Financial Crisis: A Black Swan

The financial crisis that has hit the world economy is a direct result of the huge amount of credit that has been evident over the last 30 years. The current US debt is reminiscent of the 1920’s when there was incredible prosperity and confidence amongst the population. However, as with the 1920’s, far too much money has been lent to individuals who cannot service their debts. A similar trend to today is that of US debt as a % of GDP. From 1920 through to the Wall Street Crash in 1929, US credit expanded dramatically from 175% of GDP to 300% of which a large proportion of the borrowings were used to buy shares in firms like Cable and Wireless – the Internet of today. It took nearly 20 years before deleveraging was completed and the total US debt to GDP stabilized below 150%. Not surprisingly, there was a strong aversion to debt from 1950-80 and the 1987 stock market crash nipped in the bud any resurgence ofdebt. However, in recent years personal debt levels have soared and US debt to GDP has risen from 150% in 1980 to approximately 372% by the end of last year – 2009 (see chart below).

Total US Credit Market Debt as a % of GDP

Source: Bureau of Economic Analysis

The book entitled “The Black Swan” (2007) by Nassim Nicholas Taleb describes a black swan as a highly improbable event with three principal characteristics:

1. its unpredictability;
2. its massive impact; and
3. after it has happened, our desire to make appear less random and more predictable than it was.

The current banking crisis now being played out unquestionably meet the criteria as a Black Swan. No one saw it coming and no one knows how it is going to end. Nassim Nicholas Taleb could see the banking crisis being realized, and this quote from “The Black Swan” explains partly the rationale for the current environment. Remember it was written when the world was awash with cheap credit and leaders were content with what was happening.

“So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails,
they all fall. The increased concentration among banks seems to have the effect of making financial crises less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur I shiver at the thought.” Pages 225-226

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