Counterintuitive: (Some) Volatility is Good for You, Stability Not So Much

Originally posted on resourceinsights.blogspot.com

Written by Community Solutions Fellow, Kurt Cobb

With stock markets around the world plunging and commodity prices in free fall, it seems appropriate to return to a theme which I've taken up previously: That a certain amount of volatility is good for humans and the systems they build, and that attempts to stifle the natural and healthy volatility of a system can lead to greater and even catastrophic volatility in the end.

All of this runs counter to the propaganda with which we are regaled on a daily basis. For example, investors are told that the lower the volatility of their portfolios, the lower the risk. But, in 2008 that turned out not to be true. More recently, as volatility in the widely watched S&P 500 settled down to historic lows this year, investors believed that the magic of low volatility was here to stay. Central banks--through their periodic interventions when markets began to fall--had somehow engineered a no-lose situation for investors. It was going to be clear sailing ahead for...well, forever if you listen to Wall Street.

The history of volatility in markets and in life suggests that high volatility lies just around the bend after a prolonged period of low volatility. It is impossible to say what would trigger the kind of crash we saw in 2008. For now, the Chinese stock market crash and recent negative economic news in China and the United States have unnerved many investors. The Chinese stock market is now more than halfway to a 2008-style meltdown. Stocks in Europe and the United States have finally started to fall in earnest after holding up and even advancing in the face of major declines in emerging markets such as Brazil, Indonesia, Malaysia, and Turkey. Money rushed from the emerging markets to major developed economies looking for--you guessed it--stability.

In the wake of the 2008 crash central banks and governments were determined to revive economic growth. They didn't care that we had too much manufacturing capacity, too much housing, too many banks, too many brokerages, and too much of many other things as well. That excess had to be taken up by consumers and businesses with access to cheap borrowed funds, funds those groups would spend to revive the economy. Marginal enterprises, overleveraged speculators in real estate, and insolvent banks and brokerages had to be bailed out so they could live to speculate and operate another day. The excesses of the previous bubble would be carried over to the next. Few would be disciplined for their mistakes.

Having had several cycles of this brand of policy starting back with the 1987 crash, marginal parts of the economy--like large overleveraged, overextended money center banks--have been allowed not only to survive, but actually to flourish and engage in ever more risky behavior, confident that authorities would always bail them out if they became insolvent.

The seeming market stability and low volatility engineered by central bank bond buying and zero interest rate policy after the 2008 crash is an illusion. It is very much like the illusion that a quiescent earthquake fault gives to people who live over it. The stress on the unseen fault builds gradually over a long period. Everything is fine until the sudden adjustment comes and the ground starts to shake taking highways, bridges and buildings with it. It's the geological equivalent of a market crash.

But as Nassim Nicholas Taleb and his coauthor, Gregory Treverton, pointed out earlier this year in Foreign Affairs, these ideas about volatility apply not only to markets, but also to entire countries.

The piece contrasts the seeming stability of Syria with the relatively chaotic environment in Lebanon just prior to the Arab Spring. But Lebanon which has had to adapt itself to new conditions after a 15-year civil war has proven robust in the face of widespread upheaval throughout the Middle East. Syria which seemed to be a picture of stability is now in shambles, a victim of its own rigidity.

The authors outline five causes for this fragility among seemingly stable regimes:

  1. Concentrated decision-making system
  2. Absence of economic diversity
  3. High overall indebtedness and high leverage to particular industries
  4. Lack of political variability
  5. No record of surviving shocks

Counterintuitively, Italy is rated as far more robust than France because of Italy's highly decentralized political system, a system in which 14 different prime ministers in 25 years have caused minimal upheaval in Italian governance. France, which is much more centralized and also heavily indebted, is fragile in comparison with regard to economic shocks and changes in top leadership. The almost constant parliamentary political crises in Italy hardly register on the country. The rise of the anti-immigration right in France is sending shudders through the electorate.

Japan which has been a paragon of stability in Asia is actually quite vulnerable for two reasons: the highest debt-to-GDP ratio in the world and the uninterrupted reign of the Liberal Democratic Party from 1955 to 2009. High debt and lack of political variability await a trigger that would bring about unusual volatility.

Turkey, a highly centralized country heavily dependent on tourism for its foreign currency, is experiencing intense turmoil related to internal dissent from the ethnic Kurds, the spillover of the civil war in neighboring Syria, and the consequent loss of tourist revenues. In Taleb's and Treverton's parlance, the country is highly leveraged to tourism.

Moderate volatility in economies in the form of periodic recessions weeds out weak firms thus making the overall economy stronger. When that volatility is suppressed, as it has been again and again in the last 30 years, many of the weak and reckless survive along with the strong and prudent. In fact, the reckless get rewarded for taking dangerous risks, especially in the financial sector where they get to keep their bonuses while taxpayers clean up the mess.

Moderate volatility in the affairs of nations teaches them lessons, forces them to adjust to changing circumstances and in general keeps people sharp and on their toes. Difficulties teach us far more than successes and thus make us far more robust in the face of future difficulties.

There is such a thing as too much volatility. Exercising is good for your health. Dying of heat exhaustion because of an overly long workout in excessive heat is too much volatility. On the other hand, sitting and watching television for most of the day only sets up the mind and body for catastrophic volatility in the form of major health problems such as a heart attack and an impaired ability to think through and solve major life problems.

Finding the right level of volatility for individuals and for societies and their institutions isn't as hard as it seems. What's hard is accepting that level.