Sunday, June 26, 2016

26/6/16: Black Swan ain't Brexit... but

There is a lot of froth in the media opinionating on Brexit vote. And there is a lot of nonsense.

One clearly cannot deal with all of it, so I am going to occasionally dip into the topic with some comments. These are not systemic in any way.

Let's take the myth of Brexit being a 'Black Swan'. This goes along the lines: lack of UK and European leaders' preparedness to the Brexit referendum outcome can be explained by the nature of the outcome being a 'Black Swan' event.

The theory of 'Black Swan' events was introduced by Nassin Taleb in his book “Black Swan
Theory”. There are three defining characteristics of such an event:

  1. The event can be explained ex post its occurrence as either predictable or expected;
  2. The event has an extremely large impact (cost or benefit); and
  3. The event (ex ante its occurrence) is unexpected or not probable.

Let's take a look at the Brexit vote in terms of the above three characteristics.

Analysis post-event shows that Brexit does indeed conform with point 1, but only partially. There is a lot of noise around various explanations for the vote being advanced, with analysis reaching across the following major arguments:

  • 'Dumb' or 'poor' or 'uneducated' or 'older' people voted for Brexit
  • People were swayed to vote for Brexit by manipulative populists (which is an iteration of the first bullet point)
  • People wanted to punish elites for (insert any reason here)
  • Protests vote (same as bullet point above)
  • People voted to 'regain their country from EU' 
  • Brits never liked being in the EU, and so on
The multiplicity of often overlapping reasons for Brexit vote outcome does imply significant complexity of causes and roots for voters preferences, but, in general, 'easy' explanations are being advanced in the wake of the vote. They are neither correct, nor wrong, which means that point 1 is neither violated nor confirmed: loads of explanations being given ex post, loads of predictions were issued ex ante.

The Brexit event is likely to have a significant impact. Short term impact is likely to be extremely large, albeit medium and longer term impacts are likely to be more modest. The reasons for this (not an exhaustive list) include: 
  • Likely overshooting in risk valuations in the short run;
  • Increased uncertainty in the short run that will be ameliorated by subsequent policy choices, actions and information flows; 
  • Starting of resolution process with the EU which is likely to be associated with more intransigence vis-a-vis the UK on the EU behalf at the start, gradually converging to more pragmatic and cooperative solutions over time (what we call moving along expectations curve); 
  • Pre-vote pricing in the markets that resulted in a rather significant over-pricing of the probability of 'Remain' vote, warranting a large correction to the downside post the vote (irrespective of which way the vote would have gone); 
  • Post-vote vacillations and debates in the UK as to the legal outrun of the vote; and 
  • The nature of the EU institutions and their extent in determining economic and social outcomes (the degree of integration that requires unwinding in the case of the Brexit)
These expected impacts were visible pre-vote and, in fact, have been severely overhyped in media and official analysis. Remember all the warnings of economic, social and political armageddon that the Leave vote was expected to generate. These were voiced in a number of speeches, articles, advertorials and campaigns by the Bremainers. 

So, per second point, the event was ex ante expected to generate huge impacts and these potential impacts were flagged well in advance of the vote.

The third ingredient for making of a 'Black Swan' is unpredictable (or low predictability) nature of the event. Here, the entire thesis of Brexit as a 'Black Swan' collapses. 

Let me start with an illustration: about 18 hours before the results were announced, I repeated my view (proven to be erroneous in the end) that 'Remain' will shade the vote by roughly 52% to 48%. As far as I am aware, no analyst or media outfit or /predictions market' (aka betting shop) put probability of 'Leave' at less than 30 percent. 

Now, 30 percent is not unpredictable / unexpected outcome. It is, instead, an unlikely, but possible, event. 

Let's do a mental exercise: you are offered by your stock broker an investment product that risks losing 30% of our pension money (say EUR100,000) with probability of 30%. Your expected loss is EUR9,000 is not a 'Black Swan' or an improbable high impact event, but instead a rather possible high impact event. Conditional (on loss materialising) impact here is, however, EUR30,000 loss. Now, consider a risk of losing 90% of your pension money with a probability of 10%. Your expected loss is the same, but low probability of a loss makes it a rather unexpected high impact event, as conditional impact of a loss here is EUR90,000 - three times the size of the conditional loss in the first case. 

The latter case is not Brexit, but is a Black Swan, the former case is Brexit-like and is not a Black Swan event. 

Besides the discussion of whether Brexit was a Black Swan event or not, however, the conditional loss (conditional on loss materialising) in the above examples shows that, however low the probability of a loss might be, once conditional loss becomes sizeable enough, the risk assessment and management of the event that can result in such a loss is required. In other words, whether or not Brexit was probable ex ante the vote (and it was quite probable), any risk management in preparation of the vote should have included full evaluation of responses to such a loss materialising. 

It is now painfully clear (see EU case here:, see Irish case here: that prudent risk management procedures were not followed by the EU and the Irish State. There is no serious contingency plan. No serious road map. No serious impact assessment. No serious readiness to deploy policy responses. No serious proposals for dealing with the vote outcome.

Even if Brexit vote was a Black Swan (although it was not), European institutions should have been prepared to face the aftermath of the vote. This is especially warranted, given the hysteria whipped up by the 'Remain' campaigners as to the potential fallouts from the 'Leave' vote prior to the referendum. In fact, the EU and national institutions should have been prepared even more so because of the severely disruptive nature of Black Swan events, not despite the event being (in their post-vote minds) a Black Swan.

Post a Comment