People pay too much attention to their forecasts (which are unreliable) and too little to their assumptions, and that often gets them into serious trouble. I argued in the last post that the assumption driving much EU integration – that international law and international organization is the foundation of the last seventy years of peace in Europe – is not always true.
So what else may have kept the peace in Europe for the last seventy years? What worked, if international law sometimes doesn't work? Think for a moment.
It isn't the same as the question of what you think international law is ideal or moral aspiration or a nice idea, but, again, what actually works. We all know people who are wonderfully nice, but maybe should not be entrusted with arranging your summer trip, or running a company, or handling air traffic control for inbound flights at LaGuardia. You may think it is ideal and moral that everyone should be honest as well. But you probably locked your front door when you left home this morning too. So what actually kept the peace, if not the EU?
Might it have something to do with the US deploying hundreds of thousands of troops in Europe, a chain of air bases from Keflavik in Iceland to Incirlik in Turkey, and the Sixth Fleet in the Mediterranean? Not to mention the threat of thermonuclear escalation if anyone started a war. The US assumed much of the security of Europe, and strongly supported European rebuilding from the Marshall plan onwards, as well as the EU itself as a bulwark against communism. The Red Army might have been entirely unthreatening and peaceful and admired European law, but the citizens of Budapest and Prague who saw Soviet tanks on their streets in 1956 and 1967 might disagree. Yet western European countries could afford to reduce defense spending and focus on welfare and economics. In other words, the EU itself is more a symptom of the US stabilizing the security situation than the cause of security.
Let's say you splutter with outrage at the idea. There are definitely some people in Europe and elsewhere who are very uncomfortable with any positive consequence of Ameican foreign policy, ever. Fine. How would you test that? What kind of implications would you expect to see? The explanations lead very different places and feed different narratives. Seeing the question from different angles and questioning assumptions is usually essential to figuring out the right policy. And the things you feel uncomfortable about are the most likely place for blind spots, because you never look there.
In the same way, the reaction to the publication of the Chilcot report on British participation in the Iraq war was published yesterday. Most of the attention, like this Guardian editorial, is focused on poor prediction of consequences.
Let's agree the war was bad in retrospect. It is also clear that there was not enough effort to question the assumptions underlying intelligence assessments that Saddam Hussein still had weapons of mass destruction, or prepare for the aftermath.
But the press reaction doesn't really come to grips with a recurrent theme in the executive summary of the report. Why did Blair, a European multilateral liberal, stick so close to Bush, a Texan Republican? Was it to preserve the special relationship? Get invited to delightful Crawford, TX? Be a poodle and get dog biscuits?
Most media reactions lean towards thinking it was because Blair was a pathological liar, a vain foolish potential war criminal who ignored advice. They personalize the issue. But Blair was a highly skilled, highly popular leader before the war, not a cartoon villain, and he clearly had doubts about direct UK interests in Iraq. So what was he thinking?
In fact, Chilcot documents how Blair kept trying to push the US to go the multilateral route, to get UN resolutions, to persuade a coalition of allies rather than take unilateral action.
The report references a 2003 speech by Blair several times.
370. In Mr Blair’s view, the decision to stand alongside the US was in the UK’s long‑term national interests. In his speech of 18 March 2003, he argued that the handling of Iraq would:
“… determine the way in which Britain and the world confront the central security threat of the 21st century, the development of the United Nations, the relationship between Europe and the United States, the relations within the European Union and the way in which the United States engages with the rest of the world. So it could hardly be more important. It will determine the pattern of international politics for the next generation.”
In other words, it wasn't really about imminent threats from Iraq or whether it had WMD or supported terrorism for Blair. At best, those were fig leaves or PR concerns. It wasn't even primarily about the effect of disagreement on US-UK relations. It was to get the Americans to follow the norms of international law. It was to stop them acting outside the multilateral framework.
So consider this: international law didn't stop the Iraq war, because the Americans felt they couldn't rely on the UN framework. And Blair, as an internationalist progressive, went along to try to make sure the “pattern of international politics for the next generation” was based on international law and multilateral organizations. He tried to rein back American unilateral use of force by participating as a junior partner, to preserve international norms, albeit not enough for domestic opponents or some other EU governments.
