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Black Swans & Minsky Moments -
Day of Reckoning

Financial MarketsJuly 12, 2014 | by Steve McCurdy

Introduction


Anyone who studies the economic numbers today and who knows that 2 + 2 still = 4 knows that we are headed for financial disaster. However, no one knows when the day of reckoning will arrive or what form it will take. Most likely, the snowflake that starts the avalanche will either be a “Black Swan” or a “Minsky Moment.” The term “Black Swan” derives from an ancient belief that all swans were white, a belief that was shattered when a black swan was discovered in Australia. According to current economic theory, a Black Swan event always has three features: 1) It is an outlier and a complete surprise to the observer, 2) It has a catastrophic economic impact, and 3) Human nature requires that we concoct after-the-fact explanations to rationalize the event. Notable historical Black Swans were the outbreak of WWI, the great dust storms at the height of the Great Depression in 1934, and 9-11.

 

A “Minsky Moment” on the other hand, is a sudden, major collapse of asset values prompting lenders to call in their loans. The loan calls lead to a massive sell-off of the assets and a further precipitous collapse in prices, creating a drop in market liquidity and a severe demand for cash. This phenomena is named for economist Hyman Minsky. The 1929 stock market crash and the 2007 sub-prime mortgage crisis are notable examples of Minsky Moments.

In the context of today’s global capital markets, a geopolitical event such as a major terrorist attack, an outbreak of war, or a nuclear event would be a Black Swan, and a collapse in bond prices or a default on sovereign debt would be a Minsky Moment.  (Note: In the financial industry, Black Swans and Minsky Moments are both sometimes referred to as "fat-tail events.")

Complexity Theory


One way to analyze the gravity of the current situation is to employ “complexity theory.” Monetary expert and bestselling author James Rickards relies heavily on complexity theory extensively in his recent bestsellers Currency Wars,” andThe Death of Money.” Complexity theory is a relatively new branch of science that was developed in the 1960s.
 
According to complexity theory, “complex” systems differentiate themselves from all other systems by having four unique characteristics; they arise spontaneously, they behave unpredictably, they exhaust resources, and they collapse catastrophically. Complex systems consist of autonomous agents, which make decisions and produce results in the system. The autonomous agents have “connectedness,” they have “interdependence,” and they are “adaptive.” The risk in complex systems is exponential, i.e. when the size of the system doubles the inherent risk increases by a factor of 10, and when it doubles again, by a factor of 100, etc.
 
Complex systems normally work well and operate in a “non-critical state.” Sometimes, however, when bad decisions produce bad results, complex systems move to a critical state. In a critical state, a very small cause can result in a catastrophic failure, which in complexity theory is known as a “phase transition.” For example, climate is a complex system, and a single snowflake can cause a village to be destroyed by an avalanche when a mountain is in a critical state. The avalanche would be a “phase transition.”

The Global Capital Markets System

 
According to Rickards our system of capital markets is a complex system nonpareil. Millions of Global Marketstraders, investors, and speculators are autonomous agents, connected by networks of brokers, exchanges, automated execution systems and information flows. They are obviously interdependent and certainly adaptive. This brings us to the questions of size and risk, and these factors are extremely important in financial markets. In our avalanche example above, the risk can be reduced by making the system smaller. That is why the ski patrol throws dynamite on unstable slopes before skiing begins. They are reducing size to try and get the mountain system back to a non-critical state.
 
But in the case of our global markets, the system keeps growing larger and larger through quantitative easing, and is now larger and many times more complex than it was prior to the collapse in 2007. Mr. Rickard’s thesis is that the next system collapse will be different than any other we have ever experienced. He says it will not be stopped by governments, because it will be larger than governments. He compares it to a five foot seawall protecting us from a 10 foot tsunami. The wall will fall. In an interview with Bloomberg Television, Rickards put it this way:
 
“The problem with the Federal Reserve is they think they are toying with the thermostat, but in reality the thermostat is a nuclear reactor, with fuel rods and control rods. You can dial it up and down, but if you get it wrong, you have a catastrophe and the whole thing melts down.”

Summary

 
Death of the DollarSo that is where we are. We have a complex system in a critical state, and the risk continues to grow exponentially. When we look at the world’s geopolitical situation, we see potential powder kegs throughout the Middle East, Africa, and Western Europe. Iran gets closer to going nuclear every day and Isis has taken over most of Iraq. Potential Black Swans lurk everywhere throughout the Region.
 
Meanwhile governments continue to print money and manipulate financial markets. The BRICs are reportedly plotting to replace the dollar as the World’s reserve currency, and Mr. Rickards believes a meltdown of the Dollar would undoubtedly crash world financial markets. The flow of physical gold and silver continues to move from the West to the East, and the Federal Reserve has announced plans to end QE in October despite the possibility of destroying the bond market, which would also be a Minsky Moment.
 
We are all essentially just observers as this sad story unfolds, but there is one thing that we can all do. That is that we can PLAN, and that is what our web site is all about. To get some planning ideas, take a look at some images here.
 

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