Tuesday, 7 October 2014

When the Nile floods fail

http://famouswonders.com/wp-content/gallery/pyramids-of-egypt/the-sphinx-at-gizacairo-in-egypt-with-the-pyramid-of-chephren-khafre-in-the-background.jpg

I recently watched a BBC documentary on the fall of the Egyptian Old Kingdom. A thousand years of stability and prosperity came to an abrupt and chaotic end, apparently out of the blue. Most Egyptologists blamed dynastic change and political unrest. But something didn't quite add up. The end of the Old Kingdom coincided with terrible famines. To be sure, conflict can cause famines. But these were exceptional: thousands of deaths for years on end, people resorting to cannibalism, whole cities being abandoned.

New research cast doubt on the "political change" theory for the collapse of the Old Kingdom. Sudden catastrophic climate change occurred at that time, causing a mini Ice Age in Europe and widespread famine around the world. In Egypt it resulted in the total failure of the annual Nile floods, upon which the Egyptian economy critically depended. No wonder it collapsed. But it took archeological research over 4000 years later to identify the massive exogenous shock that caused the sudden collapse of a great civilisation. People at the time would not have known the cause. And they certainly would not have expected the Nile floods to fail. They had not done so for a thousand years.

The financial crisis of 2008 was certainly not a disaster of that magnitude. But it displays some similarities. The US housing market had been stable for 70 years. And because of its stability, the US economy had become critically dependent on it. Indeed not only the US economy, but since the advent of securitization also the global economy, had become dependent on the US housing market. Like the Nile in Ancient Egypt, it was the safe, familiar, predictable source of prosperity. Via its derivatives, the world bought into its safety and stability.

Then it failed suddenly and catastrophically. We still don't know exactly why, but the work of Mian & Sufi on the huge increase in debt backed by housing is important, and Steven Gjerstad & Vernon Smith's analysis of the root causes of the failure of the US housing market is impressive. Interestingly, among other things, Gjerstad & Smith show that there has been a housing market collapse of that magnitude before. Just as failure of the Nile floods had no doubt happened occasionally before the fall of the Old Kingdom (it has happened once or twice since), but had disappeared from memory, so Gjerstad & Smith show that failure of the housing market was a primary cause of the 1930s Great Depression. But we have forgotten about this. Time and wishful thinking create amnesia.

The people of the Egyptian Old Kingdom and the people of the modern global economy made the same mistake. They believed that something was predictable when it was in fact unpredictable, safe when it was risky, certain when it was uncertain. Nile floods vary in magnitude from year to year, and from time to time there are transient agricultural failures when the volume is too low. Small shocks of this kind can be accommodated within a stochastic model: there is short-term disruption but the economy soon returns to "normal". But total failure of what has previously been considered "safe" is traumatic. The Egyptian economy did not return to "normal". It entered a dark age that lasted perhaps a hundred years. And we, too, are now in a dark age: we do not yet know how long it will last.

Despite the clever models of modern economists, we are no better at predicting extreme events than our ancestors. We make the same mistakes, and frankly with much less justification. It took a thousand years of prosperity to lull the Egyptians into a false sense of security. But less than a hundred years ago we were living through the greatest destruction of physical, financial and human capital in recorded history. You would think we would be alive to the possibility of extreme events. But instead, we convinced ourselves that we had had fixed all the problems and there would never be extreme events again. We thought we could control (human) nature. How wrong we were. As ever, Hubris invites Nemesis.

Here's Olivier Blanchard of the IMF describing the hubris of mainstream US economics:
Until the 2008 global financial crisis, mainstream US macroeconomics had taken an increasingly benign view of economic fluctuations in output and employment......The benign view reflected both factors internal to economics and an external economic environment that for years seemed indeed increasingly benign.
The priests believed their own oracles because the Nile floods didn't fail.

