The other day, on Pragmatic Capitalism Cullen Roche drew our attention to a fascinating Ted Talk by Didier Sornette about: How we can Predict the Next Financial Crisis.
Didier Sornette has an impressive CV which shows that he is
Professor of Entrepreneurial Risks
Professor of Finance at the Swiss Finance Institute
Director of the Financial Crisis Observatory
Founding member of the Risk Center at ETH Zurich
Associate Member of the Department of Physics (D-PHYS), ETH Zurich
Associate Member of the Department of Earth Sciences (D-ERWD), ETH Zurich.
Furthermore, he is the author of a much-noticed book on Why Stock Markets Crash: Critical Events in Complex Financial Systems.
In the Ted Talk, Didier Sornette presents his concept of the “Dragon King”.
He starts from the observation that the great recession of 2007/2008 has shattered the idea that the economy has transformed to a world of everlasting growth and prosperity. In a chart he illustrates how a few hundred billion dollars of losses in financial markets “cascaded” into 5 trillion dollar losses in world GDP and about 30 trillion dollar losses in stock markets.
As he says, the general understanding is that the crisis came as a complete surprise. To the initiated, his choice of the word “cascaded” to describe the dynamics at work indicates that he has a different view. His hypotheses are
(1) Financial bubbles can be diagnosed in real-time before they end, and
(2) the termination of financial bubbles can be bracketed using probabilistic forecasts.
His underlying concept is the theory of “Dragon Kings”:
Dragon Kings represent extreme events which are “in a class of their own”. They are special. They are outliers which are generated by a specific mechanism which, as Sornette emphasizes, makes them “predictable and perhaps controllable”.
Studying the distribution of peak-to-valley losses of a financial time series, Sornette explains that a large part of these losses can be represented by a power law.
NB: The best short explanation I came upon for a power law is by Philip Ball in his book The Self-Made Tapestry: Pattern Formation in Nature (p. 193). In a system following a power law “some property of the system [such as energy or mass …] is proportional to a variable (commonly a size scale) raised to some power (called the scaling exponent).” A little later (p. 210), he mentions as an example Per Bak’s sand pile [which I described elsewhere]: “The number of landslides decreases as the number of grains it involves increases, and the relationship between the two is a power law” – a kind of (inverse) relationship between the size of the event and the probability that it will attain that size.
However, Sornette continues, there are outliers which occur one-hundred times more frequently than predicted by this law – the Dragon Kings. They are the result of dependencies where a loss is followed by a loss is followed by a loss …
As Sornette describes vividly, the mechanism of a Dragon King is a slow “maturation” to the instability of a bubble – he compares the dynamics to the slow heating of water to the boiling point – and the climax of the bubble is the crash.
Sornette stresses that any tiny perturbation can make this instability occur.
Do you remember the idea that the flap of a butterfly wing may cause a tornado in Texas?
The process “is the reflection of a collective emergent behaviour which is fundamentally endogenous”. The instability does not come as a shock from outside. It is inside, developing as a characteristic of the system.
The “irrational exuberances” of financial markets, as of all complex systems, are “At Home in the Universe”, to quote the title of a famous book by Stuart Kauffman.
At this point, Sornette contrasts his Dragon King to Nassim Nicholas Taleb’s Black Swan:
A black swan is a rare bird. Seeing it shatters all beliefs that swans should be white. The black swan stands for the idea of unpredictability and extreme events being “fundamentally unknowable”.
As Sornette emphasizes, the Dragon King is “exactly the opposite” of a Black Swan, as in his concept, most extreme events are actually knowable and predictable.
Well, this is only a brief glimpse to whet your appetite for more. Enjoy the talk:
*I want to say thank you to Markus Sagebiel, @msgbi on Twitter, for drawing my attention to many of the following links and for great comments.
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After my recent bitcoin update, debates about the nature and chance of survival of the cryptocurrency were going on. Markets remain volatile and there were bad news again. One referred to Silk Road, the anonymous online market.
Willard Foxton from The Telegraph asked: “The Online Drug Marketplace Silk Road Is Collapsing – Did Hackers, Government Or Bitcoin Kill It?”
And Michael Fowlkes from the Market Intelligence Center wrote in Bitcoin Volatility Spikes Again As Silk Road Website Crashes:
“While I have argued against buying into the Bitcoin rally on more than one occasion, I will be the first to admit that illegal drug purchases are far from their only use. Bitcoins do have a place in today’s world, but the wild price fluctuations are going to continue to occur until it matures and becomes more accepted by the mainstream.”
