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Tuesday, October 21, 2008

Taleb and Mandlebrot on the Markets

The October 21, 2008 edition of The NewsHour on PBS aired an interview of Benoit Mandlebrot and Nicholas Taleb and their thoughts on the worldwide economic picture. If the names don't immediately ring a bell, Mandlebrot is famous for his work on fractal geometry (remember those crazy, paisley / psychedelic looking images?) and chaos theory. Taleb is newly famous for his book The Black Swan about unexpected catastrophic events and how they arise from "normal" situations. It becomes apparent very quickly how the two areas of research intersect.

Chaos theory basically states that systems involving even a relatively small number of variable inputs which themselves all may behave according to well understood patterns within well-controlled bounds can produce wildly unexpected outputs. Engineers familiar with control system design or mechanical engineering are very familiar with the concept. That's how a suspension bridge facing a wind blowing laterally across the deck just so suddenly becomes "Galloping Girdy" and collapses into the river below. (#1) Taleb's black swan concept is his label for a pattern of thinking which slowly, systematically, over the course of years, decades or centuries, confirms the practical impossibility of an event occurring --- which then occurs.

The interview segment with Paul Solman will eventually be posted on their site here for viewing:


There have been a few signs that the immediate credit crisis is abating (like a reduced TED spread, slightly higher short term Treasury yields...) but the take of Mandlebrot and Taleb is decidedly pessimistic. DARK in fact.

Two things occurred to me listening to the two discuss their work and its application to the current financial situation. First, Taleb described the lack of "slack" in virtually every system in the financial markets and the larger economy. Paradoxically, this lack of "slack" is produced by the "efficiencies" produced by the incredible concentration of market share in both megabanks and corporations in general. Squeezing every ounce of profitability out of the supply chain -- whether you're making TVs, iPods, or financial instruments -- certainly funnels a huge amount of the overall profit to the firm at the top but leaves no room for error anywhere along the line for one missed delivery, one bad batch of LCD screens, or one bad bet on a currency bet in a hedge fund that's leveraged its assets by a 20x to 50x factor.

Sound familiar?

This is exactly the point made in a book published in 2005 by Barry Lynn entitled The End of the Line. See (#2) for a review.

The assumptions of chaos theory are also worth considering when looking at the current situation. The normal starting point for analyzing a system for chaotic behavior is analyzing its reaction to "normal" inputs, each of which vary in predictable patterns and likely vary in a "continuous" manner. From a mathematical standpoint, a "continuous" input means the rate of change in the value of the input is always finite / limited. Think of a sine wave instead of a square wave.

Worldwide markets are heavily influenced by computerized algorithms which monitor key data and generate trades when patterns of changes are detected in those inputs. These algorithms may be able to handle "square wave" changes in input values (price closed at $90.00 yesterday but opened today at $81.00 without going gradually from $90.00 to $81.00) but they likely assume that their outputs can vary based upon whatever scale the algorithm dictates. That's not a good assumption given circuit breaker mechanisms in markets. More importantly, the algorithms likely cannot accommodate a sudden change in regulation or government / central bank intervention as inputs. Even if they attempt to do so, they most likely cannot anticipate the impact of thousands of other automated traders all suddenly operating outside their original design boundaries and generating their own shocks into the system as inputs.

The gross, irresponsible, over-expansion of credit has produced one of the most frightening "IFs" to ever face our economy and society. The need to solve that problem in a world of highly inter-dependent economies, highly interconnected financial systems and highly computerized trading systems aimed at exploiting the smallest of anomalies in the system seems to remove the IF from the analysis and replace it with a WHEN.


#1) http://www.archive.org/details/SF121

#2) http://boards.fool.com/Message.asp?mid=23143009