Many people are now familiar with the idea of the Black Swan event. It was developed by Nicholas Nassim Taleb. The basic concept is that it is those events whose probability has been largely discounted, which have the potential for causing most harm, precisely because no one believes they can happen. The term Black Swan goes back probably to Aristotle, and is used in Philosophical Logic to demonstrate the idea of arguments that fail because of being based on a false premise. Everyone believed that being white was a condition of being a swan, because no one throughout Europe had ever seen a swan that was not white. The argument “All swans are white”, seemed to be a consistent argument that allowed other arguments to be built upon it. That is until Europeans discovered black swans in Australia!
This also provides the basis for understanding another aspect of Philosophical Logic, the impossibility of proving a negative. For example, it may have seemed possible to prove the negative statement “No swans are black”, but that too would have been false. In fact, this forms a basic element of the scientific approach, which is that all statements are only conditionally true. That is they remain true, only so long as they have not been disproved. Another example, is Bertrand Russell's argument in relation to God. Russell argued we cannot prove that God DOES NOT exist, because it is impossible to prove a negative. However, this is different to assuming that because we cannot prove his non-existence, then God must exist. He says, we cannot prove that there is not some giant teapot orbiting the Sun, but that is not the same as believing that such a teapot exists. All the evidence we have points to the contrary, and there is no evidence either that such a teapot or God does exist. A rational response then is to base out beliefs and our actions on what the evidence suggests is most probably true. 
But, its precisely for this reason that Black Swan events pose the greatest risks. They are events that all of our evidence, all of the laws of probability suggest will not happen. As a consequence, everyone's beliefs, everyone's actions are based on the principle that they will not happen. As a result, no one acts in such a way as to prepare for them. It is not the event itself, that is necessarily catastrophic, but the lack of preparedness, and the chaos that ensues, which is often what makes such an event catastrophic.
Take an earthquake. When no one understood the causes of earthquakes, then even in areas where they occurred, no one was prepared for them. People may have believed that they were some kind of punishment from the Gods, and made periodic sacrifices to assuage them, but that was hardly the kind of preparation that is of any practical use. But, today in a country like Japan, because earthquakes are commonplace, because we understood their causes, and can even predict them to a certain extent by seismic monitoring, its possible to prepare for them. Buildings can be built so as to be “earthquake proof” and so on. In fact, with the Fukushima earthquake, most of those preparations for an earthquake worked. Even the nuclear plant resisted the earthquake. What had not been prepared for, and what did for the nuclear plant was the tsunami.
Capitalism too does this. For all the talk about risk-taking and so on, the drive of both Capitalism, and of Capitalists has also been to try to remove risk. Certainly that was a central aim during the 20th century. Outright price competition was recognised by Capital to be dangerous even during the 19th Century golden age of free market liberal capitalism. Firms attempted to protect themselves against being crushed by competition, by themselves becoming the biggest, most dominant firm in the industry. When a few firms in an industry became very large, then they attempted to remove damaging competition between each other, by forming cartels and Trusts. They sought to protect themselves against foreign competition via protectionism, or the support of their nation state in the colonial markets. They also tried to protect themselves against the risks involved in market fluctuations by introducing various forms of planning, which governed their increasingly large investment plans. As Engels put it in his Critique Of The Erfurt Programme,
“Capitalist production by joint-stock companies is no longer private production but production on behalf of many associated people. And when we pass on from joint-stock companies to trusts, which dominate and monopolise whole branches of industry, this puts an end not only to private production but also to planlessness.”
One problem that firms faced in making investment decisions was future prices. A firm that is considering buying a new machine, for example, looks at its price, and compares this with the potential for revenues it will crate over its lifetime. If this revenue, at current prices, will be greater than the cost of the machine, then it will be a profitable investment. But, the question is what will future prices be? The firm under a free market can only base itself on current prices. But, suppose every firm in this industry decides to invest in this kind of machine. The consequence is that the supply of commodities from this industry rises, and the cost of producing them falls due to the introduction of the machine. The result is that the price of these commodities falls, and may fall significantly. What seemed like a profitable investment decision turns out to be a loss making decision.
There is, however, even a solution for this problem available for Capital, particularly at the stage of large firms. For a long time, in relation to agricultural prices, there emerged “Futures markets”. These markets removed some of the uncertainty, and therefore, sharp fluctuations that went along with large changes in supply and demand for agricultural products caused by the weather etc. The idea of a Futures Market is quite simple. A farmer can agree to sell the proceeds of their next year's crop not on the uncertain basis of what prices might be then, but on the basis of a certain price offered to them by buyers now. The way this works then is that buyers in this Futures Market speculate on what prices will be next year. Some will think prices will be the same as today, some think they will be lower, some higher. But, out of all this variation emerges an average figure, which is then the market estimate of what prices will be in a year's time.
