Attempts to Suppress Volatility Could Lead to a Crash in Existing Economic and Political Systems
by George Washington
Financial analyst and author Nassim Taleb demonstrated that suppressing market volatility in the short-run leads to much more violent bursts of dislocation and chaos in the long run.
Taleb learned many of his ideas from mathematician Benoit Mandelbrot (who discovered fractals). As Scientific American noted in 2008:
One of those long-time market watchers is fractal pioneer Benoit Mandelbrot. In 1999, Scientific American published an article by Mandelbrot that showed how fractal geometry can model market volatility, while revealing the intrinsic deficiencies of a cornerstone of finance called modern portfolio theory (for which there has been awarded more than one Nobel Prize in Economics).
Mandelbrot, 83, contends that portfolio theory, which tries to maximize return for a given level of risk, treats extreme events (like, say, yesterday’s market shockers) with “benign neglect: it regards large market shifts as too unlikely to matter or as impossible to take into account.” The faulty assumption of modern portfolio theorists, in Mandelbrot’s view, is that price changes do not drift far from the mean when observing daily ups and downs—so extreme events are exceedingly rare. “Typhoons, in effect, are defined out of existence,” he wrote.
Similarly, Graham Giller – from Oxford University in experimental elementary particle physics, then strategy researcher and portfolio manager for Morgan Stanley – writes today:
The Greenspan [and Bernanke] era monetary policy has altered the distribution of changes in interest rates in a way that exchanges a reduction in day-to-day ‘normal’ variability for a considerably higher (perhaps catastrophically higher as we are finding out this week) likelihood of extreme shocks.