In brief, the Bookstaber posits that traditional economic models lack the capacity to deal with economic crises - the ultimate in model stress tests as it were [my view]. His analysis of the deficiencies of economic modelling in Section II, is penetrating and is, in itself, an intellectual journey of note. The book is worth reading for that alone.
Bookstaber's use of agent-based models opened new doors of understanding into the financial crises of 1987, 2008 and 2010. In essence, the disruptions are explained by"stories" describing the actions of various agents and how differences in their outlook and subsequent actions disrupted the "system" when one or more of the agents was put under stress.
If anything, I learned that it is impossible to predict the timing, extent and nature of the next disruption. As a friend of mine who has been in the stockbroking business (successfully) for 46 years recently said to me, "I've learned that you can only do the best you can and struggle through."
I am in the early stages of absorbing Bookstaber's work. With luck, I hope to identify a few indicators which might be used to monitor the stability of the "system" but I fear that it will be a fruitless exercise. Better to read voraciously and extensively in order to get an animalistic sense of the environment and then adapt as some conditions emerge.
For example, here is an insightful article by Ambrose Evans-Pritchard of The Telegraph:
World finance now more dangerous than in 2008, warns central bank guru
The world financial system is as dangerously stretched today as it was at the peak of the last bubble but this time the authorities are caught in a ‘policy trap’ with few defences left, a veteran central banker has warned.
Nine years of emergency money has had a string of perverse effects and lured emerging markets into debt dependency, without addressing the structural causes of the global disorder.
“All the market indicators right now look very similar to what we saw before the Lehman crisis, but the lesson has somehow been forgotten,” said William White, the Swiss-based head of the OECD’s review board and ex-chief economist for the Bank for International Settlements.
The refrain, "we've seen this before", is common to the observations of many people quoted by Pritchard-Evans. However, my sense is that the liquidity trap, the condition of most financial crises, will be sprung somewhat differently than in previous crises:
While banks now have high capital buffers, the risk has migrated elsewhere: to investment funds concentrated in crowded trades. The share of equities traded in “dark pools” outside the exchanges has mushroomed to 33pc. “A lack of market liquidity may lead to fire-sale risk, a downward price spiral,” it said.
One worry is what will happen to ‘risk parity’ funds when the inflation cycle turns. RBI Capital warned in its investor letter that these funds could lead to a “liquidity crash”. Deutsche Bank has advised clients to take out June 2018 ‘put’ options on the S&P 500 - a hedge against a market slide - arguing that the rally looks stretched and that risk parity funds will amplify any correction.
Some readers may dismiss Pritchard-Evans as a pessimist as he often expresses rather dark views of things such as the viability of the EU and the state of world affairs. However, it's always best to read widely and to explore new areas of investigation as a result.
For example, I followed up on some of the organizations represented by a few of the people quoted by Pritchard-Evans. It lead to yet more insights and the further shaping of a personal "view" of the state of the global financial system - also some potential strategies to address increased levels of risk.
I hope not to be caught on the strand when the next tsunami rolls in. Better to retreat now and enjoy the breezes from a safer location.
There are innumerable threats to the stability of the system. Taking a lead from the aforementioned article, I started to explore findings of the Office of Financial Research. One report in particular, Office of Financial Research Reports on Risks to Financial Stability (December 2017) lists some of the threats:
1. Vulnerabilities to cybersecurity incidents – A large-scale cyberattack or other cybersecurity incident could disrupt the operations of one or more financial companies and markets and spread through financial networks and operational connections to the entire system, threatening financial stability and the broader economy.
2. Obstacles to resolving failing systemically important financial institutions – There are two paths for the resolution of a failing systemically important financial institution that is not an insured depository institution. Both paths have shortcomings for handling the failure of the largest and most complex bank holding companies, known as global systemically important banks.
3. Structural changes in markets and industry – Three aspects pose threats: (1) lack of substitutability, or the inability to replace essential services if a provider fails or drops that line of business, (2) fragmentation of trading activities through multiple channels and products, and (3) the chance that the transition to a new reference rate to replace the London Interbank Offered Rate, or LIBOR, could be difficult.
I have subscribed to receive updates on the activities of the Office of Financial Research. If anything, I hope to gain a better appreciation of thinking processes and outlooks of various participants in the system. And occasionally, a few tidbits about potential strategies to cope with emergent opportunities and risk.
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