So international law did not lead to peace but was the cause of at least UK participation in the Iraq war. Uncomfortable? Fine. But Blair might have stumbled into huge mistakes because of his assumptions. Forecasts and data and judgements got altered to fit them.
And that happens all the time.
Now some of the initial shock of Brexit is wearing off, it's time to think about reactions. So don't make overconfident predictions, or pronounce on cloudy abstract principles, like so much of the media. Being for or against “globalism” or “openness” or “cosmopolitanism” is a self-deluding waste of time that just distracts you. Instead, look for flaws in your fondest, most cherished assumptions, because that's where you can find blind spots and the basis for action to make things better. It's much less comfortable but more effective.
So what is the biggest assumption about the EU and Brexit? Much of the shock is not really a matter of the result being statistically improbable (it wasn't), or even the medium-term economic implications for the UK. Instead, it seems to be a challenge to deeply-held ideas about international cooperation and global progress. It challenges the ideal of international law and cosmopolitan aspirations.
The great emotional driving force, the hundred-thousand-volt spark behind the EU Project is to make war unthinkable on the continent again. It's symbolized by Helmet Kohl and Francois Mitterand standing arm in arm at Verdun, saying never again. International law must replace international conflict. Instead of meeting on the battlefield, young people should meet in Ibiza nightclubs or Berlin coffee bars. Instead of war and nationalism, prosperity and peace. How could anyone be against that?
The fundamental assumption is that international law and organization prevents war, and that justifies ever closer union. So here's a question. Do you recognize these two faces? They're not pretty celebrities, admittedly.
On the day of their greatest success, both probably thought streets would be named after them in every city, town and village on every continent. You would probably have gone to a high school named after one, or joyously celebrated a national holiday named after the other. They would be remembered as perhaps the two greatest moral benefactors of mankind in history. In fact, both won the Nobel Peace Prize for their efforts.
Not triggering any admiring memories? The first one is Frank Kellogg, American Secretary of State at the time. The other is Aristide Briand, foreign minister and later Prime Minister of France.
They signed the Kellogg-Briand Pact, which abolished war as an instrument of statecraft forever. Think about it. They made war illegal.
Think about it some more. It was agreed to by every major nation on earth.
Who could achieve more than that? Surely it justifies renaming a few major cities in their honor. Instead of Chicago, Kelloggsville, perhaps.
Signatory states promised not to use war to resolve “disputes or conflicts of whatever nature or of whatever origin they may be, which may arise among them.” Besides America and France, it was signed by Germany, Italy, Japan, the Soviet Union, China and the U.K., not to mention other countries from Afghanistan and Australia to Panama, Peru, Portugal and Persia. It passed the US Senate 85-1.
Unless you're a specialist in international law or legal history, you probably haven't heard about any of this. Why not?
Because the pact was signed in 1928. Within 5 years, Hitler had come to power. Within nine years, the Imperial Army of Japan murdered hundreds of thousands of civilians in the Nanking Massacre. Within 11 years, the worst war in human history had started. One signatory perpetrated the holocaust. Others killed hundreds of thousands in a single night in firestorm air raids that destroyed whole cities of civilians such as Hamburg or Tokyo.
So the assumption that international law prevents war in and of itself or creates new inviolable moral norms is catastrophically wrong. At best, international treaties were ineffectual, having little ability to hold back deeper, darker forces driving towards disorder. At worst, the legalistic perspective was actively harmful self-delusion, like the related League of Nations system, that distracted efforts and delayed more effective action.
So you can't just complacently assume international law or international organization works or produced good results as you congratulate yourself on your high moral standards, or even take a trip to Oslo to collect a Nobel Peace Prize. The world may slide towards carnage thanks to your ignorance. Symbolism and aspirations and norms may not work. The fundamental assumption about the EU is sometimes false.