Blanchard goes on to describe the limitations of economic oracles models and the unrealistic beliefs of economists:
The techniques were best suited to a worldview in which economic fluctuations occurred but were regular, and essentially self-correcting. The problem is that we came to believe that this was indeed the way the world worked......We in the field did think of the economy as roughly linear, constantly subject to different shocks, constantly fluctuating, but naturally returning to its steady state over time. Instead of talking about fluctuations, we increasingly used the term ‘business cycle’. Even when we later developed techniques to deal with nonlinearities, this generally benign view of fluctuations remained dominant.
That small shocks could sometimes have large effects and, as a result, that things could turn really bad, was not completely ignored by economists. But such an outcome was thought to be a thing of the past that would not happen again, or at least not in advanced economies thanks to their sound economic policies.
The Nile floods can never fail because 1) our models haven't considered that they might (and we don't know how to model such an event) 2) sound economic policies will ensure that the Nile floods never fail.

You couldn't make it up.

The trouble is that economists are using essentially linear models to explain and predict a non-linear world. Hahn's description of Blanchard's models as "Mickey Mouse" is all too accurate. Economic models that only work as long as nothing goes seriously wrong are about as useful as a windsock in a typhoon. Something goes seriously wrong somewhere in the world quite a lot of the time. Nassim Taleb's criticism of statistical models used by economists is cutting:
The simple argument that Black Swans and tail events run the socioeconomic world - and those events cannot be predicted - is sufficient to invalidate their statistics.
 (Antifragile, p.305)
 
Blanchard admits that omitting the financial system from economic models was a major error. I totally agree. But incorporating it into existing models, or developing new systemic risk models to run alongside existing macroeconomic models as Blanchard suggests, won't solve the problem. As the story of the Egyptian Old Kingdom shows, tail events pose the biggest threat to our civilisation. But we can't model them. We can only model things we know about. Now we know about the systemic risks that the financial system poses, we can model them. And we can stay away from the dark corners where those systemic risks lurk. But those are not the only dark corners, and the problem is that we can be so focused on avoiding yesterday's dark corner that we fail to notice tomorrow's bigger and darker one.

We stumbled into the financial crisis because we were focusing on inflation control to the exclusion of all else. That was a reaction to the inflation of the 1970s, which we walked into because we were focusing on full employment to the exclusion of all else. That in turn was a response to the terrible unemployment of the 1930s, which we walked into because we were focusing on restoring historic value after a disastrous war. We walk blindly into crises because we are looking backwards, not forwards. Now we are focusing on systemic risks so much that we are in danger of wandering into another crisis. I have no idea what that crisis will be - maybe a war, maybe a global pandemic, maybe a catastrophic natural disaster. But of one thing I am certain: there will not be another major financial crisis until we have completely forgotten about this one.

And therein lies the problem with Blanchard's recommendation that we should "stay away from dark corners". The dark corners we really need to stay away from are those we don't know about. And modern economics has no credible way of modelling those, any more than the priests of Ancient Egypt did. Who in the Old Kingdom would have predicted the failure of the Nile floods? Would they have been believed? What changes could the Egyptians have made to their economy to enable them to survive such a disaster?

In fact Blanchard's argument is deeply flawed. He acknowledges that existing economic models are fundamentally inadequate, but then calls upon policy makers to set policy in such a way that existing economic models can still be used. This amounts to saying that policy makers can prevent tail events and Black Swans from happening. Sound economic policies will still prevent the Nile floods from failing......

It seems that Blanchard still believes that the economy can be made to work linearly if only policy makers get it right. I suppose it is hard for someone who has spent his life developing linear models of the economy to accept that the economy is fundamentally non-linear and the models are not fit for purpose. But economic models that are not fit for purpose should not be used. Because they lull people into a false sense of security, they are not only inadequate, they are dangerous. Better no model at all than one which steers you on to the rocks.

Our best guide to managing the disasters of the future is the experience of the past. Anthropology, archeology and ancient history, as well as the natural sciences, have much to teach us about how our world really works. It would help if mainstream economists were more aware of the limitations of their mathematical models and more willing to embrace heterodox thinking. But it would be better still if, as Piketty says, they gave up their "childish obsession with mathematics". The proper study of economists is not mathematics. It is natural and social history.

