is watch for recessions and run for safety.

Liquidity and Negative Black Swans

I believe we can use history as a guide to determine how bad a condition can get.  Unfortunately, we cannot predict precisely when and the magnitude of the next black swan.  When liquidity is present, a black swan can happen, however the susceptibility of the system to the shock is low.  The financial system can recover.

The tide comes in and a hole appears like the 1987 crash...but the hole is filled by liquidity and the system goes on.  When the tide is out and the Black Swan happens, a near-term recovery is unlikely. 

By responding with lots of liquidity in 2001 and 2002, the Fed saved the economy. Isn't it the case the Fed was lucky in the 2001 recession that the Black Swan didn't sink it?   The system was very susceptible to a long downturn as it is now.

The Tide and Black Swans

In the last scenario, there is no liquidity to 'plug' the hole.

Network Theory

As banks buy other banks and globalization of finance spreads, the network of world finance grows more vulnerable to a catastrophic failure.

The old system was characterized by many countries, many banks and currencies.  The interlinks were many with relatively small banks.  Today we have grown to a large network interlinked with some super-nodes.