But this shouldn't be a wholesale indictment of belief in international law or good intentions either. Instead, we can ask: what's different? Maybe the Second World War was so much worse that it reinforced the desire for legal norms, and that lasted fifty years. Then again, who needed convincing after the Somme or Verdun? Or maybe legal norms themselves are unreliable and fragile when put under stress, just when you need them most.
Or maybe there's a balance to be struck between law and international cooperation and other forces, that varies in different times and places. The tragedy is universalized principles can also actively undermine balances and blind people to problems.
That's the debate we ought to be having. Instead people talk past each other, shouting from within their fortresses of rigid assumptions.
So instead of mourning or celebrating Brexit this weekend, think about what we can do differently to Kellogg and Briand. Why didn't it work? Why has the EU worked till now? What has changed? What are the key assumptions which can break under pressure? Because that may point to specifics rather than abstract principles. Look for tangible, concrete, situational things, not norms.
The Brexit vote in the UK is an epic watershed event, of course, upending 40 years of settled expectations about the shape and direction of the international system. But it’s time to keep calm.
The violence of the market reaction today is partly because of misplaced predictions that the vote would be to remain, as investors had to cover their positions. At one point late yesterday financial markets had it at 80% chance that the UK would still be in the EU today. Expensive private polls conducted by financial institutions also reportedly indicated a remain vote.
As ever, excessive confidence in expert ability to predict political and economic events is foolish, and made people much more vulnerable to damage.
But that also means it’s time to be skeptical about the usefulness of the endless amounts of analysis and prognostications that the media and banks will now publish in the next week or two. Most of the pundits didn’t understand what was going on before and they don’t understand now. Yes, there are likely to be negative economic consequences, especially for the UK economy. Yes, the legitimacy of the EU and the international legal framework has been damaged. But people also adapt and find ways to mitigate the impact of change. It will take time for the full consequences to work themselves out. So it’s time for some patience and moderation.
It may turn into one of the most spectacular corporate disasters in history. What were Volkswagen thinking? Even after it became apparent that outsiders had noticed a discrepancy in emissions performance in on-the-road tests, the company still kept stonewalling and continued to sell cars with the shady software routines.
We won't know the murky, pathological details for a while. But understanding how this happens is urgent. If you ignore this kind of insidious problem, billion-dollar losses and criminal prosecutions can occur.
In fact, it's usually not just one or two “bad apples,” unethical criminals who actively choose stupid courses of action, although it often suits politicians and media to believe so. It's a system phenomenon, according to some of the classic studies (often Scandanavian) like Rasmussen and Svedung.
.. court reports from several accidents such as Bhopal, Flixborough, Zeebrügge, and Chernobyl demonstrate that they have not been caused by a coincidence of independent failures and human errors. They were the effects of a systematic migration of organizational behavior toward accident under the inﬂuence of pressure toward cost-effectiveness in an aggressive, competitive environment.
It's not likely anyone formally sat down and did an expected utility calculation, weighting financial and other benefits from installing cheat software, versus chances of being found out times consequent losses. So the usual way of thinking formally about decisions doesn't easily apply.
It's much more likely that it didn't occur to anyone in the company to step back and think it through. They didn't see the full dimensions of the problem. They denied there was a problem. They had blind spots.
It can often be hard to even find any point at which decisions were formally made. They just … happen. Rasmussen & co again:
In traditional decision research ‘decisions’ have been perceived as discrete processes that can be separated from the context and studied as an isolated phenomenon. However, in a familiar work environment actors are immersed in the work context for extended periods; they know by heart the normal ﬂow of activities and the action alternatives available. During familiar situations, therefore, knowledge-based, analytical reasoning and planning are replaced by a simple skill- and rule-based choice among familiar action alternatives, that is, on practice and know-how.
Instead, the problem is likely to be a combination of the following:
- Ignoring trade-offs at the top. Major accidents happen all the time in corporations because often the immediate benefits of cutting corners are tangible, quantifiable and immediate, while the costs are longer-term, diffuse and less directly accountable. They will be someone else's problem. The result is longer-term, more important goals get ignored in practice. Indeed, to define something as a technical problem or set strict metrics often embeds ignoring a set of trade-offs. So people never think about it and don't see problems coming.