We need to learn from the past, but look to the future.




14 comments:

  1. On the whole your paragraph about stumbling is a pretty hopeful one; the Great Depression was absolutely unambiguously less bad than World War One, and the inflation in the seventies was absolutely unambiguously less bad than the Great Depression. Falling into small holes while working around the big ones isn't that bad a problem to have.

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    1. I'm afraid you've missed the point. You do not know the size of the hole you are falling into. It may be small, or it may be very large. The 2008 crisis was unambiguously worse than the inflation of the 1970s, unambiguously less bad than World War 1, and we don't yet know how it compares to the Depression of the 1930s (we aren't through it yet and the Eurozone's hole looks set to be a lot bigger than the 1930s). That's what I mean by non-linear. Just because we haven't fallen into any really big holes recently doesn't mean we won't do so in the future.

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    2. Global climate change is unambiguously worse than World War I and the Depression of the 1930s, and we've fallen right into it. :-P

      I'm not sure what that means, but ow.

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  2. if you're looking for an equivalent massive exogenous shock, Frances, the GFC is hardly it...but we could be in for one just as bad if Ebola spins out of control and cuts down a significant percentage of the population...

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    1. Indeed, I said in the post that the GFC was hardly on the same scale as the Old Kingdom collapse. And I agree with you about the risk from Ebola - in the post, a global pandemic was one of my candidates for the next crisis.

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  3. Nice piece, Frances. Thank you. 'We need to learn from the past, but look to the future' - would add only that we need to know what kind of future we want - how best to satisfy the universal basic human material needs of food, clothing, shelter; our emotional needs; and 'political' delivery systems.

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  4. Interesting post.

    So basically we should be looking at things that 'could' happen, but if you say they might, everyone looks at you like you've got 2 heads? I'm trying to imagine such things that could totally derail the world, economically and socially. How about a slip into a mini Ice age, as in Thames frozen over etc? It has obviously happened before, within recorded history, so it could happen again. But we are so in thrall to the whole 'the world is going to fry and its all man's fault' global warming schtick, that to suggest such a thing is akin to saying the earth is flat. But such an event would completely decimate the world's population due to famine, and the inevitable wars over food supplies etc. It would be a New Dark Age.

    Then there's the obvious ones, like an asteroid impact, and the mega volcano eruptions, such as Yellowstone. And mutated viruses as mentioned above. Another possible one is mass rejection of fiat currencies. - what if everyone just suddenly decided that they wouldn't accept bits of paper as money any more? Thats happened before too, and in an age of instant communication such a mass mood change could go global very quickly.

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  5. Two things here. The US housing crisis seems a totally man-made problem. The banks failed in their role as 'risk transformers' low risk/small returns v higher risk/bigger returns. They were not regulated properly, probably due to the punch-bowl effect. We know people will cheat and lie and twist the truth, that is what the press and regulation is supposed to be for (both ways).

    Re exogenous effects, we cannot do much about giga volcanoes or asteroids - except muddle through afterwards - if there is an afterwards. But slower developing things like climate change or increased flooding we could at least hold off the effects for a few 100s of years but such costs money and is bothersome and so some means of denial or inaction is developed. As for Ebola etc, the wheels fall off most problems before they develop as 'experts' aver - unless they don't. If we defended against every risk we would all be living on bread and water.

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    1. I think the distinction between "man-made" and "natural" disaster is not so clear-cut. I might agree with you that the GFC was entirely man-made: but was Fukushima a man-made disaster or a natural one? Is the failure of the Nile floods really a disaster - or was the real problem man-made, namely an entire economy built on the assumption that the floods would never fail?

      Re your point about defending against every risk, yes I agree that over-caution is as dysfunctional as recklessness. I'm planning a follow-up post to this one on why people choose to live near volcanoes. The risk of occasionally being wiped out is worth taking because of the fertility that volcanic activity generates. And there is usually heroic denial of the risks, too - collective amnesia, belief that it won't happen in our own lifetime or that of our children, belief that we will get away in time if it does happen, underestimating the economic effects. I think our attitude to volcanoes is quite a good indicator of our attitude to other risky but rewarding activities. Housing bubbles, for example: I remember the late-1980s housing bubble - I think we all knew it would blow, but we thought we could benefit before it blew and get out without too much damage when it did. Volcano thinking, see?

