When I reflect on major economic events in the first quarter of this year, I visualize a whole flock of black swans descending around me.
One might ask, why black swans?
I have become enchanted by the visual image conveyed by the best-selling author Nicholas Taleb, who wrote a book called “The Black Swan.” In this book, Taleb discussed the frequency of unlikely events. For example, until the 17th-century discovery of black swans in Australia, everybody assumed that only white swans existed.
Taleb pointed out that outliers occur more often than mathematical probability tables forecast. Moreover, we cannot easily determine the causes of irregular events or even which effects produced which events.
That is, do we have $100 oil because the dollar has declined to 66 percent of the value of the euro?
An atmosphere of mystery surrounds the occurrence of the unusual.
Why do we care about the proliferation of unusual events? In a nutshell, unusual financial events shake the economic foundation of the capitalistic world because institutions build their business models based upon the expected or the “usual course of business.” One cannot insure against “acts of God” or war.
Let me mention just a few of the first quarter’s unpredictable events.
* Oil cracked the $100-per-barrel barrier.
* At about $1.60, the euro is trading at record highs against the dollar.
* Gold broke records when it traded above $1,000 per ounce.
* Wheat exploded up over four times this past year to $22.40 per bushel from last year’s level of $5.
* In the past few months, the auction-rate market that had functioned effectively for some 30 years suddenly collapsed, leaving investors with close to $300 billion of illiquid paper.
* Housing prices, according to the S&P/Case-Shiller home prices index, have dropped 10.2 percent from their high in summer 2006. Nationwide price declines of this magnitude had not occurred since the Great Depression.
Most of us ordinary investors never anticipated these cataclysms. We made investment decisions based on our belief in the continuation of normalcy and ended up losing money. We were not contrarians and therefore did not think outside the box or invest heavily in anticipation of unusual price movements.
The subprime mortgage meltdown was a Black Swan event. Until the past year, mortgages were considered very safe investments with very low default rates. When home mortgage defaults soared to record amounts, Wall Street and Washington were caught in a bind. For many institutions to survive, the Federal Reserve, the Treasury and Wall Street firms resorted to emergency measures.
First of all, the Federal Reserve lowered the federal funds rate by 325 basis points in nine months.
Secondly, the Federal Reserve for the first time allowed non-commercial banks to borrow at the discount window by posting non-U.S. Treasury collateral of dubious value that has been “marked to myth,” meaning its worth has no basis in reality.
Thirdly, the Federal Reserve Bank and foreign Central banks poured billions of dollars of additional reserves into the financial system.
Fourthly, the Federal Reserve lent JP Morgan $29 billion in order to facilitate its purchase of Bear Stearns for slightly more than $1 billion.
Finally, the Treasury has proposed far-reaching regulatory changes in the hopes of forestalling future credit crisis.
The Treasury proposals raised criticisms from both sides of the political spectrum. Liberals wanted greater regulation, and conservatives wanted an even more laissez faire administration. The Treasury defended its actions by saying that the challenges of the 21st century require a new broom. That is, the proliferation of new products, the expansion in the use of off-balance sheet financing and the development of heretofore unregulated financial players like mortgage bankers and hedge funds require updated regulations.
The Standard & Poor’s 500 declined 9.7 percent in the first quarter of 2008. Many international stock indexes did even worse. Were the declines in these far-flung global exchanges related?
For example the United Kingdom stock market declined 11.8 percent; the Indian stock market declined 19.3 percent, the Chinese stock market declined 32 percent, and Australia’s declined 15.6 percent. In the case of Australia, its resource-rich economy should theoretically not have suffered because of a U.S. recession.
I would like to conclude on an upbeat note. The world economy for the moment looks better than that of the United States. It is expected to grow 3.8 percent this year. This compares with expectations of a flat U.S. economy. Hopefully, overseas demand for our goods and services could pull us out of our economic straits.
Originally published in the Sarasota Herald-Tribune
