What are the chances that an extreme tail event like a pandemic is followed by another outlier? asked my senior colleague and further nudged, pretty low, right? wanting to engage all of us and stir up a conversation amongst colleagues and global fora.
Before I dive into sharing my views please allow me to indulge in a bit of mathematics – what are the chances of another outlier post an extreme tail event? Contrarian, as my response may seem to be, I would argue its ‘High’. The world loves simplification because that is what a human mind can absorb and fit into its logical neural circuits. But that’s precisely where the problem lies. More or less all analytics, economic, financial, geopolitical, or otherwise assumes Normal distribution of outcomes. The number of studies done, starting from Mandelbrot and Fama, proves otherwise but still, we choose to regress, consciously or unconsciously, to this convenient simplification. This convenient relapse, an amenity, allows one to limit the probability of a tail event, due to finite variances, and therefore exclude the unpleasantness associated with increased risk, if assumed otherwise. This understating of risk helps every participant to look the other way and keeps everyone happy, for e.g. allows a portfolio manager to provision lesser loss reserves and look good on returns, a credit rating agency to bias its way towards investment grade and earn additional fee income, an institutional money manager to manage capital by calculating VaR acceptable to investors, etc. However, this simplism which coerces us to eliminate all outcomes that cause jarring dissonance with our ‘yeah, it makes sense’ simplified thinking, is also its curse. Continuing with the parsimony of the Gaussian assumption is unreasonable and potentially dangerous in an increasingly VUCA world and we ought to move to fat-tailed distribution as a default assumption and wed it with an EVT distribution for tails. Normal distribution has to be relegated to being a ‘special case’ And why limit it to the world of economics and finance, we are now seeing extremes of temperatures, storms, wildfires, floods, etc. In the words of Leslie Rahl, founder of Capital Market Risk Advisors, “We seem to have once-in-a-lifetime-crisis every 3 or 4 years.” Therefore, coming back to the opening comment – what is the likelihood of another outlier after the current tail event? – I say, “High”.
Direct Democracy as a (Black Swan) idea looks most appealing at an individual level, very logical and yet very revolutionary. Looks like epidemics are akin to ‘stress test’ on political and economic functioning. In a curious case of similarities, it was the Cholera epidemic of 1867 which laid the foundation of direct democracy in Switzerland, and the COVID pandemic could well prove to be the stimuli for a similar outcome in many EU countries. Still, to me, the path to the full form of direct democracy appears to be distant, best case I see some optionalities on its way – something which may be guiding in nature but not binding. In a binding scenario, we could see some bizarre situations, for e.g. the trial and death of Socrates back in 399BC, a consequence of direct-democratic action, while frivolous but understandable given the era it took place. Fast forward to this century, another direct-democratic action, an ultra-modern, super-rich, well-educated, democratic state, Switzerland, didn’t allow women to vote as late as 1971!
I like colliding two different thoughts to generate new ones or solidify my thinking. So let me collide the (Black Swan) idea of direct democracy with another (Black Swan) idea, the fiscal union of EU, and let us see where it leads us to. In a fiscal union scenario I see more tough calls coming its way than popular calls. And the citizenry will be asked to vote on that in a direct democracy. This will require a heightened feeling of solidarity, very understandable within the national boundaries (e.g. centre-state) and in recent history during German unification. But to wish for that across National boundaries is a stretch. Let us remind ourselves that bailouts didn't come out of solidarity. It came out of compulsion and fear of contagion. I regularly come across intelligentsia making a case in favor but find it difficult to fathom support within the masses. I foresee the raw tsunamic wave of referendum votes smashing the fiscal union idea on its path. Let's run a thought experiment and play out an actual referendum - citizens of a Country X, toil hard, pay high taxes, maintain fiscal discipline at the sovereign and individual level, are asked to vote - 'to take on liability for a loose sovereign spender' who breaks the fiscal rules. Not too difficult to imagine the outcome. Another round - this time citizens of a country who currently pay lower taxes, have maintained a competitive economy and therefore retain jobs are asked to vote on a referendum to pay higher taxes because of EU fiscal policy, a byproduct of which would be redistribution, lost competitiveness and jobs destroyed. Not too difficult to predict the outcome here either. Continued severe levels of austerity aren't very popular either. Fiscal union goes with the political union and that is a minefield. Politicians are accountable to local people and an argument that they are helpless is difficult to fly. That they are puppets with rules being set in the opaque chambers of Brussels will not get them votes. Do you see an opening for far-right here? I do. In summary, both not happening or best happening in a diluted version.
Staying with the fiscal union just a little longer to connect it with my next observation, as much as I hate to think and certainly would wish that I be entirely wrong on this one, the tail event I foresee is EU break-up rather than progressing on a fiscal union. With the foundation of the longest peace-time period history has seen completely rattled, the break-up need not be full-scale. On the lower-risk side, the introduction of multi-tiered Euro currency, which gives some leg room to economies and on the higher-risk side, multi-tiered EU unions or an absolute worst-case scenario of multiple exits. The bloc is a study in contrast – loose spenders at one end of the spectrum and the ones who run a tight ship at the other. It will require an exponential leap of faith to expect that citizens of the latter keep bailing out the former and smilingly keep assuming debt, a paradoxical reward for being fiscally disciplined. With the existing paradigm shaken by an earthquake of a massive Richter magnitude, the idea of the fiscal union stands weak on its knees and resultant challenges may lead to a break-up. An EU break up would be a catastrophic black swan.
Being a European lover and not wanting to end on low, let me sip a white wine to gulp down this black swan thought and truly wish it never happens! Simplistic thinking of a simple man!