Other incidents included
„Bitcoin: Aussichtsreich, gefährlich oder was?“ fragte Vera Bunse auf diesen Seiten im Mai 2011 als die virtuelle Währung in den deutschen Medien erstmals Schlagzeilen machte. Sie zitierte Torsten Kleinz, der damals einer aufkeimenden Euphorie mit Nachdruck wiedersprach. Er schrieb unter anderem:
„Leute, die ernsthaft Bitcoins als Wertanlage in Betracht ziehen, sind Spekulanten unterster Klasse, die auf Nicht-Leistung und Voodoo Gewinne aufbauen wollen.“
Wie nachvollziehbar diese Sicht in jener Zeit auch gewesen sein mag: Spätestens mit den jüngsten Entwicklungen in der Eurokrise hat sie viel von ihrer Gültigkeit verloren.
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More on CARTA
In the few days since I published my last article on parallel currencies, Bitcoin did not stop catching the headlines. Apparently, the “cryptocurrency” easily digested the disruptions caused by hack attacks on MTGox which had resulted in a temporary drop in value of one Bitcoin from over $140 to about $120. (Remember that when Bitcoin first started in January 2009, it was trading under one penny.) But, after a short respite, market turmoil started again.
See, for example, this note from Zerohedge from a turbulent night:
“Gresham’s law, observation in economics that “bad money drives out good.” More exactly, if coins containing metal of different value have the same value as legal tender, the coins composed of the cheaper metal will be used for payment, while those made of more expensive metal will be hoarded or exported and thus tend to disappear from circulation. Sir Thomas Gresham, financial agent of Queen Elizabeth I, was not the first to recognize this monetary principle, but his elucidation of it in 1558 prompted the economist H.D. Macleod to suggest the term Gresham’s law in the 19th century.” (Encyclopedia Britannica)
Does a similar law also hold for paper money, bank loans and virtual currencies? Apparently not, because otherwise the following examples of parallel currencies would not exist. The reasons why they survive, and thrive, and why, on the other side, they do not entirely replace their rivals, are an interesting topic for future research.
Here comes my collection of samples.
Germany’s withdrawal from EMU and return to the D-Mark,
Bundesbank already printing D-Mark to prepare for breakup,
euro breakup into smaller currency unions,
Italy already de facto out of the euro,
contagion from Cyprus.
fears of Spain’s euro exit,
considerations of France leaving the euro to regain monetary sovereignty,
repatriation of German gold reserves as sign of an impending collapse of the monetary union,
the immediate success of a German initiative to abandon the euro,
and an overall rapidly waning confidence in the future of European monetary policy.
— Considering the headlines, Europe seems to be in standby mode with flight instincts growing every day.
In this situation, anger, frustration and fear seem to leave no room to develop a constructive European-wide approach to future monetary policy cooperation. But this is exactly what is currently needed most urgently. The euro experiment has failed, and a more or less orderly retreat which allows to contain the damage to the process of European integration requires a clear signal that lessons have been learned and a less ambitious, but viable system will be established paving the way for Europe’s return to “normality”.
On January 30, 2013, the Bank of England (BOE) released the latest semi-annual FX turnover survey results for the UK for October 2012. Similar surveys had been conducted at the same time by
- the New York Foreign Exchange Committee,
- the Singapore Foreign Exchange Market Committee,
- the Tokyo Foreign Exchange Market Committee,
- the Canadian Foreign Exchange Committee,
- and the Australian Foreign Exchange Committee.
The following table presents an overview of volumes and annual changes:
Two aspects are remarkable. One is the clear, and partly massive, overall decline of trading volumes in spot markets. Secondly, this decline is not matched by developments in foreign exchange swap markets. There were modest reductions in swap trading in the US and the UK (possibly reflecting banks’ cutback of proprietary trading in reaction to the financial crisis and in face of looming financial regulations). But elsewhere, swap volumes have risen – in Canada and Japan even by over 20 per cent.
*The author was Visiting Scholar, Bank of Japan, Institute for Monetary and Economic Studies (IMES), Tokyo (1994), and Visiting Scholar, Economic Planning Agency, Tokyo (1995).
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Currently, partly in reaction to earlier threats by Japan’s premier Shinzo Abe to curtail the independence of the Bank of Japan (BOJ), a big fuss is made in the news and in public debates about an increased “politicisation of exchange rates”and a potential “devaluation competition”: To observers’ bewilderment, talk about a currency war dominated discussions at Davos and elsewhere. Policymakers and central bankers are expressing their growing concerns. One example is Jens Weidmann, president of the Bundesbank, who said in a speech in Frankfurt:
