At this measure of year we construe many financial forecasts for the year ahead. Nearly all of these are written with the "separate" assumption of infinite growth. "Oil production problems are a temporary issue; after a short dip the economy is likely to act growing rapidly again. We may undergo a bunco recession but we will soon be back to business as usual." Etc.
I evaluate this filter is fundamentally in error and leads to a mistaken impression with consider to where the world is headed. The world is changing in a very study way. Oil is in short supply and this shortage is likely to get larger in the future. The compel of short supply and rising prices adds a systematic prejudice that the financial community is not recognizing. This bias has as its basis the fact that it is becoming more and more difficult for both populate and businesses to pay approve loans because of the rising costs of oil and food. This situation cannot be expected to go away. In fact it is certain to get worse in years ahead as oil supplies become tighter.
Besides the systematic bias there is also a systemic risk arising from the interconnectedness of all of the parts of the economy. This was come up described in a post a few days ago called. One of the issues in systemic assay relates to the financial system itself. If one party in the financial system fails it increases the likelihood that other parties in the economic system will fail as come up.
Another aspect of systemic risk is the close ties of the financial system to the be of the economy. One example is the higher oil and food prices mentioned above that bring about to a systematic prejudice toward higher defaults. Another is the fact that the lack of oil can be expected to impede economic growth making the infinite growth copy underlying the current economic system less sustainable based on the of Robert Ayres and Benjamin Warr. Another linkage is that of oil with ethanol. Higher oil prices leads to increased compel to produce more ethanol which further raises food prices as demonstrated by Stuart Staniford in.
Systematic bias occurs in a system when a process favors a particular outcome. Instead of errors being random they are consistent and repeatable. One example might be a thermometer that consistently reads high. In the economy systematic bias occurs when loans undergo a greater and greater tendency toward defaults because of changes in the system (rising oil prices) since the measure when the probability of fail was originally estimated. As another example rising oil prices can also create profits of individual companies to grow more slowly than expected (relative to base period undergo) because of a contraction in general economic growth.
Systemic assay is risk relating to the interconnectedness of the system. A displace on one part of the system will lead to a displace on another move of the system leading to unanticipated failures. As an example the failure of one tip may bring about to other banks failing because of counter party assay. There is significant reason to believe that the interconnectedness of the system is increasing over measure as food becomes used as a fuel and as financial products become more complex. See.
The financial community has designed many models. Some of these are used by "quants" in pricing the newer sliced and diced financial products. Others are used by insurance companies in pricing the assay of defaults on bonds and on mortgages.
The assumption that is made in these models is that historic experience can be used with only minor adjustments as a command for pricing current products. This approach fails to recognize the greater risk now entering the system due to systematic bias because of rising oil prices and due to greater systemic assay because of greater interconnectedness.
One way of describing these models is to say that they anticipate that defaults are "independent events" -- that is there is no systemwide bias that would create more and more defaults. This assumption of independence keeps insurance prices low and makes the slicing and dicing of packaged securities bring home the bacon. Clearly with the systematic prejudice and systemic risk that is now infecting the financial system these assumptions are no longer valid.
Closely related to the assumption that events are independent is the assumption that distributions are "normal" - that is that they follow the Gaussian distribution. Benoit Mandelbrot has shown in that the actual tails of distributions are much "fatter" than implied by the Gaussian distribution. The bias introduced by the oil situation makes the normal distribution even less appropriate. For example with higher oil prices the be of defaults on bonds ordain be much greater than would be predicted if one simply assumes that a normal distribution applied to past undergo ordain be predictive of future experience.
If one looks at financial theories desire the and the one discovers that they assume normal distributions and statistical independence. These models were not quite right before because the underlying distributions are not really normal as shown by Mandelbrot. Now that systematic bias and systemic risk are playing greater roles the predictive value they had previously can be expected to advance change state.
I don't think we can know precisely. In the material that follows. I give my views as to how the financial situation may unfold in the year ahead taking into account the issues discussed above.
Bond and mortgage insurers are likely to have difficulty because these coverages are written with the assumption that past default undergo can be used as a guide to needed prices. If there is a systematic bias toward higher defaults as there is today prices will be too low.
Once bond insurers suffer their AAA ratings their coverage will be of little determine. Rating agencies will rate the bonds based on the financial standing of the organization issuing the attach instead of imputing the insurer's credit rating to the attach. This could convey widespread downgrades of bonds.
Warren Buffet a new bond insurer. change surface if this insurer stays strictly with municipal bonds and charges higher rates. I question the long-term viability of the company. It will be difficult to charge a price in 2008 that will reflect the real risk of default five or ten years from now when oil supply will be much tighter than today.
We have already seen how oil markets act differently once the sellers of oil realize that arrive at oil is not far away. Sellers of oil become more aggressive and demand more favorable terms. They cognise that they have leverage and begin to use it.
In 2008 it seems likely to me that financial markets will begin to accept arrive at oil as well. Leading economists are now speaking openly about peak oil. On December 15. 2007 the WSJ Alan Greenspan as saying that oil supply peaked lower and sooner than had been contemplated earlier. The Toronto Star Jeff Rubin chief economist of CIBC World Markets as saying. "I just don't think we're going to see increases in conventional oil production any more. I think (arrive at oil) is here." With economists like Greenspan and Rubin talking openly about arrive at oil it seems likely that some financial decision-makers ordain go away thinking about the implications of peak oil for loans and other financial products. This seems especially likely if oil production remains relatively flat or declines in 2008.
Once financial markets begin to recognize arrive at oil. I expect lenders ordain be more wary of long-term loans.
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