- Trade-offs can also happen because general orders come from the top – make it better, faster, cheaper and also cut costs – and reality has to be confronted lower down the line, without formally acknowledging choices have to be made. Subordinates have to break the formal rules to make it work. Violating policies in some way is a de facto requirement to keep your job, and then it is deemed “human error” when something goes wrong. The top decision-maker perhaps didn't formally order a deviation: but he made it inevitable. The system migrates to the boundaries of acceptable performance as lots of local, contextual decisions and non-decisions accumulate.
- People make faulty assumptions, usually without realizing it. For example, did anyone think through how easy it to conduct independent on-the-road tests? That was a critical assumption on whether they would be found out.
- If problems occur, it can become taboo to even mention them, particularly when bosses are implicated. Organizations are extremely good at not discussing things and avoiding clearly obvious contrary information. People lack the courage to speak up. There is no feedback loop.
- Finally, if things do wrong, leaders have a tendency to escalate, to go for double -or-quits. And lose.
There scarcely seems to be a profession or industry or country without problems like this. The Pope was just in New York apologizing for years of Church neglect of the child abuse problem, for example.
But that does not mean that people are not culpable and accountable and liable for things they should have seen and dealt with. Nor is it confined to ethics or regulation. It is also a matter of seeing opportunity. You should see things. But how? That's what I'm interested in.
It's essential for organizational survival to confront these problems of misperceptions and myopia. They're system problems. And they are everywhere. Who blows up next?
So how did the predictions from polls and pundits and consultants do on Greece so far? I’ve been arguing that people shouldn’t put so much faith in prediction, but look for potential errors and blind spots. The key is to look for leverage and resilience, not get trapped into vain prophecy when you can be doing something to adapt to the situation instead.
But is that justified by the latest events?
Unsurprisingly, the latest predictions are yet another tale of epic illusion and incompetence, on the evidence which Nate Silver examines here. The polls were bad:
Coming on the heels of the U.K. general election, the Israeli general election, the Scottish referendum and the U.S. midterms, Sunday’s Greek referendum looks like the latest in a series of bad outcomes for pre-election polls across the globe. While the last few polls before the vote showed “Oxi” (“no”) ahead by just 3 to 4 percentage points, it in fact took 61 percent of the vote to 39 percent for “yes,” a margin of more than 22 percentage points. It was a landslide: “Yes” didn’t win a single parliamentary constituency.
The pundits and market conventional wisdom were even worse.
When I use the term “conventional wisdom” in this article, I mostly mean the opinions of political pundits and journalists. In the case of Greece, however, the failure also extended to betting and financial markets. One bookmaker, Paddy Power, was so convinced that “yes” would win that it pre-emptively paid out “yes” bets. Most banks and financial institutions expected a “yes” vote. Betting markets like Betfair continued to show “yes” favored even after the polls had turned back toward “no.”
Markets are full of people who want stupid overconfident predictions, and even more people who will provide them to the gullible. There were plenty of instant experts on Greek politics. Plenty of journalists we’d convinced they knew what would happen. Did you believe them?
The answer? Not to be gullible. Instead of journalism and forecasting, which don’t work, look for ways to be resilient and adaptable. There’s all too many people who will believe the current conventional wisdom.
If you can avoid being naive, that’s 90% of the battle.
Let’s step back a bit from the immediate Greek vote, which is happening today. How did we get to this? There is no good outcome, now matter whether the vote is “yes” or “no.” As one opinion piece by a Greek writer in the Guardian puts it, it’s a choice between “catastrophe or absolute catastrophe.” It seems every year brings another financial disaster or crisis of one kind or another, and it’s been like that for a generation.
Why? Think about this: It has not been a matter of getting the facts wrong. The basic facts of the situation have rarely been in dispute. No-one has deliberately concealed the relevant economic theories, the interests of the parties, or the choices at issue. Even if some Greek statistics have been distorted or falsified in the past, that self-delusion is largely past.
