In using Byzantine, I intended no particular comment on longevity nor was it expressing an implied preference for simple, designed systems vs complex, self organising ones. Indeed, like you I think the latter are likely to be more stable and creative.

The problem, as I see it, is that to endure, adapt and prosper such complex, self organising systems need to have constant real world feedback. In the case of our financial architecture, that loop has for decades been clogged and distorted. Implicit or explicit central bank guarantees and various government support schemes have over time fundamentally altered the perception of risk. This, in turn, together of course with central bank accommodation, has enabled credit growth to far exceed all historical parameters. Put simply, if the financial system is to be deregulated (which I certainly favour) then participants must not be saved from their own foolishness. If the political decision is made that protection is to be provided, then fairly stringent regulation ought to continue. What we have is the worst of both worlds.

Danger, in a true secular sense, is not in my view so much a consequence of everyone leaning the same way (an analogy that has more application to cyclical moves) but rather arises when gearing becomes sufficiently widespread and extreme to seriously distort the prices of one or more asset classes. In arriving at such a point, holdings will necessarily become concentrated in weaker and more indebted hands. Such extremes are by definition multi-generational (hard experience must have time to fade) and ours excess is truly sui generis. Not only in its extent but also in the proliferation of financial instruments, all designed to facilitate the trading and manipulation of risk.

Now, I readily grant you much of this cancels out and some of it is no doubt even used for the sensible management of otherwise unavoidable risks. Still, when all the netting out is finished, and all the derivative paraphenalia is notionally stripped away, every real remaining security is a net exposure to risk. Any given participant can trade or hedge it away but the market can’t. What derivatives and financial engineering have done – amongst many other things of course – is facilitate the creation of a veritable Zambezi of fresh securities. The slicing and dicing, the ability to offload loans, the resulting separation of origination from responsibility, all these acted to supercharge an already overheated financial system.

I certainly don’t know what Black Swan will finally come along, or when, although I clearly have my suspicions. My expectations, or anyone else’s, won’t make the slightest difference to its eventual arrival. It isn’t that Black Swans are literally unexpected, it’s that few expect them. When conditions are ripe, any number of triggers can conjure one seemingly out of the air. Indeed, as you suggest, we may already have had one or more; the massive compression of volatility you noted, for example, or perhaps the entry of China et al into our global extravaganza. Still, as I said, these were convenient, friendly, with the trend Black Swans. I think what we all really mean when we use this phrase is something quite different, something that inspires fear and loathing.

Great blog, by the way. I arrived here via TED and find the combination of amused distain, informed analysis and intelligent discussion you both display most enjoyable.

That said, do you think a complex order (which is what the market is) which we humans have designed and understand is necessarily more stable than a “byzantine” one we have not designed and do not understand ? Interesting choice of words, by the way: Byzantium existed as a separate entity much longer than the Roman empire which it grew out of; it should not follow that a Byzantine stucture is less stable or enduring. Complex systems, in the way of many interconnected things doing many slightly different things, may be much more stable/resilient than simple ones.

Markets on this reading become dangerous when everyone leans the same way. This is likely not happening yet, or this situation has only just emerged. Right now, the shorts are everywhere, all the stock I own, and you put it as if that was the end of it, is lent out! That means there is someone short of the stocks I own, someone will make the money I lose. Yes, everything is owned, but do not dismiss the jiggery pokery.

As I note, the markets have been pretty lively in the face of some pretty bad news. How do you know that we have not had a -ve Black Swan already? Buttonwood, for example, is distraught that we did not recognise subprime as the disaster it will no doubt imminently prove to be. Also if you expect a Black Swan, unlike the Spanish Inquisition which no-one expects, surely that means that whatever you are in fact waiting for CANNOT BE A BLACK SWAN. Think about that.

TED seems to me to be on the right track but doesn’t in this case go quite far enough. The vaunted dispersion of risk is, I think, an illusion. When all the derivatives, short trades and general financial jiggery-pokery is netted out, all outstanding underlying securities must still, by definition, be owned by someone.

What this byzantine, headache inducing financial superstructure has done instead is to provide the means for the creation of a far greater quantity of such securities than would have otherwise existed, thereby adding to net risk rather than reducing it.

My suspicion is that the apparent resilience is primarily the result of an apparently limitless fount of speculative funds eager and willing to take on risk. So long as nothing sufficiently drastic happens to douse this appetite, hordes of willing sellers of risk insurance act like shock absorbers, dampening swings and corralling the markets.

The real question is how they’ll react when a Black Swan finally arrives (an inconvenient one as opposed to the convenient one you rather cleverly posit in a later post about Taleb). The strategies which have to date generated buying into weakness and selling into strength (although this latter has not been terribly obvious) may at that point, in my view, become accelerants.

On the other hand, perhaps I’ll have to spend more years clumly observing the carnival from the sidelines.

You don’t mind waiting, do you?

TED