2.8 A World Economic Crisis Results
27
and getting more so. … The derivatives genie is now well out of the bottle, and
these instruments will almost certainly multiply in variety and number until
some event makes their toxicity clear. Central banks and governments have so
far found no effective way to control, or even monitor, the risks posed by these
contracts. In my view, derivatives are financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially lethal.
As we know, it still took five years until the “investment time bomb” exploded,
but then it caused trillions of dollars of losses to our economy.
2.9 Fundamental (“Radical”) Uncertainty
In liquid financial markets and many other systems, which are difficult to predict,
such as our weather, we can still determine the probability of close enough events,
at least approximately. Thus, we can make probabilistic forecasts such as “there is a
5% chance to lose more than half of my money when selling my stocks in 6 months,
but a 60% chance that I will make a profit…”. It is then possible to determine the
expected loss (or gain) implied by likely actions and events. For this, the damage
or gain of each possible event is multiplied by its probability, and the numbers are
added together to predict the expected damage or gain. In principle, we could do
this for all the actions we might take, in order to determine the one that minimizes
damage or maximizes gain. The problem is that it is often impractical to determine
these probabilities. With the increasing availability of data, this problem may recede,
but it will often remain difficult or impossible to obtain the probabilities of “extreme
events”. By their very nature, there are only a few data points for rare events, which
means that the empirical basis is too small to determine their probabilities.
In addition, it may be completely impossible to calculate the expected damage
incurred by a problem in a large (e.g. global) system. Such “fundamental” or “radical”
uncertainty can result from cascading effects, where one problem is likely to trigger
other problems, leading to a progressive increase in the overall damage. In principle,
the overall losses may not be quantifiable in such situations at all. This means in
practice that the actual damage might be either insignificant (in the best case) or
practically unbounded (in the worst case), or anything in between. In an extreme
case, this might lead to a failure of the entire system, as we know it from the collapse
of historical empires and civilizations.
23
23 Diamond [11], Tainter [12].
27
and getting more so. … The derivatives genie is now well out of the bottle, and
these instruments will almost certainly multiply in variety and number until
some event makes their toxicity clear. Central banks and governments have so
far found no effective way to control, or even monitor, the risks posed by these
contracts. In my view, derivatives are financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially lethal.
As we know, it still took five years until the “investment time bomb” exploded,
but then it caused trillions of dollars of losses to our economy.
2.9 Fundamental (“Radical”) Uncertainty
In liquid financial markets and many other systems, which are difficult to predict,
such as our weather, we can still determine the probability of close enough events,
at least approximately. Thus, we can make probabilistic forecasts such as “there is a
5% chance to lose more than half of my money when selling my stocks in 6 months,
but a 60% chance that I will make a profit…”. It is then possible to determine the
expected loss (or gain) implied by likely actions and events. For this, the damage
or gain of each possible event is multiplied by its probability, and the numbers are
added together to predict the expected damage or gain. In principle, we could do
this for all the actions we might take, in order to determine the one that minimizes
damage or maximizes gain. The problem is that it is often impractical to determine
these probabilities. With the increasing availability of data, this problem may recede,
but it will often remain difficult or impossible to obtain the probabilities of “extreme
events”. By their very nature, there are only a few data points for rare events, which
means that the empirical basis is too small to determine their probabilities.
In addition, it may be completely impossible to calculate the expected damage
incurred by a problem in a large (e.g. global) system. Such “fundamental” or “radical”
uncertainty can result from cascading effects, where one problem is likely to trigger
other problems, leading to a progressive increase in the overall damage. In principle,
the overall losses may not be quantifiable in such situations at all. This means in
practice that the actual damage might be either insignificant (in the best case) or
practically unbounded (in the worst case), or anything in between. In an extreme
case, this might lead to a failure of the entire system, as we know it from the collapse
of historical empires and civilizations.
23
23 Diamond [11], Tainter [12].