BLACK SWAN EVENT STRAIGHT AHEAD – KEEN, MINSKY AND A COMPLEX ECONOMY

I was inspired to write this piece after a dream I had of my father who sadly passed away suddenly with a huge heart attack exactly 6 years ago today. The piece is not going to be a melancholy one so if that first sentence gave you that impression, ignore it and read on, as this blog topic is one I have been meaning to write and rant about for the longest time.

The global economy is headed for a black swan event, I believe it is straight ahead, imminent and when it arrives will be catastrophic. For those of my readers that do not know what a “black swan” event is, Investopedia defines it as “An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. This term was popularized by Nassim Nicholas Taleb, a finance professor and former Wall Street trader”

Taking a look at the definition, as given by Investopedia, the sudden passing of my father was a text book example of a black swan event. He was only 61, he was retired, had lost weight and was exercising. Statistics say that he should have lived at the very least another 15 years right? So why did that not happen? Why did he not live to be 75 or 80? I have wrestled with all of these questions as his son, and in fact added to them, could I have done more? He mentioned acid reflux, did he report that issue the last time he attended the doctor for a check up? Did the doctor ask the right questions or moreover did my father answer honestly?

To ponder all of the aforementioned questions highlights the complexity of human psychology, how this affects perception and behaviour.  The diversity and complexity are just part and parcel of what it is to be human – to think, feel, touch, smell, emotions, love, hate, trust, faith etc.

 Feeding into this psychological and behavioural human aspect is our natural tendencies to want to control outcomes. We study and formulate statistics, average life expectancy, climate change, economic growth, unemployment, the list is endless.

Once these statistics are derived and analysed we then assume at a subconscious level that everyone or every system is stereotypical and apply constraints and assumptions to future predictive models. I believe it is here where the flawed logic begins as it is these very constraints and assumptions in models that make the “black swan” the unpredictable phenomenon it is. I will address this point in more depth later in this piece.

I would like to begin this next section of the blog by acknowledging that I have been both humbled and blessed to have had some truly remarkable teachers in my life. The lessons I have learned and the manner with which they were taught were dynamic, interactive and involved traditional conventional methods along with unconventional and sometimes borderline strange.

Thinking back on my life during my early 20’s, I have many fond memories. Lessons learned through rigorous debate, challenged thought processes, to pick the right road even if it was the one less travelled.

My mind was wired to challenge theory, positioning, strategic and tactical planning. I was blessed having a father who was such a great mentor. I remember fondly our debates on proposed business decisions over a Sunday pasta lunch.  There were so many lessons but the theme was always that I had to think about business from a competitors’ perspective. If I were in their shoes, what would I do to kick my own butt? To answer those questions meant challenging thought and theory, the way the business operated, my assumptions and reasoning.

The thought was simple yet profound and affects just about every part of human life including my views on the global economy. Retrospectively looking back through the cyclical history of the global economy of booms and busts I often pondered why a better model had not been developed.

It is here where my truly blessed upbringing took a monumental twist. After graduating out of high school I had gained the grades to attend Sydney University to study a Bachelor of Commerce degree with a plan to major in economics and sub major in marketing. Most of my friends had decided to attend our local university which at the time was not held in the same esteem as Sydney University. I wanted to remain with friends so chose UWS Macarthur and had the unbelievable opportunity to study under Professor Steve Keen.

After contacting Professor Keen recently on Twitter it seems we both landed at UWS Macarthur at the same time, 1996, it seems so long ago! As time has passed I have followed Professor Keens work on Minsky, as I was drawn to Keens persistence at questioning and challenging the validity of existing mainstream neoclassical economic theory and modelling.

Although most of my adult life has been spent (post my university days) in the private sector, my passion for economics has never faded. I will say that in the lead up to the crisis of 2008 I was in the corner of the likes of Professor Keen and Peter Schiff in sounding the alarm bells. I will admit that my timing was off, I was calling the crash in 2005/06 and so was seen as one of those “broken clock” prediction makers!

Annoyed at seeing the crisis coming and having been right in so many ways other than the exact timing, my thirst for a better predictive model grew stronger. It seems I had to work at review, and that review began with a study of my former Professors work.

