Submitted by John Mauldin, via Thoughts from the Frontline
We have all had the fun as kids of going to the beach and playing in the sand. Remember taking your plastic bucket and making sandpiles? Slowly pouring the sand into ever bigger piles, until one side of the pile starts to collapse?
In his very important book Ubiquity, Why Catastrophes Happen, Mark Buchamane wrote about an experiment with sand that three physicists named Per Bak, Chao Tang, and Kurt Wiesenfeld conducted in 1987.
In their lab at Brookhaven National Laboratory in New York, they started building sandpiles, piling up one grain of sand at a time. It’s a slow process, so they wrote a computer program to do it. Not as much fun but a whole lot faster.
During this experiment, they learned some interesting things that can help us understand how all sorts of calamities, including market crashes, unfold.
What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found out there is no typical number:
Some involved a single grain; others, ten, a hundred, or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur.
The pile was completely chaotic in its unpredictability.
Now, let’s read this next paragraph. It is important, as it creates a mental image that helps us understand the organization of the financial markets and the world economy. (emphasis mine)
To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, “ready to go,” color it red. What do you see? They found that at the outset, the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever.
Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc.
But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]…. In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains.
So, they asked themselves, could this phenomenon show up elsewhere? In the earth’s crust, triggering earthquakes… in wholesale changes in an ecosystem… or in a stock market crash?
Fingers of Instability
The scientists found that the size and timing of an avalanche depend on what they refer to as “fingers of instability”:
[A]fter the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into “fingers of instability” of all possible lengths. While many are short, others slice through the pile from one end to the other. So, the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate, or long finger of instability.
Now we come to a critical point in our discussion. Read this next excerpt with the markets in mind (again, emphasis mine, and this is critical to our understanding of markets and change. Maybe you should read it two or three times.):
In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.
Now, let’s couple this idea with a few other concepts.
First, economist Dr. Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist. And then when the trend fails, the more dramatic the correction.
Long-term stability produces unstable financial arrangements. If we believe that tomorrow will be the same as last week, we are more willing to add debt or postpone savings in favor of current consumption.
Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.
Relating this to our sandpile, the longer a critical state builds up in an economy, the greater the potential for a serious “avalanche.”
As I wrote in my “Train Wreck” series, (recap here). We are adding sand to not just one inevitably collapsing sandpile, but dozens and maybe hundreds of them. They will not keep growing forever.
Which particular sandpile will fall first? It could be many, but I think high-yield corporate debt is the most likely. Millions of investors think they can collect those juicy yields and then be able to sell when trouble appears.
I think the mother of all Minsky moments is building. It will not be an instant sandpile collapse, but instead take years because we have $500 trillion of debt to work through.
Remember, that debt just can’t be pooped away. It is both money somebody owes and an asset on somebody else’s balance sheet. We can’t just take that away without huge consequences to culture and society.
But the fingers of instability, the total credit system, are seemingly growing with more red sand dots every month. All are inextricably linked. One day, another Thailand or Russia or something else (it makes no difference which) will start the cascade.