Returning to Taleb, and probability theory, there is good reason for believing that this estimate will be quite accurate. That is because of what is known The Wisdom Of Crowds. It has been mathematically demonstrated that a large number of people asked to guess about a wide range of things, from the number of jelly beans in a jar, to the weight of an ox were able, when the average of their guesses was taken, not only to arrive at a very accurate number, but one that was more accurate that any single individual was able to estimate. Futures markets, are made up of a large number of reasonably well informed individuals, often representing an even larger number of not so well informed people all of whom have their own view about what might happen to the weather, to people's incomes, to the economy and so on, and therefore, what will happen to demand and supply for any particular commodity, and consequently what will happen to its price.
A farmer, for example, selling Corn, will attempt to sell their Corn to whichever of these buyers will pay the highest price for delivery in a year's time. If they cannot sell it all to this buyer they will sell some to the next highest bidder and so on. The buyer, obviously hopes that the actual price in a year's time will be even higher, so they will make a gain on their purchase. If the price is higher than that, the farmer might regret they agreed to sell at that price. On the other hand, they removed the risk that the price might have been lower. In the same way, some people in the futures market might believe that prices will be much lower in a year's time. So, they agree to sell commodities they do not own. That is called short selling. Once again, if they are right they stand to make a gain. Suppose they agree to sell 1000 tons of Corn for delivery in December 2013 at £10 per ton. They do not own this Corn. They expect that the actual market price of Corn in December 2013 will be less than £10 per ton. Let us say it turns out to be £8 per ton. In December 2013, they buy 100 tons of Corn at £8 per ton, which they then deliver to whoever had agreed to buy it from them a year earlier, and are paid £10 per ton for it. They make £2 per ton gain.
But, it can be seen how this speculation by potential buyers and sellers in the Futures Market removes some of the risk for producers of Corn. It does not mean that the price of their Corn will not rise or fall from year to year, but because they are able to obtain a certain rather than an uncertain price for their output, they are able to act accordingly. If the Futures market prices for some commodities suggest prices will be lower, they can reduce their production of that crop, and increase their production of some other crop where the Futures Market suggests that prices will be higher. 
But, Futures markets now exist not just for agricultural products, but for almost everything. The irony is that something that was intended to reduce risk and uncertainty, however, became the source of a considerable amount of risk and uncertainty, because of the development of further derivative markets based upon them, and the unregulated nature of those markets, which led to the sub-prime crisis. However, it could be argued that the real cause of the sub-prime crisis was not the operation of the futures and derivatives markets, but was in fact due to the actions in the primary markets e.g. the lending of vast amounts of money to people who had no possibility of paying it back!
This distribution of what, on average, people think is illustrated by the normal distribution of the Bell Curve. It shows that the majority of responses come under the bulge of the bell in the middle of the range. However, there will always be some responses at the edges – what are called the “fat tails”. It is events that occur within these regions that constitute Black Swan events.
The other way of thinking about them is in terms of the now well known Rumsfeldian “Known and Unknown Unknowns”. We might think of events occurring within the central range as being “Known Knowns”. Things further out in the distribution might be “Known Unknowns”. For example, we know that there will be another San Francisco earthquake at some point, but we also know that we don't know exactly when! On the other hand, a true Black Swan event is an “Unknown Unknown”. It is something that is completely off the radar.
On that basis its difficult to understand the markets at the present time. Its understandable that markets do not price in true Black Swan events, precisely because they are off the radar. Its like trying to price in the likelihood of someone discovering a giant yellow teapot orbiting the Sun. No one does it, because no one believes there is any possibility of it.
But many catastrophic events that could happen are not off the radar. In fact, its possible to look back – with the benefit of hindsight, of course – and see many of these events, that markets should have anticipated, should have prepared for, which would have meant they were not then catastrophic. Was it really impossible to foresee that the Tulipmania was unsustainable, for instance?
Given that all of Europe was mired in Depression during the 1920's, and the US economy and Stock Market was inflated on a sea of cheap credit, was it unforeseable that it would end in tears, before it resulted in the 1929 Stock Market Crash?