Just like the run-up to the 2008 financial crisis, most of the problems have been in plain view for years. Instead, people choose to ignore or discount the facts, and talk past each other when it comes to arguments and narratives. Decision-makers get stuck into ruts and find it difficult to change course.
Most major mistakes do not come about because people don’t have access to facts, or can’t talk to the different parties. Instead, people see things in very different ways despite the facts, and it often takes the most dramatic or final losses to shake their conviction that they are right. By which time it is too late, like today.
That means a standard journalistic account , in a the way a good wire service reporter might file a story laying out the facts, is actually of surprisingly little value at this point, although many investors will be glued to their Bloomberg or Reuters screens today. There’s always people with a sudden insatiable need for facts about electoral trends by region, or what party lieutenants say, or expert opinion, despite overwhelming recent evidence that political reporting is little or no use in practice. Yes, a scoop like finding out exit poll results an hour early would be a good story. But those journalistic instincts to break news are often a distraction from understanding the underlying game. A good hard-news story and finding value in a situation are two very different things.
The facts about Apple
Unfortunately, that is a very difficult thing for some people to understand. There is a kind of mindset which is deeply uncomfortable with things that are not hard, uncontested fact. Everything which is not sure or verified by several sources is “opinion” or “speculation” or “vague”. But in business the most valuable things are often matters of judgment or taste.
Take Apple, for instance. It is rarely at the cutting edge of technology. Its software engineering is often notoriously shoddy, as anyone who downloaded the bug-infested mess known as iOS 8 initially found out. Competitors often sell products with similar capabilities for much less money. Apple is not known for financial brilliance in the way it invests its over $194 billion of cash reserves. But it is the most valuable company in the world. Why?
Of course, you can reduce it to discounted streams of future income or brand value or current market positioning, but what produces the income or the brand or Steve Job’s notorious “reality distortion field” in the first place?
It’s largely matters of judgement and taste – a feel for ease of use and style, an ability to look beyond engineering features to put together a combination of things which delight users. And here’s an interesting point – it’s precisely because those intangibles are very hard to replicate that they produce excess value which isn’t immediately competed away.
In the same way, dozens of places around the world have tried to be the next Silicon Valley, spending billions of dollars and hiring very smart engineers. But the particular combination of culture and attitude and interpersonal connections that power the Valley is very hard to replicate in Malaysia or Russia or France. It’s not reducible to easily reported fact. Can you really imagine reading a story in the newspaper tomorrow which reveals a stunning new fact which completely explains the secret of Apple’s success? It’s not that easy.
That’s also why journalism is in such trouble as a business, in contrast to Apple. There’s very little value in information and basic facts, with rare exceptions like a legitimate tradable scoop. Facts are instantaneously replicable, Even if it is a legitimate news story a scoop has almost no cash value unless you can react within a few milliseconds before algorithms trade. Instead, value is mostly in processes and patterns and culture and combinations which are not easy to replicate.
The real sources of value are not revelations or scoops. It’s about recognition and understanding, and persuasion, and creativity, and synthesis, and a sense for what works. It’s about alertness and adaptability. None of that is reducible to easily reported fact.
Of course judgment is fallible, and particular kinds of narrowly-defined judgment are better turned over to algorithms. (I’ve discussed that, as well as the pros and cons of big data and linear models at length before.) But hard-nosed facts tends to lose out where it most counts for business – hard cash.
I’ve just got back from several weeks in Europe, mostly vacation. We might have been in Athens today, lining up at an ATM.
We had long wanted to go to Greece, and hoped this would be the year to do it. But two months ago we decided that the Greek situation was looking worse and worse. We dropped the dream of the Greek islands and booked flights to Scandanavia instead, which the strong dollar makes much cheaper than usual. So we’ve been floating around the Stockholm archipelago and Norwegian fjords rather than Santorini. All the same, it’s impossible not to feel sadness and regret about reports of Greek ATMs and gas stations running dry.
