Attempts to Suppress Volatility Could Lead to a Crash in Existing Economic and Political Systems

George Washington's picture

Suppressing Financial Instability Increases Risk of Market Breakdown

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.

20110922 Kurtosis 0 Attempts to Suppress Volatility Could Lead to a Crash in Existing Economic and Political Systems

I first made the attached chart in 2004 after attending a lecture by Benoit Mandelbrot, and reading his “Fractals and Scaling in Finance.”


So a narrative for what the Greenspan era monetary policy has done to the distribution of changes in rates is to exchange a decreased daily variability for a higher (perhaps catastrophically higher as we have found out) likelihood for extreme shocks. [And nothing has changed under Bernanke.]


The whole enterprise of bond portfolio risk management is intrinsically unreliable.


It is this constant papering-over of the day-to-day cracks (and business cycle) that is supposedly so beneficial for our society (and central planners) as a whole that creates a building tension as the underlying causes grow larger and larger and are never purged until in one fell swoop, the market mechanism finds a way.

And as I noted last year, interest rate derivatives – like portfolio insurance in the 1980s – might also be creating huge risks, while appearing in the short-run to be reducing risks.

Of course, Taleb, Mandelbrot and Giller’s analysis of volatility means that the Fed and other central planners’ attempts to prop up some asset prices or drive some indicators down as a way to reduce volatility could well lead to a more explosive crash of the entire financial system.

Suppressing Political Volatility Increases the Risk of a Breakdown in Existing Social Order

This principle not only applies to markets and finance, but also to sociology and politics.

“Those who make peaceful revolution impossible will make violent revolution inevitable. ”
- President John F. Kennedy

“If you shut up the truth and bury it under the ground, it will but grow, and gather to itself such explosive power that the day it bursts through it will blow up everything in its way.”
- French author Emile Zola

Indeed, Taleb co-wrote an article in May with Mark Blyth – Professor of International Political Economy at Brown University – stating:

Why is surprise the permanent condition of the U.S. political and economic elite? In 2007-8, when the global ?nancial system imploded, the cry that no one could have seen this coming was heard everywhere, despite the existence of numerous analyses showing that a crisis was unavoidable. It is no surprise that one hears precisely the same response today regarding the current turmoil in the Middle East. The critical issue in both cases is the arti?cial suppression of volatility — the ups and downs of life — in the name of stability. It is both misguided and dangerous to push unobserved risks further into the statistical tails of the probability distribution of outcomes and allow these high-impact, low-probability “tail risks” to disappear from policymakers’ ?elds of observation. What the world is witnessing in Tunisia, Egypt, and Libya is simply what happens when highly constrained systems explode. [Well, Al Qaeda also had a role in creating chaos in Libya, that's beyond the scope of this post.]

Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These arti?cially constrained systems become prone to “Black Swans” — that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.

Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems.

Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups. And it is the same misperception of the properties of natural systems that led to both the economic crisis of 2007-8 and the current turmoil in the Arab world. The policy implications are identical: to make systems robust, all risks must be visible and out in the open — fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying.

So the efforts of governments, powerful corporations and mainstream media all over the world to stifle dissent could backfire … and lead to a wholesale dissolution of the entrenched systems of power.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Georgesblog's picture

History is filled with the stories of men who lost control ofr the things they set in motion. Or have they, this time? Currency collapse is deliberate. The basnks have worked the Bait-And-Switch so often and so successfully, that people think it's normal. We know the outcome, when the paper is dead and gone.

NuYawkFrankie's picture

If I ever come across a real Black Swan I'll be sorely tempted to give it a royal kick in the a$$ - for being the source & inspiration for the eponymous, shopworn, maddening and cliche'd phrase!

And, for good measure,  if Mr Taleb is in the vicinity he might just get one as well (this time in the nutz!) - not only for popularising the phrase but for attempting to make a career-as-a-seer outta stating the obvious - after wrapping in layers of pseudo-scientific gobbledygook!

ping's picture

Being a c**t isn't complex. We live and work in a world where inbred f**kheads from the monied classes try to rig things in their favour, to keep their chinless progeny at the top of the social pile, and we pay the price. 'We' being the 99.9% who don't come from the right schools. None of this is hard, or needs reductiblity into mathematical forumlae. Rich f**ks rig the market, the laws, the government. They lie, they steal, they cheat, they murder. Full stop. They fuck with us, and in between the fucking we prosper, and during the fucking we scratch our heads. That is it, in essence. Nothing fancy about it. Might as well discuss whether the length of Hitler's hair contributed towards global conflict. It's about as relevant, and it overlooks the elephant in the room just as much. Things are unstable because c**ts made them unstable, wittingly and deliberately, in a f**k-headed attempt to prosper.  

