Collectivized security leads to riskier behaviour

A most interesting piece by John Mauldin (Safe Haven, 8 December), relating mathematical and scientific discoveries in other fields, to the economic system.

Research into piles of sand grains showed that the timing of sudden collapses is quite unpredictable, but there is an inverse correlation between their magnitude and likelihood. As the sand piles up, "threads" of instability form, that can be triggered by the fall of a single grain in the wrong place. This is akin to the "Butterfly Effect" in catastrophe theory, I suppose.

Mauldin connects this up with a paper published last year, about uncertainty created by humans in the development of their economic structures:

...the greater the number of connections within any given economic network, the greater the system is at risk.

This underscore the concerns I hinted at in an earlier post. The potential for catastrophic change is building up, and we can't predict what will be the trigger. Therefore, all the connections we are forming with each other need to be balanced by provisions for disconnecting, or for insulating one region from changes occurring in another.

To use an analogy, the supertankers that take oil around the world's oceans are internally divided into compartments. It would be cheaper, and so more profitable, not to install the internal compartments. But without them, a large wave hitting the ship could cause a movement in the liquid cargo that would shift the balance and quite possibly sink the vessel altogether.

So there is a trade-off between efficiency and survival.

Another aspect is how human behaviour changes in relation to risk perception. For example, research shows that when road junctions are widened and vision-obscuring vegetation cleared, drivers compensate for the extra security by going faster and less carefully. I understand that each of us has his/her our own preset level of risk tolerance, and when circumstances change, will seek to bring things back to that level .

But what if you don't fully understand the new circumstances? A miscalculation as to the level of security inherent in the situation could lead to your behaving more dangerously than you realise. The complexity and obscurity of CDOs, derivatives and credit default swaps are examples in the world of finance and economics, but surely this applies to other fields, too.

Perhaps conservative instincts are not just laziness, stupidity and timidity, but survival instincts. Have you noticed how those maddeningly slow drivers don't have dents in their old, lovingly-polished cars?

Maybe I'll get a hat, for driving.

The Fed may trigger off a run on Treasury bonds, says Wallenwein

Alex Wallenwein thinks the Fed will curb its impulse to drop interest rates as much as people want, because of its fear of inflation. He expects it will backfire when people figure this out.

Wallenwein suspects that the Fed has been buying longer-term US Treasury bonds to sustain demand and so keep interest rates low, but he thinks that once others scent the Fed's fear, there will be a massive dump that will throw more on the market than the Fed can mop up. This, he thinks, will send longer-term interest rates soaring.

His conclusion is that gold will perform its usual function of a safe haven in times of uncertainty.

As I pointed out this summer, the UK has (fairly recently) become the third-largest holder of US Treasury bonds.

A run on non-banks

The Great Depression of 2006: Cash Only

Jim in San Marcos explains that it's probably not the banks we need to worry about, but the financial entitities that are NOT covered by Federal deposit insurance.

And Karl Denninger also details other areas threatened by financial contraction.

Little boxes

In India, where many people cannot read, you sign for the State pension by thumbprint. This seemed like a secure system, until a man was caught with a tobacco-tin full of thumbs.

It would have made no difference had it been a tin of cloned credit cards. You don't need to know what's in the box, or how it works; you need to know what it does, and who it's for.

Once you start thinking along these lines, things get so much clearer. For example, you don't have to be a "quant" like Richard Bookstaber, to know that derivatives are about risk. More precisely, they're for increasing risk.

Supposedly, a derivative reduces risk; but if you look at its use, it's a box that tells lenders and gamblers how far they can go. Seeing the fortunes that can be made in high finance, there is the strongest temptation to push the boundary.

My old primary school had a lovely little garden behind it, where we played at morning break. One game was "What's the time, Mister Wolf?". You went up to the "wolf" and asked him the time; he'd say nine o' clock; to the next child he'd say ten o'clock and so on, until he'd suddenly shout "Dinner time!" and chase you. Obviously, the game was not about telling the time.

So it is with financial risk models that service the need to maximise profits: always another trembling step forward. There's only one way to find out when you've gone too far.

But what if you could ask the time, and know that someone else would end up being chased? I think that explains the subprime packages currently causing so much trouble.

The bit I don't understand is why banks started buying garbage like this from each other. Maybe it's a case of the left hand not knowing what the right hand is doing, since these organisations are so big. Or maybe it's that everyone has their own personal box.

Then there's credit default swaps, and other attempts to herd together for collective security. They don't work if the reduction in fear leads to an increase in risk-taking. United we fall: no point in tying your dinghy to the Titanic's anchor-chain.

In fact, I think this opens up a much wider field of discussion, about efficiency versus survivability. In business, economics and politics we might eventually find ourselves talking about dispersion, diversity and disconnection.

Liberty update

Bernard Nothaus is retaliating and preparing for his court case.



As Chumbawumba sang:

I get knocked down
But I get up again
You're never going to keep me down
We'll be singing
When we're winning
We'll be singing

... good luck.

Better to be rich and mis?

Elmer, a Filipino living in Hong Kong, comments on insurance group AXA's "Life Outlook Index". He wonders whether being happy and optimistic holds back economic progress in the Philippines. For, of eight Asian countries surveyed, the Singaporeans had most insurance and were the most miserable.

So I'd ask whether economic progress is more important than being happy and optimistic. Read "Insurance - The White Man's Burden" and decide.

UPDATE

...and a nice little thread in Market Ticker's forums section, on rat-race dropouts who've taken to the beaches in Hawaii

The Dow is a shape-changer

A brilliantly clear and succinct essay by Nadeem Walayat for Financial Sense, showing that the Dow tends to rise long-term simply by adding winners and dropping losers. Not only that, it's vulnerable to manipulation for official "feelgood factor" purposes. And the 30 stocks are not equally weighted, so a few stars can carry a load of duds with them.

An argument for betting on the index, if you're not an attentive stock-watcher.

This, I suggest, is one to bookmark, or print and put in in your wallet.