Greece is terribly alone. The most important thing in all this, of course, is the fact that the previous “doom loop” between European sovereign debt and European bank exposure isn’t active, at least for now. European bank stocks have taken a hit on worries about their exposure to Greece. But that’s as nothing compared to what would happen if there are renewed fears about other sovereign defaults, or massively expensive bank recapitalizations, which feed off each other. Instead, ECB quantitative easing purchases seem to be supporting other government debt markets. And European officials will doubtless double down on support for the next line of vulnerable Club Med countries. It’s also doubtful foreign investors will lose enough money to produce serious system risk from this situation in other markets. That is why markets remain relatively calm.
So long as people are worried about the solvency of Greece and not the solvency of the German or Spanish banking system, the situation is horrible – but contained.
It’s even possible last-minute deals will defer the crunch another few days or weeks, kicking the can down the road one more time. This drama has been running for almost seven years now and one more curtain call won’t make much of a difference.
In fact, I’d worry more about a break in China in the short run. One crisis is bad. Two at the same time is exponentially worse.
The interesting question is whether European officials will learn anything from this. Yes, the Greeks have been irresponsible. But Brussels has been just as bad, filled with self-delusion and wishful thinking and inability to allocate losses in a coherent or sensible way. It’s not so much ignorance of economics that is at fault. The fundamental problem here has not been ignorance of optimum currency area theory or even experience with previous fixed exchange regimes like the gold standard. Instead, it was the hidden assumption that willpower would be enough to conquer all the problems in pursuit of a higher end. Problems were opportunities to consolidate an ever-closer union.
It’s blind spots that interest me above all else – things people just can’t see from their rigid positions. The Eurocrats were blinded by the dazzling vision of the European project, dreaming of how it would nobly end a thousand years of war instead of figuring out what would make it work. I talked to many a few years who considered what is happening now inconceivable. Will they double down on the vision yet again? Look for speeches on how crises in fact make Europe stronger….. while supermarket shelves are bare in Greece.
Today we had one of the biggest political surprises in recent memory. Instead of the expected hung UK parliament and endless coalition negotiations, David Cameron won an outright Conservative majority. Yesterday, Labour leader Ed Milliband thought he had a good chance of moving into 10 Downing St in coming weeks. Instead, he has already moved into dark political oblivion, already resigning as party leader in disgrace.
The pollsters were wrong. But none of the pundits predicted anything like this, either. The politicians themselves were stunned. I wasn’t paying much attention, but I didn’t predict it either. What’s going on?
There’s a deeper pattern. I have been arguing for a long time that right at the top of the list of challenge decision makers face is one stark fact: experts and pundits and data-merchants are horrifically bad at prediction. That argument includes yesterdays’ post – forecasters can’t forecast. It applies to many of the biggest central bank decisions in the last two years. In fact, the research shows the same applies to almost all the really big decisions since the second world war.
Why? Markets and political events are complex. And complex systems are inherently unpredictable, beyond short-term trend following. Worse, it’s usually at the big turning points and big market-moving surprises that forecasters do worst. They produce overconfidence rather than accuracy.
It’s only human to want to forecast the future. The Romans tried to do it by examining sheep livers, and paid trained “haruspices” . They picked that up the Etruscans, who picked it up from the Babylonians.
We might not use sheep livers any more, but large parts of the investment and business and policy communities still have the sheep liver mentality.
The way to stay alive and thrive is not to predict better, or have a better theory or even better data. It’s to adapt and evolve faster, despite all the pressures within organizations to do the opposite. It’s essential to test assumptions and develop resilience, instead of developing “rigorous” self-defeating models that don’t work. And that requires a different way of thinking.
The real lesson here: Drop the sheep liver. It doesn’t work, even if you’d like it to.
Investment adviser Ned Davis has a wonderful phrase which sums up how markets often work: you can be be right, or you can make money. (He wrote a book about it.) Everyone makes mistakes all the time, he says. Most of Wall Street is in the business of making predictions, but
Perhaps the biggest myth in financial markets is that experts have expertise and forecasters can forecast. The reality is that flipping a coin would produce a better record. [..] So if we all make mistakes, what separates the winners from the losers? The answer is simple – the winners make small mistakes, while the losers make big mistakes.