Buck Johnson's picture

You explained it well my friend.  The ones on top do everything they can to stay in power and wealth along with their family and friends.  And in so doing they mess the system up and eventually leads to it's downfall.

anonnn's picture

These words appeared under this article's header on ZH home-page:

"Of course freedom - as envisioned by the Founding Fathers - and free markets would go a long way towards allowing normal volatility, and thus preventing Black Swan collapses ... but the Chairistan... " Until the hi-lighted terms are defined, all else is murk. Freedom has no meaning in context unless the freedom from  what or to do what is specfied , or tl least clearly inferred. Then more useful understanding may occur. As for fractals and mathematics, indeed such might be useful for application in seeking fairness, also known as justice. Any other application would be of lesser importance...  This assumes that fairness is the overarching principle of human affairs...a startling assumption, perhaps? But... Without fairness, there is chaos. Fractals, the calculus, Fourier transforms, randomity generators, speed of light. non-linear space and Portfolio Risk ...all depend on fairness, aka justice, for universal utility.  Without fairness, their application gets ugly and advances chaos.  First, seek fairness, aka justice.
Chris George's picture

There are two freedoms: the false, where a man is free to do what he likes; and the true, where he is free to do what he ought. - Charles Kingsley

11b40's picture


While I agree with the premise/conclusion of the article, I don't need mathmatical models to justify it's accuracy.

Any cook knows the difference betweening using a covered stock pot vs. using a pressure cooker.....and what happens if you use the latter improperly.  Burned up roast beef vs. blown up kitchen.

Where do I apply for my prize?

title examiner's picture

At the risk of being hated, take a look at how we handle insurrection and rebellion:

US 14th Amendment, Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.


I don't buy arguments that these folks are just goofy and make goofy mistakes.  There are tons of planning and model making, even before it all gets white papered.  Why should we have to pay for our own destruction?

CH1's picture

Why should we have to pay for our own destruction?

Because the people who pay the teachers and policemen and newscasters say so!

If you don't agree, you are a conspiracy monger and a crazy person. You are dangerous and should be kept away from other people so you don't threaten our way of life!

geekgrrl's picture

Taleb said that "And it is the same misperception of the properties of natural systems that led to both the economic crisis of 2007-8 and the current turmoil in the Arab world. The policy implications are identical: to make systems robust, all risks must be visible and out in the open"

But, but, but, how will the big banks make any money if they can't hide the risks? <sarc>

As far as I can tell, hiding and misrepresenting risk is the Corporate Way. The Tobacco companies do it, as do the chemical companies, nuclear operators, coal fired power plants and let's not forget the media, who are the salesmen and women who downplay risks to the people for a living. Those mortgage companies who wrote liars loans and NINJA loans were misrepresenting risk. The banks that packaged and sold toxic securities knew they were misrepresenting risk. So it seems odd to me that Taleb thinks that risk transparency has any chance of happening in the financial sector. Sorry, not going to happen. They will sink the ship first.

A more useful measure of the stability of a system than robustness is flexibility, or ability to tolerate variations in system variables. It's fairly obvious that the economic and financial system in the US is almost entirely unable to tolerate much change. Just one example would be the consequence of even a small increase in interest rates on the US debt, which would have a dramatic effect on the deficit and put increased strain on an already over-indebted country. Gregory Bateson describes this process in one of his essays:

"More broadly, I regard the grooves of destiny into which our civilization has entered as a special case of evolutionary cul-de-sac. Courses which offered short-term advantage have been adopted, have become rigidly programmed, and have begun to prove disastrous over longer time. This is the paradigm for extinction by way of loss of flexibility. And this paradigm is more surely lethal when the courses of action are chosen in order to maximize single variables."

shazbotz's picture

Unleash the hounds of Hell



stiler's picture

hounds of hell here....


I think many people are inspired by their own greed and thus by the Devil, who has the grand scheme of taking down our free market. He has many angles he can take; the seven mind-molders, in government, education, culture etc, etc, and dossiers on people.

Smiddywesson's picture

Reducing volatility allows for ever increasingly complex financial instruments that you simply can't do without, but are gradually tied together in a complex web that can easily be destroyed.  Buy hey, they make a lot of money.  Eventually, something comes along and threatens to destoy everything, but then you get yummy bail outs and even more money and bonuses.  What's not to like about it?

Tao 4 the Show's picture

Good article, GW, and important point in these times of manipulation.

I think it is wise to make a distinction here between suppression of volatility and steering the markets in particular directions. Suppressing volatility is dangerous for the reasons you outlined, but steering or manipulating price levels consistently in one direction or the other creates a disconnect with reality or "pressure" in the opposite direction.

