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Forget about those black swans

It has become highly fashionable to talk about “black swans” since the crisis began in 2008 and now even Scott Sumner talks about it in his recent post “Don’t forget about those black swans”. Ok, Scott is actually not obsessed with black swans, but his headline reminded me how much focus there is on “black swans” these days – especially among central bankers and regulators and to some extent also among market participants.

What is a black swan? The black swan theory was popularized by Nassim Taleb in 2007 book “The Black Swan”. Taleb’s idea basically is that the financial markets underprice the risk of extreme events happening. Taleb obviously felt vindicated when crisis hit in 2008. The extreme event happened and it had clearly not been priced by the market in advance.

Lets go back to back to Scott’s post. Here he quotes Matt Yglesias:

Here’s a fun Intrade price anomaly that showed up this morning. The markets indicate that there’s more than a 3 percent chance that neither Barack Obama nor Mitt Romney will win the presidential election. That’s clearly way too high.

Scott then counter Matt by saying that we should not forget “something unusual happening”:

1.  One of the two major candidates is assassinated, and the replacement is elected (as in Mexico’s 1994 election.)

2.  Ditto, except one pulls out due to health problems, or scandal.

3.  A third party candidate comes out of nowhere to get elected.

Scott is of course right. All this could happen and as a consequence it would obviously be wrong if the market had price a 100% chance that nobody else than Obama or Romney would become US president.

Scott and I tend to think that financial markets are (more or less) efficient and as a consequence we would not be gambling men. Scott nonetheless seem to think that the odds are good:

“But 3% is low odds.  It’s basically saying once in ever 130 years you’d expect something really weird to happen in US presidential politics during an election year.   That’s a long time!  Given all the weird things that have happened, how unlikely is it?  Some might counter that none of the three scenarios I’ve outlined have occurred in the US during an election year (my history is weak so I’m not certain.)  But mind-bogglingly unusual things have happened on occasion.  On November 10, 1972, what kind of odds would Intrade have given on neither Nixon nor Agnew being President on January 1 1975?”

Scott certainly have a good point, but I will not question the market on this one. The market pricing is the best assessment of risk we have. If not there would be money in street ready to pick up for anybody – and there is not. Obviously Taleb disagrees as he believe that markets tend to underprice risk. However, I fundamentally think that Taleb is wrong and I don’t see much evidence that market underprice black swan events. The fact that rare events happen is not evidence that the market on average underprice the likelihood of this events.

The fashion long-shot bias and central banks

In the evidence from betting markets seem to indicate that if anything bettors tend to have a favourite-longshot bias meaning that they tend to overprice the likelihood that the favourite will loose elections or sport games. Said in another way if anything bettors tend to overprice the likelihood of a black swan events. I happen to think that this is not a market problem in markets in general, but it nonetheless indicates that if anything the problem is too much focus on black swan events rather than too little focus on them.

This to a very large extent has been the case of the past 4 years – especially in regard to central banking and banking regulation. There seem to be a near-obsession among some policy makers that a new black swan could turn up. How often have we heard the talk about the major risk of bubbles if interest rates are kept too low too long and most of the new financial regulation being push through across the world these days is justified by reference to the risk of some kind of black swan event.

Media and policy makers in my view have become obsessed with extreme events happening – you will be reminded about that every time you go through the security check in any airport in the world.

The obsession with black swan events is highly problematic as the cost of policy makers obsessing about very unlikely events happening lead them to implement very costly regulation that lead to massive waste of resources. Again just think about how many hours you have spend waiting to get through airport security over the last couple of years and if you think that is bad just think of the cost resulting from excessive new regulation of the global financial markets. So my suggestion is clearly to forget about those black swans!

Finally three book recommendations:

Risk by Dan Gardner that tells about the “politics of fear” (of black swans).

The Myth of the Rational Voter by Bryan Caplan explains why democracy tend to lead to irrationality while market lead to rationality. Said in another way policy makers would be more prone to focus on black swans than market participants in free markets would be.

Risk, Uncertain and Profit – Frank Knight’s classic. If you are really interested in the issues of risk and uncertainty then there is no reason at all to read Taleb’s books (I have read both The Black Swan and Fooled by Randomness – they are “fun” and something you can read while you are waitin in line at the security check in the airport, but it is certainly not Nobel prize material). Instead just read Knight’s classic. It is much more insightful. It is actually something that frustrates me a great deal about Taleb’s books – there is really nothing new in what he is saying, but he claims to have come up with everything himself.

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Expectations and the transmission mechanism – why didn’t anybody think of that before?

As I was writing my recent post on the discussion of the importance of expectations in the lead-lag structure in the monetary transmission mechanism I came think that is really somewhat odd how little role the discussion of expectations have had in the history of the theory of transmission mechanism .

Yes, we can find discussions of expectations in the works of for example Ludwig von Mises, John Maynard Keynes and Frank Knight. However, these discussions are not directly linked to the monetary transmission mechanism and it was not really before the development of rational expectations models in the 1970s that expectations started to entering into monetary theory. Today of course New Keynesians, New Classical economists and of course most notably Market Monetarists acknowledge the central role of expectations. While most monetary policy makers still seem rather ignorant about the connection between the monetary transmission mechanism and expectations. And even fewer acknowledge that monetary policy basically becomes endogenous in a world of a perfectly credible nominal target.

A good example of this disconnect between the view of expectations and the view of the monetary transmission mechanism is of course the works of Milton Friedman. Friedman more less prior to the Muth’s famous paper on rational expectation came to the conclusion that you can’t fool everybody all of the time and as consequence monetary policy can not permanently be use to exploit a trade-off between unemployment and inflation. This is of course was one of things that got him his Nobel Prize. However, Friedman to his death continued to talk about monetary policy as working with long and variable lags. However, why would there be long and variable lags if monetary policy was perfectly credible and the economic agents have rational expectations? One answer is – as I earlier suggested – that monetary policy in no way was credible when Friedman did his research on monetary theory and policy. One can say Friedman helped develop rational expectation theory, but never grasped that this would be quite important for how we understand the monetary transmission mechanism.

Friedman, however, was not along. Basically nobody (please correct me if I am wrong!!) prior to the development of New Keynesian theory talked seriously about the importance of expectations in the monetary transmission mechanism. The issue, however, was not ignored. Hence, at the centre of the debate about the gold standard in the 1930s was of course the discussion of the need to tight the hands of policy makers. And Kydland and Prescott did not invent Rules vs Discretion. Henry Simons of course in his famous paper Rules versus Authorities in Monetary Policy from 1936 discussed the issue at length. So in some way economists have always known the importance of expectations in monetary theory. However, they have said, very little about the importance of expectation in the monetary transmission mechanism.

Therefore in many ways the key contribution of Market Monetarism to the development of monetary theory might be that we fully acknowledge the importance of expectations in the transmission mechanism. Yes, New Keynesian like Mike Woodford and Gauti Eggertsson also understand the importance of expectations in the transmission mechanism, but their view of the transmission mechanism seems uniformly focused in the expectations of the future path of real interest rates rather than on a much broader set of asset prices.

However, I might be missing something here so I am very interested in hearing what my readers have to say about this issue. Can we find any pre-rational expectations economists that had expectations at the core of there understand of the monetary transmission mechanism? Cassel? Hawtrey? Wicksell? I am not sure…

PS Don’t say Hayek he missed up badly with expectations in Prices and Production

PPS I will be in London in the coming days on business so I am not sure I will have much time for blogging, but I will make sure to speak a lot about monetary policy…

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