Investment survival is everything, he says, and most of that comes from a willingness to recognize mistakes and adapt quickly. Many investors make a blazing impact through one successful, “right” big prediction which turns out to be a lucky bet, but then almost inevitably flame out. Big heroic predictions tend to lead to overconfidence and meltdown.
Instead, what is needed for survival is in essence a kind of agility, and being overcommitted to one particular view as “right” or “correct” defeats that. Davis advocates quantitative timing models and indicators, which I don’t believe in, but his effective point remains: you usually don’t do better by having better forecasts or information, but in how you change your mind in response to evidence.
As I’ve argued many times on this blog, people mostly don’t change their minds. People fall in love with a view. Or they change with a lag, or in simple-minded imitation of what others are doing. That’s the main problem confronting decision-makers in financial markets and business, especially at senior levels.
That kind of rigidity has bedeviled discussion of events in Europe in recent years, because so much of it gets caught up with emotional commitments to (or sometimes against) the larger European integration project. For most euro enthusiasts, it’s not ultimately about exchange rates or economics. It’s the issue of deeper legitimacy of a project rooted in memories of the destruction of two world wars. The trouble is that can lead to very entrenched and moralized views on the issue.
But there tends to be a natural rhythm to most economic policy: successes cause side-effects which cause new problems. Media cycles exaggerate and then ignore problems. Market attention focuses on an issue and then wanes. Periods of apparent success set the grounds for subsequent failures, and vice versa. So the effective thing to do is avoid large mistakes about the ultimate success of decades-long projects and big commitments for or against, and look at how people are thinking and adapting to current evidence about specific problems. It’s about the right amount of flexibility now and responsiveness to the rhythms, not commitments about who the superpowers of the 22nd century will be.
In that sense, the latest round of “grexit” talk has been usefully more technical and local in focus, centering on the potential failure of Greece rather than the potential failure of the wider euro project. That has reduced the rigidity of the discussion so far, as the EU institutions and the Greek government play their game of chicken. But suspicions of “Anglo-Saxon speculators” are now surfacing again, as in these comments by Juncker. It’s a sign of rigidity.
What causes a game of chicken like this to go wrong and produce a crash or meltdown? Of course, people overestimate or misread their chances. (The Greeks may have done so far, but events are forcing them to reconsider. ) People believe their own propaganda. It often happens decision-makers get so entrenched in a view they don’t realize the situation is moving against them. Looking at people’s stretchiness, or sensitivity to contrary evidence, is the key. And what they say is often a poor guide to how their underlying view is changing.
The other reason for crashes in games of chicken is that there are timing or side-effects which mean the situation gets out of control even if the participants realize to their horror too late that they need to change course. This is often a matter of technical issues – things like cross-default clauses or the minutiae of how settlement systems work. I always think of it in terms of the mobilization railway timetables in the run-up to the First World War. Or, more recently, the bullet-to-the-heart impact of Lehman’s failure, which was far worse than the Fed or Treasury expected.
For the time being, the seemingly endless dragging out of the Greek drama is boring. But if the current scene is about Greek overconfidence and increasing desperation, the next scene will probably be problems caused by EU overconfidence and hubris that they can control the situation. The notion of hubris, after all, is a Greek invention.
You’ve probably seen those films about Pompeii that begin with bustling sunlit scenes of normal life, and end with ash clouds and panic and burning and suffocation. The victims had become used to rumbling and smoke from the volcano for decades, and paid no attention to the mountain. Then an epic disaster overtook them and burnt them alive.
Yet people still live on the slopes of volcanoes. They ignore small risks of terrible outcomes , in a consistent pattern called disaster myopia. The slopes are often fertile and attractive. Vesuvius is now surrounded by far more people today than it ever was in Roman times.
In fact, recent discoveries suggest the site of city of Naples itself has been buried under ten feet of ash in the past, in more ancient eruptions far worse than the infamous Roman disaster. The trouble is that evacuating the Naples area would be logistically almost impossible. So Italian authorities largely ignore the possibility.