It's the snap back that is worrisome in the latter case.

the grateful unemployed's picture

good points and not terribly complicated if you have ever gone to one of those interactive websites where you can build bell curves. as you decrease variability the top of the bell curve raises and the amount of variance required to reach the tail areas is lessened.(both upper and lower)

the point of attempting to lower this variability in economic terms is two fold. one it allows planners greater leverage. if the stock market can see one year ahead, that is not as desirable as if they can see five years ahead. however the sides of the bell curve get very steep, while variability, or risk is taken out of the market. the consequences of being two standard deviations off the mean growth projections are more severe, (in  this case lets say economic numbers which miss, say a spike in CPI, or an unexplained rise in unemployment, or lets say interest rates rise a mere 1/4 point the Feds balance sheet is toast)

point two is this leveraging out of lower variability over time allows greater economic growth, just as compound interest paid daily is better than compound interest paid monthly.

if the model the economists are running, lets say a model based on consumer spending (70% of GDP) is suddenly rendered obsolete by social and technological change, then you have real problems. they can't control that, other than to set the wayback machine to 1950, (or the restore point for computer geeks) its always easier to understand the past.

the new economic reality always takes over, which is why we arent'  living in caves, and it is always painful, and the old guard always rejects it because they are all in on their system.

we are at just such a moment, probably.


falak pema's picture

when you talk about volatility is it political or financial? The current financial volatility is increasing the resonance of the financial structure into unknown zones pushing it to unsustainable amplitude by loose money moving at increasing speed in search of ephemeral safe havens. As the FED has now run out of bullets, the expectations are high but the reality of undue asset book markup value is now impinging like glue onto the market. Its begining to stick and the cry to boost upwards asset pricing in fiat money is now sounding more and more hollow. The economic crash can only be avoided by a political concerted will to solve a global problem by globally spread pain. There lies the collective rub...

MrBinkeyWhat's picture

"Lions and Tigers and Bears...OH MY"

Ghordius's picture

As much as I admire Taleb and agree with most of his views, I do have to ask a stupid question: how much volatility is "natural" and how much is "artificial"? Is this century up to now "normal"?

Taleb himself worked in banks selling options and his favourite strategy (called "bleeding" if I remember right) is one that wins when prices don't behave as forecasted (while losing a little when everything is "normal") - without caring if it's on the upside or the downside.

A lot of quants/banks have made money by keeping in "the corridor", could it be that now a lot of new masters of the universe try to make money by "shaking" the markets? At the end, the more trades, the more fees.

Perhaps they chant: "Keep them moving, keep them trading, kill the buy-and-hold!"

the grateful unemployed's picture

there is no "natural", economics is policy, not empirical science. High volatility shows the weakness in current economic policy. Volatility helps the trader, but their market (policy) isn't written for the trader its written for the investor. We just need to realize how really REALLY important it is to take the stock market out at YOY gains of at least 3%, to prove that stocks are better than bonds, and the world is not upside down.. I would not bet against their efforts to achieve this goal.


disabledvet's picture

Why do I feel like I just read "the smartest men in the room" writ large? It's really not this complicated anymore. It goes something like this:
Ben Bernanke: "hello, Wall street? I literally have all your money right now. Returns are great btw! But I really, really, really, really don't want it. Whatdaya say?"
Then Wall Street replies "Shhhhh! We're trying to blow up Wisconsin again! Ain't that amazing!"

Which is worse - bankers or terrorists's picture

The Fed makes revolution impossible. How do you revolt against a private company? Can't do it.

disabledvet's picture

Shunning indeed. Truly shunning actually. Personally though I must say this whole European "we won't do anything now GO TO HELL FRIENDLY AMERICAN TREASURY SECRETARY" isn't working too well either.

Spastica Rex's picture

Torches, pitchforks, and guillotines - same as it ever was.

Spirit Of Truth's picture

Max Keiser spells out the fate he sees for international banksters:

This is a very good article.  Note that Mandlebrot's studies of financial markets jives with the Elliott Wave Principle, i.e., there appears to be the same statistical "pattern" w/regard to scale.  Black swans are predictable using the Wave's move in silver and gold being a good example (EWI saw it coming). Nassim Taleb is quoted at length in my thesis.  BTW, according to my own form of anylysis, the probability of a black swan geopolitical event is significant in the coming days, particularly w/regard to Israel and the Middle East.  Hope I'm wrong.

Racer's picture

The sooner we get rid of the Leech Class the better

johnQpublic's picture

leaving whom exactly?

and which leach class are you speaking of?


i can count several

Racer's picture

Exactly... too many leeches and not enough blood

johnQpublic's picture

ok, now i agree with you