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    2. I think the Fukushima disaster was man made - the power station structure stood up OK but the backup generators for cooling were inundated - not built to same standards. I suspect cost-cutting and poor regulation and politics. Bad tsunamis happen there about once in 500 years and the 50 year lifecycle of a nuke is long enough to make trouble fairly likely and nuke trouble is big trouble. Re the Egyptian flood failure, a poor farmer does not need much and can survive anywhere, but a priest and shopkeeper class is a more delicate thing, who died out first I wonder.

      I don't mind taking my chances with a volcano, they are a sort of agricultural free ride. Everyone wants a free ride and a house (used to) represent a financial free ride. But whereas volcanoes are random and not choosy the housing market seems rigged and a plaything of the politician's feel-good factor and the mortgage seller's greed with those on the margins getting hurt most.

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  6. Frances ...

    This is hands down one of the best articles you have written to date, if I wasn't already a fan I would become one overnight.

    Indeed we are all servants to higher masters, that we have duties as well as rewards. We are stewards of this world, it does not belong to us but to all the generations to come. We need better models but we also need the sense of responsibility that goes with them. Our models can at best be guides, it is our actions that matter; in place of greed there must be generosity, along with the taking must be giving.

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  7. Mario Draghi shares Blanchard's faith in .....politics. He always stated that the ECB can help only to some extent.

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  8. As a housing planner in the U.S., working on the fringe of the Washington, D.C. MSA 1973 - 1990, after which Front Royal, Virginia - Warren County, became part of the MSA - 60 miles from D.C. The increases in housing cost far exceeded the increase in wage and salary income. Though Northern Virginia had the highest median household income - the house was six times that. If in a locality, the median income will not enable purchase of the median priced home, wages are too low or housing costs are too high. Even today, people who qualify to buy because they can make the payment, will never pay off the mortgage. The goal is to own the ranch, not keep betting on it by taking out equity. The cash out scenario was always to move to a lower housing cost region, like the Shenandoah Valley, where with the sales proceeds one could buy what they want, put money in the bank, and live off the pension or investments. That gentrifies the receiving exurban area, making local housing unaffordable for those making the local wage. Easy credit flamed up the prices - my appraiser friend quit the business because they didn't want appraisals. Easy credit leads to bad decisions.

    Still too much unpayable private debt. There are very few income generating assets to pay interest and principle on this debt. The vacation or fancy car may have made people feel more productive, but they didn't result in a raise - actual income to pay off the debt. The private debt problem was/remains widespread.

    For the sad, but true story, check this from C-Span's BookTV - "Richard Vague talked about his book, The Next Economic Disaster: Why It’s Coming and How to Avoid It, in which he argues that the threat to our economic stability comes from privately held debt, which stood at over $11 trillion. He said that many of the big economic downturns in the U.S. and around the world could be traced to privately held debt and questioned whether the economy was on the verge of another downturn. Mr. Vague spoke at New America New York City. August 27, 2014.

    http://www.c-span.org/video/?321267-1/book-discussion-next-economic-disaster

    Read David Graber's "Debt: The first 5,000 Years" to understand the predatory uses of debt. Economist Michael Hudson is one of the few who knew what was going on. Steve Keen is now working to improve models to provide for the Minsky Moment as a option.

    With the global weather monitoring we have today, floods and droughts are not mysterious at all. If the outcomes in the world are different than the model can predict - bury the model. Don't get new priests, get better science - including sociological, psychological, anthropological and spiritual. Thou shalt not steal is a very simple law. That lawyers can write contracts that we sign that say the contractor can steal from us, though it would take six lawyers to find it, is not a problem of theory, but morality. Lying as a legitimate business method should not be tolerated, but it is. And then things fall apart.

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