Professor Keen has been outspoken about Minsky’s work and has done a tremendous job in building a Minsky software package which offers features to build your own version/model of today’s financial system. Below is a link to the open source site from which you can download the program.

http://www.debtdeflation.com/blogs/minsky/

Keen has also been outspoken on the role the financial sector with a focus on banks and the role debt plays both in financial crisis creation and the duration the crisis lasts. Professor Keen asserts “debt matters” and puts particular emphasis on private sector debt rather than public sector/government debt.

It seems to me that the assertion that “debt matters” has some solid statistical data to support it. Strong correlations between indictors such as credit acceleration and change in unemployment and also change in private debt and unemployment etc support Keens case.

Below are some of the correlations taken from Keens blog www.debtdeflation.com/blogs. The strength of the correlation is strong and striking and provide a great starting point for examination and analysis of where an economy is at present and perhaps where it will be tracking into the future.

I believe that the development of the Minsky software has provided a huge framework for developing a more robust systemic risk assessment model that can be used to implement a tail risk investment strategy for those heavily exposed to the markets.

I have wrestled with Keens Minsky model, on his data supported case that “debt matters”. I cannot help but think that the missing pieces to the Minsky software are non statistical empirical data that tackle the issue of the human psyche. If the case that debt matters is statistically proven through correlation, then how do we get a more proactive predictive model that may provide more dynamic detail rather than a retrospective model?

I feel the answer is not in answering the question does debt really matter, but rather WHEN DOES DEBT MATTER ENOUGH to begin the psyche shift from a risk on to risk off position?. To add flesh to the Minsky model perhaps code needs to be written to scan for the psychological feeders that swing the pendulum from risk on to risk off, triggering the deleverage cycle and move away from consumption to savings.

A more dynamic model needs to find those indicators. The model needs to find the "right signal amongst the noise” in a world of 24 hour news cycles and other feeders such as social media, surveys, obscure statistical data, changing demographics and lifestyles, perceptions, zeitgeist, political and geopolitical environment etc. Whatever these factors are, the human aspect needs to be the flesh to the framework for it is the human psyche that ultimately drives behavior.

I also believe that a predictive model needs to make an assessment of risk that is not based solely on the lead up to previous financial collapses but also major divergences from economic cycles of the past. Given that a black swan event is largely an unpredictable event by definition, why do we constrain ourselves by assuming that the next crisis will be the same as the last, have the same set of indicators, conditions and stages? Why do we assume it will be triggered by the USA or CHINA? Why not Japan? Or the Eurozone? Or a large international event like a derivatives market meltdown? 

If the idea is that a black swan is unpredictable then surely we need a model that can also determine when certain markers (statistical and non statistical) are moving away from historical norms. Risk exists when divergence increases from previous cycles or where none of the cyclical progression is the same, none of the economic conditions are the same. The model needs to evaluate/calculate then correlate the predetermined human psyche markers with the patterns prevailed in the lead up to previous financial crisis.

 Major divergences or shifts away from “norms” must carry a weighted risk assessment that should be integrated along with previous proven statistical indicators so that a more rounded model can be derived. Having both means that the model will assess risk based on the correlation certain “markers” have with boom bust cycles of the past but also assess risk when there is a major divergence away from these indicator/marker norms. 

My assessment is that Minsky and Keen are right in their modelling direction. The theory can be supported and substantiated with data and statistics and the assumptions underpinning the theory are more reflective of how a dynamic global economy works.

My hope is that the work begun by Minsky and developed further by Keen are explored further and that the global economy can be set on a path of sustainable growth in which every participant has an equal chance at receiving maximum benefit for their contribution. I believe this will include a significant contraction in the financial sector and the need for funds to flow back into the real economy that produces real goods of real value.

Below is a chart that a fellow twitter follower @JordanEliseo sent to me which appears to be sourced from www.dailyreckoning.com – The chart shows that “real net domestic private business investment” is still less than 60% of what it was in 2006/07 in the USA. The chart highlights the fact that despite the fact that the Federal Reserve has embarked on the greatest monetary policy experiment the world has ever seen investment in the private sector of the economy has remained sluggish at best.