In 1987, with the US Trade and Budget Deficits soaring out of control, with Reagan following the Voodoo Economic policies of Arthur Laffer, which, like the ideas of the Tories today, were based on the ridiculous notion that Budget deficits could be erased by cutting taxes for the rich, was it impossible to foresee that it would result in the Crash of 1987?
With Tech Companies that produced nothing, and had no discernible income, let alone profits, seeing their share prices go through the roof as soon as they were listed, was it not foreseeable, that it would result in the Stock Market Crash of 2000. 
When UK house prices doubled in the space of just over a year after 1988, was it unforeseeable that, as interest rates and unemployment rose, they would crash back to where they were before? When in the US, people who had no job, and no means of paying back the loan, were given 100% plus mortgages on expensive new homes, when people bought homes that were not built, simply in the expectation they could sell them when they were at a higher price, was it unforeseeable that these property prices would collapse by a huge amount in 2008?
The answer is, no it was not unforeseeable. Nor does it contradict what was said earlier about the wisdom of crowds. When crowds decided that the price of Tulips would rise they were, of course right. Anyone who bought tulips before they went up would have made a significant gain, if they sold them again at any point prior to them falling. The whole point about why such bubbles end, is that the crowd ceases believing that prices will go higher. The number of people who continue to believe that – the “Bigger fools” - become smaller and smaller. The buying slows down, the rate at which the prices rise slows down. At a certain point the crowd decides that rather than prices rising they will be lower in future. Everyone wants to get out. When they do prices drop catastrophically because everyone tries to avoid being trampled by the crowd. 
But, there is an interesting psychological feature here. Professional investors try to ensure that they have no emotional attachment to anything they buy. Such an attachment means that you are more likely to hold on to it long after you should have sold it. It is something that amateur investors frequently do, leading them to incur losses, or bigger losses than they needed to do. But, that can have its own effect on markets when they crash, especially where large numbers of such investors have become involved. A classic example was the privatisation issue of BP shares back in the 1980's. BP shares were already quoted on the Stock Market, when the Government decided to sell off its own stake. There had been a number of privatisation issues, from which people had made significant gains. The Government, announced the price at which it would sell its shares, and this was below the market price of BP shares. A large number of people signed up to buy shares. Before the share sale took place, however, the BP share price fell dramatically, to way below the Government offer price. Yet, large numbers of people went ahead to buy the Government shares at the much higher price, when they could have saved themselves a load of money by simply buying the shares on the open market! 
What was going on here. Partly, it is simply a sign that large numbers of people had been convinced to buy shares without any knowledge of basic elements of financial education whatsoever. Its rather like all the people who have no idea how much interest they are paying on their credit card, or all those people who were persuaded to buy their council house without any understanding of the implications of paying a mortgage rather than rent would mean to them, or who were conned into taking out expensive private pensions by that same Government, only to find not only was most of their money going in commissions and backhanders to people in the Pension Companies, but what was left was to become worthless when the Stock Market crashed in 2000, anyway. 
But, part was also that these people had made a decision to buy these shares, confident that just as people had made money in previous privatisations, so they would make money in buying BP shares in the privatisation. They had made a decision, and were going to stick with it. That is all the more true with houses. Someone who has paid out a large amount of money for a house in the mistaken belief that house prices only ever rise, will take some convincing that they should sell it for less than the inflated figure they have for it in their mind, let alone that they should sell it for less than they paid for. That is all the more true, though less logical if they have lived in the house for any length of time. Its less logical because the longer you have lived in a house, the less you are likely to have paid for it compared to current prices. Consequently, you could well afford to sell it at a price way below current asking prices, and yet still make a gain over the price you originally paid.
In other words, psychologically people in general even when they begin to recognise that things have changed that prices instead of continuing to go up, are more likely to fall, fail to act upon that belief. They continue to hope, even if they do not believe, that the worst will not happen. So, it is impossible to prepare for a true Black Swan event because no one can see it coming, but also people in general do not prepare for those catastrophic events that can be foreseen either, because it is more in their comfort zone, to continue to believe that they will not happen. Its rather like someone who buys a house in a flood plain. They know that it means the house is likely to be flooded if there is heavy rain, but when it happens they are still surprised it happened! They only looked at the lower price for the house, without considering why it was cheaper! 
Similarly, when people come to realise that house prices have stopped rising, and have started falling, and are likely to fall sharply, they may decide not to buy another house, or might expect to buy any other house at a lower price, yet they continue to expect to be paid the current inflated price for their own house! That is the situation, that Miles Shipside, the economist at Rightmove has described in respect of sellers over the last year. But, all this behaviour does, whether it is with share prices, or with property prices is to exacerbate the crash when it occurs.
