The Strange Insouciance of Global Finance: Part 2

About a month ago, I pointed out the strange insouciance of global finance, demonstrated by the retreat of risk pricing.

Well, nothing's changed on the pricing front. But over the few days two experienced and usually level-headed investors have played it back to me, forcefully. One points out that although the US is reportedly flying teams of underwater fighters into the Straits of Hormuz,  and  Britain's secret services is warning Iran will be nuclear-tipped by 2014 unless stopped, there's virtually no risk premium built into oil prices (or Saudi sovereign CDS rates, for that matter). Meanwhile, Syria shoots down Turkish jets whilst at least one Syrian general defects to rebels lining up near the Turkish border and Russia reflags the cargo-ships carrying gunships to Syria, in order to evade P&I insurance problems. "Do people think nothing will happen," he asks?

The other - a bearded prophet visiting from the East - wags his finger at me as we mull over the political impact of the Libor scandals: "Don't people realize - when the Conservative Party publicly abandons finance, something's changing fundamentally. How can people not know?"

I could go on: the US is still facing its fiscal cliff, with a  bought-and-sold political system that seems  unable to act. The Euro continues to beggar generations of Southern Europeans, but every time you hear a Euro-pol speak, it's to assure us that they'll do whatever needs to be done to 'save the Euro'. (At this point, I mentally retune to  Highway 61 Revisited: "God says to Abraham, kill me a son / Abe says man, you must be puttin me on . . . ").

All these are problems, any one of which could collapse financial markets later this year. And it's not as if we haven't been told: there's a whole industry out there dedicated to shrieking panic at you (seen InvestmentWatch recently?)

Now, take a moment out of your day, and play some war-games in your head - what happens after the first missile is launched across the Straits?  What's the end-result? What's the end-game? Tough to figure, I think.

Yet pricing of financial assets, and commodities, seems to assume that none of this matters. Why?

These are the sort of risks, and the sort of questions, which finance gets wrong all the time. It's not Donald Rumsfeld's "unknown unknowns" that destroy value,  it's the "known unknowns" where the danger lurks. We get them wrong, time after time. We get them wrong systematically.

And this is where we should turn to Kahneman's 'Thinking Fast & Slow'. (If you haven't yet read this book, do so today.)  Risk pricing gets this wrong because, in Kahneman's terms, it's the result of Type I thinking - the fast, instinctive, automatic, usually unconscious adaptation to immediate events which characterises good traders. The great thing about Type 1 thinking is that it is cheap, fast, and almost all the time gets to the right solution.  It finds the immediate equilibrium price fast.

The problem with Type I thinking is that, for all its virtues, it invariabley makes predictable mistakes. In theory, those mistakes can be avoided by Type II thinking - the slow, effortful, expensive type of analytical thought we instinctively avoid, and which hides in the research office. But usually it's too slow, too expensive, too much effort, and anyway, the traders usually get it right, don't they?  (Did you really think through what happens after the first missile is launched across the Straits? Of course not - it's too much bother. I didn't either.)

Financial markets operate almost exclusively on Type I thinking, and risk is priced on that model. This is what is Type I is likely to be acting on right now:  "I've been hearing about Iran/Syria/Financial Crisis/Fiscal Nightmare/the wretched Euro for months now, and nothing's happened. Nothing's likely to happen. . . "

Let's hope that's right.  But recognize that it's the same  kind of reasoning that LTRM did on Russian politics . . . .