The chart also provides clues as to why real unemployment and underemployment has remained stubbornly high in spite of the Feds massive QE programs and its lunatic pursuit of ridiculously easy monetary policy.

The fact is that investment dollars are not filtering into the domestic private sector economy in the USA and this has been the catalyst for both the creation or reinflation of asset bubbles including the equities market. It also stands to reason that the lack of investment in the domestic private economy is strangling employment growth and stunts the drive of innovation and productivity that flows directly through to an economy’s real GDP.

A debt laden economy like the USA that is largely dependent on consumption to drive growth (USA economy is 70% consumption) depends on a high employment participation rate and feeds of psychological factors like job security to grow. A household is likely to borrow to spend if they feel safe financially, have a handle on job security etc. This job growth and security will come from the private domestic economy if the right mix of policies are in place both from a fiscal and monetary policy position.

The USA is not alone when it comes to the financial sector holding the real economy hostage. It appears to me that many of the developed economies have legislated for herd investment mentality designed to support exponential and unsustainable growth in the financial sector. To provide another example need look no further than my homeland of Australia ( AUSSIE AUSSIE AUSSIE OY OY OY). I would ask my Australian readers to stop and think about life as an employee as well as a business owner and employer of over 150 people across the family businesses. Examining the system from an employer’s perspective I often ponder the sanity in the superannuation system which is paid by the employer via contribution into a designated fund chosen by the employee. Before you go crazy calling me a greedy capitalist read further because my rationale and concern is not for my own welfare.

The legislated 9.25% contribution comes out of my private businesses bottom line and goes into the designated fund. These funds are then legislated in where to invest this money based on certain individual preferences. Many have lauded the fact that it was Australia’s superannuation system that assisted Australia in getting through the Global Financial Crisis better than nearly all other global economies.

In acknowledging that this may have been the case I cannot help but think that think this is still assisting in the promotion of a financial sector bubble if not a mini Ponzi scheme. This mini Ponzi is becoming more evident as government pushes for more contributions from employers like me via new legislation aimed at raising compulsory superannuation to 12%.

These progressive increases in contribution place additional burden on private sector businesses, inhibiting their growth by strangling cash flow restricting potential investment pipelines. Compounding this point is that the money then flows into supporting an already out of control finance sector in which P/E’s and company valuations dwarf what is attainable within the private sector economy.

As the financial sector inflates employees watch their superannuation balances grow, simply as the legislated super money funds it. A Ponzi scheme is one which relies on the “sucker” mentality and can only be perpetuated when a new “sucker” can be found to buy the old “sucker” out. It goes without saying that a moderating stagnate rate of compulsory superannuation is not enough to feed the growth of the financial sector.

Furthermore the need to increase the rate of compulsory superannuation to 12% from 9.25% is a Ponzi stabiliser rather than a real economic growth promoter. The increase in superannuation leeches money from the private sector robbing real investment, stunting innovation and employment and ultimately economic growth.

The most damaging part of the system is that by design it forces savings for the future, but it channels those savings into a financial system and other bubbles via legislative investment requirements. The timing of the next financial crisis and the effects it will have on retirees in Australia when it hits will be painful. Those employees looking at their balances of their superannuation funds would have been smiling in 2006, but were hurting in 2008!

I have highlighted this case because I know many that watched their “savings” cut to ribbons when the last crisis rolled through the global economy. Since that crisis, all the world has done is paper over the mess and continued down a similar if not identical path than the last.

The same old will not suffice and the next crisis is bubbling under the surface waiting to erupt. The current system (same as the old one) is broken and we need a new think tank, new ideas and contributions. What we need is to put our collective economic minds to the task of answering the question, how is the current economic system going to kick its own butt and present us with the new economic crisis? Critical analysis not done ideologies is needed to try and get the economy moving firstly, then ultimately on a better and more sustainable course.

It is for this reason that work done by Minsky and developed by Keen needs the full attention for those wanting to make a change. It resonates that if we are going to have herd investment mentality, then let us at least find a balance and more sustainable path for the herd to benefit.

This is as much a humanitarian plight as it is an economic problem that needs a solution and so I am hopeful that anyone that reads this piece and has anything they wish to add that they post a comment. Positive comments are great but critical analysis is also very welcome.

I appreciate the support and the feedback.