With property it is worse, because it is not a particularly liquid market. In the Stock Market billions of shares are being traded every day. If you have shares you want to sell, you can go on to your online stock broker and sell them immediately to any number of willing buyers. Moreover, if you decide you don't want to sell all of your shares, you can sell just a portion of them. But, ask anyone trying to sell a house at the moment. The average house has now been on the market for about a year, before it is sold, and that time is rising, as more and more properties are listed for sale, whilst sellers go through a process whereby they start off with a totally unrealistic asking price, and only in stages reduce the price down to a more realistic figure. One share in BP is the same as another, but one house is not the same as another, so they are not so easily disposed of. Moreover, you cannot generally sell just a part of your house. Its all or nothing, and in times like these its more frequently nothing.
But, if this kind of head in the sand psychology is to some extent understandable with people selling houses, its less understandable when it comes to the Financial Markets, where those who make most of the decisions on buying and selling, are supposed to be better informed, and more dispassionate.
As opposed to the Black Swan events that like the Spanish Inquisition, “no one expects”, there are no shortage of foreseeable catastrophic events, what might be called Grey Swans, which might not be as probable as the white swans, that are sufficient in number, and sufficiently likely that they would seem to suggest that a degree of caution and preparation is warranted. To some extent, the vast amount of money that has gone into Gold, Bond Markets, and Cash Deposits is an indication that such caution and preparation exists. Yet, at the same time, Stock Markets have risen by between 20 and 40% in the last year or so, and even the Bond Markets now appear to have risen so much that its difficult to justify seeing them as “safe havens”. The same is true with Gold. Gold acts as a safe haven to protect against inflation and devaluation of currencies, but its price has also risen substantially, whilst any serious financial calamity under current conditions is likely to result in large amounts of money being withdrawn from circulation, as economic activity collapses and in deflation.
What is more concerning is that many, if not all, of these Grey Swan events are linked. That means that if any one of them were to occur, they have the potential to spark all of the others. That means the probability of some kind of catastrophe occurring is increased, whilst the potential consequences of it, are increased as well. Anyone who has undertaken a Risk Assessment knows that is not what you want to see. Looking at these Grey Swans illustrates this.
The US is facing what has been called the “Fiscal Cliff”. What it means is basically that unless a deal is done before January, the US will implement a series of tax rises and spending cuts, which will cause a 4% fall in US GDP, crashing it into recession. That will have serious consequences. For the last 30 years, at least, the global economy has had a 3 year cycle. A cyclical slowdown began towards the end of 2011, and is likely to run into 2013. As a consequence, growth in the US has slowed, the Eurozone and UK have gone into recession, whilst even China's growth has slowed to around 7.5%. If the huge US economy is driven into recession, that will impact on all of these other economies, preventing any kind of recovery. 
That is probably more serious for the UK and Eurozone than it is for the US, or for China and other dynamic economies. In the US, its housing market has collapsed by around 66-75%. Its banks have largely been recapitalised. The main problem in the US will be the huge volume of private debt in the form of credit card and student debt, standing at around $2 Trillion. That is not the case in the UK and Eurozone. There an enormous amount of private debt exists alongside, a still hugely inflated property market, alongside still under capitalised banks. Private sector debt in the UK alone stands at £2 Trillion. Most of this is very tenuous. Banks have held back on repossessing property to avoid creating a firesale in the property market, but they are steadily tightening their grip on it. A third of people in the UK run out of money before the end of the month, and with the already high levels of debt, their only resort is to Usurers, and Pay Day Loan sharks charging up to 4000% p.a. interest. A fifth of all workers in Britain earn less than the Living Wage, that is not counting all those on zero hours contracts, or who are in self-employment because they can't find jobs, and whose earnings are often barely above what they would get on the dole. With real wages falling as wages are cut, and with prices of food and energy already scheduled to rise by around 10% in the next few months, this becomes an unsustainable situation. 
At least the bank will not send someone round to remove your knee caps if you don't pay, so its obvious who people will pay first. But, the consequence then will be that the Banks begin to repossess, and once that begins a stream will quickly turn into a flood given the huge number of already unsold properties on the market. As with every bubble as it bursts, the banks will not want to get trampled in the stampede, an each will try to get its money back first. That is what happened in the 1990 house price crash, it is what happened in the US in 2008 and subsequent years, and it is what happened in Ireland in 2010. It is difficult to see how UK Banks could survive such an event in their current condition, especially as it would almost certainly cause widespread defaults on other forms of credit. 
