Black Swans and Endogenous Uncertainty
March 1, 2014
John is in Florida and feeling a bit under the weather, so this week we’re bringing back one of his most popular letters, from December 2007. In the letter he discusses the work of Professor Graciela Chichilnisky of Columbia University, one of whose key insights is that the greater the number of connections within an economic network, the more the system is at risk. Given the current macroeconomic environment, it is important to remind ourselves of how complacent we were back in 2007 and how it all fell apart so quickly, just as John outlined in this rather prescient piece.
This is a theme to which John has returned again and again, pointing out that reforms such as Dodd-Frank (the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010) fell well short of solving the problem of excessive interconnectedness among global financial players. It shored up the big “sandpile” rather than breaking it up into smaller, more manageable sandpiles. Now, if the Chinese, Japanese, and/or European sides of the sandpile should avalanche, the whole US side is likely to go, too.
John will be back next week with a report from Washington DC and the next installment of his series on income inequality.
How does the risk of default in California or Thailand get spread throughout the world, causing problem in money market funds in Europe and Florida? Yes, we can trace the linkages now, but was it possible to predict the crisis beforehand? And can we use what we learn to predict...