Nobody expects the black swan

Occasionally, we create a piece which contains multiple-releases.These pieces tend to be thematic in nature, in an attempt to highlight longer-term issues which, in our opinion, are driving economic, political and financial market outcomes. This is one such piece in which we introduce our theme “Black Swan Rising.”

Long, Hard Slog

Our regular readers are aware that late in 2007 we introduced the economic concept of “Long Hard Slog.” In that piece, which was released prior to the economic meltdown and resultant recession, we highlighted financial and economic risks were rising due specifically to extremely high debt creation, which had taken place from 1982 to 2007. We expected economic change to occur due to this issue. Little did we know how prescient our view would prove.

The story of excess debt and its subsequent consequences iscontinuing. Earlier this year, Greece ran into problems, as excessive government spending and debt creation negatively affected not only Greece, but the rest of the financial world. Now, we have the excessive debt problems in Ireland negatively impacting Europe, and creating anxiety about the path of this small country’s economic future.

Irish Lullaby – The Problem

Lately, there has been much news coming out of Dublin. So, what is happening in Ireland? A housing boom led to excessive lending activity from the nation’s banking system, which eventually led to a banking bust as the housing market started to contract. Does this sound familiar?

Let’s put some numbers to work: The Irish government recently stated that the total cost of fixing its banking problems could be in the $68 billion range. This represents about a third of Ireland’s GDP. To put this in reference, the TARP program, which was the U.S. version of the banking bailout, ran about $700 billion.

So this makes the Irish problem look like small potatoes, right? Wrong. U.S. GDP is running about $14.5 trillion on an annualized basis. The U.S.TARP program represented about 7.0percent of annual GDP. Ireland’s annual GDP is about $200 billion. If our banking problem had been as bad as Ireland’s, the TARP program would needed to be about $4.8 trillion in size. Perhaps this puts the size and magnitude of the Irish banking problem into focus.

The Solution

The government in Ireland has attempted to shore up the banking system by infusing capital into their system. The government has taken control of the Anglo Irish Bank, and is prepared to take control of the Allied Irish Banks PLC, if necessary.

Ireland’s problems are similar to the U.S., as compared to Greece. The Grecian problem centered on profligate government spending on social programs. The Irish problem is a result of private-sector leverage creation, driven by a real estate bust. As the Irish government has been spending money shoring up their banking system, the government deficit has exploded. The Irish deficit now represents 32.0 percent of national GDP.

Once again, put into perspective, this ratio would represent a deficit of $4.6 trillion in the U.S., rather than our deficit of about $1.4 trillion. The government has stepped up, and “guaranteed” all deposits within the banking system, in addition to guaranteeing all debts of the banking system.
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This is a huge gamble, and it’s rocking the euro system. Is Ireland going to be the next Greece? We don’t know the answer to this question. The real message is that as excessive debt is unwound, economic weakness is going to occur. Lately, Irish GDP has shrunk to a -5.0 percent growth rate. This is significantly weaker than the weakest quarter experienced in the U.S. during our recent recession.

Ireland is simply the latest episode of the “Long Hard Slog” theme unfolding. Other highly-levered countries in Europe are still at economic risk. Is Spain, Portugal or Italy going to follow in Ireland’s steps with debt problems leading to economic growth contraction? It is already occurring in many of these countries. So, in our opinion, the “Long, Hard Slog” continues… and will do so for some time going forward.

Black Swan Rising
Humans thought all swans were white until the 18th century. At that time, the British started colonizing Australia, where black swans are indigenous. Consequently, western civilizations’ expectation that all swans were white was shattered. The event was not foreseen and un-forecastable.

In 2007, Nassim Nicholas Taleb wrote the book The Black Swan. In his book, Dr. Taleb equates a “Black Swan” as a good or bad event which occurs that has three characteristics:

1. An outlying and unforecasted event – outside the realm of regular expectations
2. An event which carries significant impact
3. People concoct explanations as to how the “event” occurred in an attempt to make it explainable and predictable.

Again, this all sounds familiar. Black Swan events can be good or bad in their outcome. Some examples of “black swan” events which have occurred in the past could include:

• The 9/11 terrorist attacks
• Hitler gaining power and leading to WWII, the decimation of Europe and the holocaust
• World War I
• Sinking of the Titanic
• Popularization of the personal computer
• World’s financial melt-down of 2007 – 2009
• Meeting your spouse-to-be

Once again, the events can be good or bad.

Building Expectations

We suggest the financial meltdown which has occurred and been driven primarily by excessive debt creation is indeed a black swan event. This event has altered all of our views towards economic reality and predictability. The Irish economic problems are simply the latest episode in the telling of this black swan event.

Final Word
What does all of this have to do with the economy and capital markets? Plenty. Banking risk management systems and most risk management systems are built on the concept of predictability and linear relationships. In a world where everything moves in a straight line, this is fine.

However, as we have shown, significant, major events well outside the realm of expectations tend to have a lasting and meaningful impact on our lives, economic and banking systems, and political systems. In other words, the unforecasted and non-predictable events within the financial markets tend to drive investor behavior over periods of time. So, simply limiting one’s thoughts to the linear leads to surprises, both negative and positive.
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