But, the position of the Spanish Banks is even worse. Spanish property prices have fallen from their previous astronomic levels, but a recent survey cited on CNBC said that house prices there need to fall another 50%, and land prices by 86%! In fact, given that Spain is already in Depression, and being driven inexorably in the same direction as Greece, its hard to understand why property prices, and the Spanish Stock Market have not collapsed already! But, the position of the Spanish Banks is worse than that in the UK. Many of them are effectively broke, and the government has been trying to rescue them by promoting mergers, and their take over by the bigger banks. But, the position of the Spanish banks is still massively flattered by the valuations of property on their books; valuations that are totally unrealistic. Already, bad loans of the Spanish Banks has risen to the worst case scenario given in the Stress Tests undertaken only a couple of months ago. If Spanish property prices fall to the kinds of levels now being discussed, then the amounts of money proposed from the ECB for bailing them out will be wholly inadequate.
That will have a serious ripple effect across Europe and the UK given the interlocking nature of the loans made between Banks. It is only the huge amounts of money printed by the ECB that has prevented a renewed Credit Crunch already, and yet borrowing costs are rising, causing banks to raise mortgage rates, which in itself puts further pressure on house prices.
The other grey swan on the horizon of the US is also the possibility of a Romney victory. US big business is hoping against such an eventuality. Although, a Romney victory might avoid the Fiscal Cliff, if the Republicans control the Congress, the implications might be at least as bad. Romney is likely to be prisoner to the Tea Party Taliban, whose representative is his running mate – Paul Ryan. They are committed to no tax rises, which would mean either that the deficit escalates out of control, or more likely swingeing spending cuts, that would again crash the US economy. Romney has also said he will sack Ben Bernanke from the Federal Reserve, and oppose the current policy of money printing. That is not what US big business wants to hear. Not only does it mean reintroducing all of the risk and uncertainty they have spent a century trying to remove, it is Bernanke's money printing that has prevented the US going into deflation, which would have been highly damaging for big US oligopolies. The Fed was set up in 1913, precisely to prevent such an occurrence.
The result again would be a crisis of the US economy, and a big reduction in profits that would suggest that current Stock Market valuations are grossly over rated. Already, the economic slowdown has seen the majority of US firms report lower earnings in the last week or so, which has sent Stock markets down marginally.
But, the consequence for the UK and Europe would be much worse. That is not just because of the fact that it would mean that their exports to the US would collapse. At the moment, the Federal Reserve buys huge amounts of US Government Bonds as part of its programme of QE. If Romney and the Tea Party ended that, the consequence would be that the price of US Treasuries would fall sharply. The Yield would then rise sharply. This in itself would be another dampening effect on the US economy. However, this might be only a very short term effect. As happened when the ratings agencies cut the US's Triple A Credit Rating, people continued to buy US Bonds. That is because everyone knows, whatever the agencies say, that the US is not going to default on its debts. The likelihood is then, that the Federal Reserves purchases of Bonds would largely be compensated by purchases from elsewhere. That is particularly true if rates were marginally higher. But, that elsewhere is likely to be Europe and the UK. Money that currently goes to buy UK and Eurozone Bonds, would instead go to buy US Bonds. So, the perverse consequence of the Fed stopping buying US Bonds would be a sharp rise in the Yields of UK and Eurozone Bonds! For reasons I've set out elsewhere, the UK is more likely to suffer in that process, as the Government is seen to be incompetent, and UK inflation rising.
Its not difficult to see how this feeds back into creating the same kind of problems previously discussed. Higher Bond Yields, a crash in the Bond Bubble and so on, could lead to a renewed Credit Crunch, higher mortgage rates, a property market crash, and the bankruptcy of UK and Eurozone banks.
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| Ed Yardeni coined the phrase Bond Vigilantes |
All of those things can arise simply from the kind of psychological responses typical of this stage of a crisis, what has been termed a Minsky Moment or an example of Keynes' “animal spirits'. Each can feedback to provoke the outbreak of the other kind of event.
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| The situation in Syria, the wider Middle East and Turkey is very reminiscent of the situation there and in the Balkans, described by Trotsky in 1912-13. It eventually led to World War I. |
There are many more of these Grey Swan events that could be listed, as well as the Black Swan events we do not know about. Given the range of threats, and their potential seriousness the present levels of global financial markets appear to have all the hallmarks of people who know that a tsunami is coming, but who instead of preparing by moving to high ground, have decided to stand on the beach to watch it arrive!
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