Rising debt = Rising volatility

I’ve discussed elsewhere the “madness” of using the normal distribution for financial market modelling and also the correlation between non-normal volatility and debt.

This analysis is actually well-grounded in Austrian theory and has empirical support as well.

Mandelbrot, in his book “The (Mis)Behaviour of Markets” (2005), lays out the data for the empirical distribution of stock price changes and compares it against the predictions of the bell curve based EMH (any version). Clearly the empirical distribution has fatter tails than the normal distribution implied by EMH. To quote from page 13:

“In fact, the bell curve fits reality really poorly. From 1916 to 2003, the daily index movements of the Dow Jones Industrial Average do not spread out on graph paper like a simple bell curve. The far edges flare too high: too many big changes. Theory suggests that over that time, there should be fifty-eight days when the Dow moved more than 3.4 percent; in fact, there were 1,001. Theory predicts six days of index swings beyond 4.5 percent; in fact, there were 366. And index swings of more than 7 percent should come once every 300,000 years; in fact, the twentieth century saw forty-eight such days. Truly, a calamitous era that insists on flaunting all predictions. Or, perhaps, our assumptions are wrong.”

There is also now clear evidence of a correlation between high volatility and leverage (debt).

I merely repeat my plea to consider a new paradigm, where the long term bell curve is replaced with “bifurcating bell curves” as debt levels increase.

This, I believe, would “close the circle” on the models and more accurately predict price volatilities (although not movements) in a whole range of markets.

It would be impossible, a priori, to predict whether a particular market will be captured by a bubble with overleverage – the bubble moves. Dot com. Then housing. Then oil. Then gold. The some other essential commodity.

But accepting that the financial system has Minsky-like Ponzi dynamics would be much more fruitful than assuming it has stabilising bell curve foundations. It has been conclusively proven that it does not.

My rule is: If you can’t replace a model with something that “works” (i.e. at least fits with the historical data), don’t use any model at all. Just look at the markets and see what “imbalances” exist and bet against the “imbalances” because they don’t last.

A simple application of the rule would be to short whatever market went up the most last year and go long whatever market went down the most last year (if you do the analysis this actually works out to be a surprisingly successful investment strategy!).

It is the very definition of madness to continue using a model that doesn’t fit with the historical data (at minimum).

Therefore, using this test, anyone using the bell curve in financial markets is literally insane.

I’ve suggested another “model” (bifurcating bell curves) but lots of work needs to be done here. What is the rate of bifurcation? How does this correlate with levels of increasing leverage/debt/gearing? What markets are vulnerable to bubbles? (I suggest markets closest to essential human needs – housing, oil, food…however tulips and dot com I don’t understand – it’s more a social/fashion issue).

Really all this model would do is correlate volatility with leverage. Big deal. That’s not particularly useful from a modelling perspective but it is very powerful from a policy viewpoint. It suggests debt is dangerous and socially destabilising. Policy-makers should be much more concerned about absolute and relative levels of debt, as well as the rate of growth and the marginal productivity of debt (as Fekete brilliantly points out).

Finally, this perspective signals a more fundamental message. Years ago, after 1987, as a student, I searched for an alternate “model” to picture the probability distribution because I was acutely aware we were entering a new world. This came from my interest in the Austrian School understanding of “money” and Mises’ (and Hayek’s) numerous writings on the history and importance of “free market money” (generally gold and silver) and the evils of embezzling FRB.

The lesson is this: The future is most likely to be radically different from the past when the institutions around the creation of distribution of “money” change. If you don’t pick up the importance of these changes you’ll miss the seismic shifts these institutional changes bring about.

August 15, 1971 was a revolution only the Austrians seemed to understand. Repeal of Glass-Steagall – again seismic. These two changes alone should have sent alarm bells screaming “Something dramatically different from the past (good? or bad?) is going come from these changes”. Yet no one from the mainstream seemed to understand the importance of what was occurring because none of them understood the importance of “money” and how far from the historical free market in money we had moved.

Again, a tiny tip from a suicidal madman (genius?):

Be prepared for maximum change when the institutional framework around money production (banking and exchange rates) changes. These changes generally manifest their results with a lag of 10 years.

However, in the case of Roosevelt’s criminal confiscation of America’s gold, the lag in its devastating effects has been 80 years.

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  1. January 6, 2010 at 1:45 am

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