The Power of Words

By David L. Brown

One of the reasons why it is so hard for many people to accept the possibility of rapid climate change is that we humans have a very short-term view of history. Because we experience only a tiny sliver of time during our lifetimes, change appears to take place only at a slow and steady pace. And yet there is growing evidence that climate changes in the past have sometimes happened very quickly. An example was the onset of the Younger Dryas, a 1300-year-long cold spell about 12,000 years ago. That reversal of the warming trend that ended the last Ice Age apparently took place abruptly, perhaps in a space of only a few years.

How can we imagine a world that could change suddenly and dramatically? The global environment is a complex system, and it is perhaps impossible for us to fully understand its workings.

Nature is not the only complex system; another example is the financial economy that has developed in lockstep with the development of Western civilization. An investigation of economic events reveals similarities to those that take place in the natural world - and can even provide evidence for the possibility of sudden and unexpected change.

Here is an analysis from the unnatural world of investments that could provide insight into these questions. It revolves around the behavior of financial markets, and you may see parallels with feedback, tipping points, and other concepts familiar from the study of climate change. The key to the analysis is volatility - the rate at which market values move up and down - a quality that can be a mystery to even to the savviest of investors.

Just as with climate change deniers, money managers generally assume that things will remain more or less the same with the passage of time. That assumption is challenged by events such as the recent “Gray Tuesday” during which the Dow Industrials dropped by more than 500 points in a single trading day, not to mention the crash of 1929 that ended a decade of “irrational exuberance” known as the “Roaring Twenties” during which it seemed that everyone could become rich. The Great Depression soon proved that although not everyone could become rich, many could become poor.
What factors are at work that can turn a calm and placid market into turmoil? We can find at least part of the answer in volatility.

The risk factor in any investment is reflected in its expected gain or loss. In other words, a high-risk investment must have the potential to yield a higher rate of return to reward the investor for accepting the equal or perhaps even greater possibility of loss. This risk-reward equation depends upon the amount by which the yields can vary from the average and upon how fast changes in value can occur - in other words, volatility.
Because most investors anticipate that markets will remain more or less stable over time, they expect they will be able to cut their losses by selling in case of a downturn. But there is one important factor that is difficult to predict, and that is the unknown question of how many others may be following the same strategy, for example by placing stop orders that kick in automatically when the market drops by a certain amount. If too many investors are following the same strategy, markets can suddenly veer out of control as sell orders kick in like falling rows of dominoes. It takes both a seller and a buyer to create a transaction. When buyers are thin on the ground, market values can drop precipitously as they did on “Gray Tuesday.”

Fortunately, it’s quite unlikely that even a large majority of money managers and investors will pursue exactly the same strategy. Therefore, even in troubled times the markets remain fairly resilient and volatility doesn’t collapse out of control.

But there is recent evidence that the potential volatility of financial markets could be far greater than anyone has considered possible. According to Goldman Sachs, the Vix (an acronym for “Volatility Index,” a marker for near-term market stability tracked by the Chicago Board Options Exchange) recently strayed eight “standard deviations” from its average.

Unless you are a statistician (which I am not), that term probably doesn’t mean very much to you. It didn’t to me, so I did a little research. Simply put, the standard deviation is an indication of the range and speed with which data moves from the mean or average.

But I learned a surprising fact: At least some authorities hold the opinion that a movement of eight standard deviations is an event that should never occur in the entire history of the universe, a “perfect wave” which even the most pessimistic statistician could never imagine except in theory.

That brief excursion into unexplored statistical territory had no serious effects, but a standard deviation of that magnitude could be an ominous portent for an uncertain investment future. No doubt economists and statisticians are working frantically to try to understand how such a high level of volatility could even be possible. We may have much to learn about how markets operate, just as we lack full understanding of the Earth’s climate.

But it gets even worse. I found an example of an even higher standard deviation reported in a recent issue of The Economist, where it was stated: “…the move in energy prices that caused the collapse last year of Amaranth, the hedge fund, was a nine standard deviation event.”

Volatility at these astronomical levels lies far beyond the ability of any financial model to anticipate or react. By providing a second example that went even further beyond all reasonable expectations, the shift of nine standard deviations in the energy market should be taken as a suggestion that economic forces are at work about which we have little understanding.

So there you have it, an economic scenario with features that resonate with the possibilities for sudden and dramatic climate change. Substitute a few different words and you can begin to see the parallels between markets and climate. Both are complex systems, and both are subject to volatility. There are feedback effects in both systems, with cascading stop orders playing the role of tipping points in nature. Volatility can affect the natural balance of the Earth, just as it can the far less complex and yet inscrutable global economy. As apparently solid markets can suddenly crash, so perhaps can the familiar patterns of our climate change course.

Economics, the “dismal science,” may have lessons for our planet’s future. And, oh yes, if sudden climate change should occur, just imagine what it would mean for that frail and flimsy construct of money, credit, and debt that supports our civilization?

© 2007 by David L. Brown, Inc. All Rights Reserved.