Disaster myopia also applies to economics and banking and finance, as researchers like Guttentag and Herring have pointed out since the 1980s. People find it very difficult to handle small risks of serious problems, so often ignore them altogether.
That brings us to the events of this week, specifically the massive losses caused by the decision of the Swiss National Bank to abandon their peg against the euro. Only one out of 50 economists surveyed by Bloomberg was expecting a change in the peg – and the one who did expected a tiny move. The Swiss currency leapt 41% after the announcement and ended the day 19% higher. If you measured risk the way so many in the markets do, using standard deviation and value at risk, that should not have happened in the lifetime of the universe. As Matt Levine of Bloomberg View points out,
An 180-standard-deviation daily move should happen once every … hmmm let’s see, Wikipedia gives up after seven standard deviations, but a 7-standard-deviation move should happen about once every 390 billion days, or about once in a billion years. So this should be much less frequent.
Complacency produced the financial equivalent of Pompeii. Losses run into billions of dollars, including major banks, hedge funds, retail fx brokerages, and probably thousands of retail clients who were foolishly trading FX on margin have been wiped out.
That said, it’s one thing to ignore volcanoes which can be expected to erupt every four or five hundred years, or longer. Even if you live on a volcano, you have a very good chance of never seeing an eruption in your lifetime, and in most places you have a good chance of escaping if you do. Events in complex systems like the economy and financial markets are much less predictable. We have, as Keynes pointed out about uncertainty in the 1930s, little or no idea of the odds of many important events.
Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of pivate wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatsoever. We simply do not know.(QJE, February 1937)
The result, he says, is people fall back on conventional judgment and copy what others are doing. Or, as we see, they use forecasts and “information” sources in much the same way the Romans used sheep entrails to try to foretell the future, despite all the evidence that forecasters almost always miss critical turning points and mostly just produce foolish overconfidence in their clients.
In complex systems formal prediction is usually a futile hope. It is stupid to make decisions on the basis of forecasts that are largely based on extrapolation of historical data and leave conventional assumptions unchallenged. Here’s some things you can do instead:
- figure out what can go wrong with a decision, or position, or point of view. That means examining your assumptions, looking for boundary conditions, and thinking about what-if scenarios. And then develop markers, to monitor events. You’ll never be able to anticipate every eventuality, but you can have enough signals to make sure you are alert, and agile, and suspicious of complacency.
- think about how you and the other side think about the situation. Step back and take a detached view of the game that is being played, and do some “second-level thinking“. I’ve worked in a central bank and have had years of working out how they make decisions from a market perspective. There are ways to do better than the market, largely by avoiding errors most of the market typically makes. I wasn’t following Switzerland so can’t claim I had any special insight here. That said, you can get a much better understanding of how events like this take place by thinking about people’s actual reaction function, not what you think they “ought” to do. Markets and central banks regularly misunderstand each other because they misread communication, misunderstand motivations and have structural incentives to say one thing and do another. Ignoring what people say and concentrating on how they actually think and do is the only way to have a chance of avoiding problems.
- think about where your edge or advantage lies. If you don’t have one, don’t play the game in the first place. What possible advantage could a retail investor have playing FX markets at a leverage of 20 or more? It’s a classic case of trying to pick up pennies just in front of a steamroller. Understanding where your edge actually lies is the first step to using it.
- manage your exposure where you can’t make easy predictions, so that it reflects underlying uncertainty. (This is a point Nicholas Taleb vociferously argues.)
- don’t be naive. Anyone who thinks that the latest soothsayer or prophet is going to help them is naive. Only suckers pay for seers. Financial market companies have wasted billions on futile attempts to forecast the future when they should pay more disciplined attention to the roots of their own views and assumptions. You have to think about the underlying validity of opinions and forecasts, which is usually extremely low.
- have a plan B. If you think about what can go wrong, you can have a plan to deal with it or turn it to your advantage. Instead of making extrapolations from the past, you need to think about how to react to various scenarios in the future.
I’ll come back to some of these in more detail. The most important thing is to develop markers that alert you to problems with your own assumptions. You have to look at mindsets and thinking patterns, not spurious “predictions” and forecasts.