Greece Exit Estimated Price Tag: €155bn for Germany and France, Possible Trillions for Contagion

Estimates have been made as to the cost of a Greece exit

Writes Ambrose Pritchard at the Telegraph, (Hat tip Bob Wenzel)

Eric Dor's team at the IESEG School of Management in Lille has put together a table on the direct costs to Germany and France if Greece is pushed out of the euro.

These assume that relations between Europe and Greece break down in acrimony, with a full-fledged "stuff-you" default on euro liabilities. It assumes a drachma devaluation of 50pc.

Potential losses for the states, including central banks

They conclude:

The total losses could reach €66.4bn for France and €89.8bn for Germany. These are upper bounds, but even in the case of a partial default, the losses would be huge.

Assuming that the new national currency would depreciate by 50 per cent against the euro, which is realistic, the losses for French banks would reach €19.8bn. They would reach €4.5bn for German banks.

Sounds about right.

I doubt that the US, China, and the world powers would sit back if the EU tried to "teach Greeks a lesson" by making life Hell for them.

There would be massive global pressure on Europe to handle the exit in a grown-up fashion, with backstops in place to stabilize Greece. The IMF would step in.

And here is the part to worry about.

More from Mr. Pritchard,

Needless to say, the real danger is contagion to Portugal, Ireland, Spain, Italy, Belgium, France, and the deadly linkages between €15 trillion in public and private debt in these countries and the €27 trillion European banking nexus.

The ECB will likely resort to printing of money in the scale like never before and will likely be backed by the US Federal Reserve.

If hell breaks lose and the Euro comes undone the more money printing will be unleashed by independent central banks to protect their banking system.

As a side note, this is about the preservation politically protected banking system which has functioned as an integral part of the current structure of political institutions—the welfare-warfare governments and central banks.

So we should expect markets to be highly volatile in either directions as events unfold.

Just a reminder, I bring this up NOT to scare the wits out of market participants (funny how from being a perceived Panglossian analyst, I am precipitately seen as the present day Jeremiah). Some people reduce stock market logic into a groupthink fallacy ("either you are with us or against us").

Paradoxically, the article I quoted above comes from the mainstream.

I am simply presenting the risks that faces the marketplace given the current conditions.

As an old saw goes, pray for the best, prepare for the worst.

As to whether Greece will exit the Eurozone or is beyond my knowledge. The Greek government emerging from the June elections will decide on that. I can only guess or toss a coin. But I can either act to ignore this or include this in my calculation for my positioning.

The fact is that in case the new Greek government decides to opt out of the EU, this would have a material impact on the marketplace—all over the world, the Phisix not withstanding.

Since the overall impact to the markets will likely be unknown, except for some numerical estimates to rely on (which may or may not be reliable) and where the psychological impact cannot be quantified or even qualified, such environment is called as uncertainty.

The current conditions suggests of greater than usual uncertainty. Add to that the China factor and the Fed’s monetary policies.

So, for me, it pays to keep a balanced understanding of how the local markets may become vulnerable to a contagion transmission from external events, than from blindly embracing or getting married to a single position.

I always try to keep in mind the legendary trader Jessie Livermore’s precious advice: There is only one side of the market and it is not the bull side or the bear side, but the right side

Since the markets are about managing opportunities, then opportunities will arise for profits, and opportunities will also arise for wealth preservation.

For now I see the right side of the trade as balancing my portfolio tilted towards the preservation of resources.

On the other hand, I must add that bloated egos will eventually be humbled by the marketplace.

Numerical Probabilities as Metaphorical Expressions

In an earlier post I argued that assigning numerical probability to what has been a constantly changing environment can be a dangerous undertaking because this either depends on presumptive omniscience or requires heavy reliance on unrealistic assumptions that replaces people’s choice.

I would like to add the allegation where numerical probabilities serve as “framework for communication” does not improve the efficacy of numerical based probabilities because the basis of such communication would be ABSTRACTION.

Professor Ludwig von Mises calls this metaphorical expression(bold emphasis mine)

It is a metaphorical expression. Most of the metaphors used in daily speech imaginatively identify an abstract object with another object that can be apprehended directly by the senses. Yet this is not a necessary feature of metaphorical language, but merely a consequence of the fact that the concrete is as a rule more familiar to us than the abstract. As metaphors aim at an explanation of something which is less well known by comparing it with something better known, they consist for the most part in identifying something abstract with a better-known concrete. The specific mark of our case is that it is an attempt to elucidate a complicated state of affairs by resorting to an analogy borrowed from a branch of higher mathematics, the calculus of probability. As it happens, this mathematical discipline is more popular than the analysis of the epistemological nature of understanding.

There is no use in applying the yardstick of logic to a critique of metaphorical language. Analogies and metaphors are always defective and logically unsatisfactory. It is usual to search for the underlying tertium comparationis. But even this is not permissible with regard to the metaphor we are dealing with. For the comparison is based on a conception which is in itself faulty in the very frame of the calculus of probability, namely the gambler's fallacy.

In short, numerical probabilities serve to gratify one’s cognitive biases which in essence is a form of self-entertainment rather than a dependable methodology for risk analysis.

Applying Methodological Individualism to the Financial Markets

I recently received a suggestion for me ‘quantify’ the probabilities of my risk scenarios.

While this may represent the conventional practise by the mainstream, I see this as a foolish undertaking.

Putting numbers assumes that I KNOW the nitty gritty or the minutest details of the risk events that I have been investigating. It also means that I KNOW how people think and their corresponding responses to the changes in the economy, the environment or the financial marketplace. Otherwise, I would be making irresponsible assumptions that may be out of touch with reality.

Besides, I don’t see the need to ‘signal’ or project my expertise just to get plaudits from any institutions. All I aim to do is to excel at my current undertakings in order to survive.

Anyway the prediction markets such as Intrade.com exhibits the probabilities of specific events based on actual risk money or bets and not merely from mathematical models.

For instance, the odds of a US recession in 2012[1] has been quite volatile.

The odds of a recession began to recede since the last quarter of 2010 and began to bottom out in the first quarter of 2011. But this trend reversed to the upside and currently stands at the highest level since the last quarter of 2009.

As of this writing, the odds of a recession by the betting public is at 43.6% and constantly changes depending on the risk perception of the betting public.

The above simply shows that there is NO constancy in people’s actions or that the only thing constant in the real world is change.

Therefore to apply probabilities based on math or econometric constructed ‘models’ from faulty and flawed assumptions would not be only ridiculous but dangerous, especially to our management of portfolio.

Class and Case Probabilities

A better option would be to apply what the Austrian School of economics calls as Class and Case Probabilities.

Class probability, as the great professor Ludwig von Mises defined is[2]

We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.

We know, for instance, that there are ninety tickets in a lottery and that five of them will be drawn. Thus we know all about the behavior of the whole class of tickets. But with regard to the singular tickets we do not know anything but that they are elements of this class of tickets.

On the other hand, Case probability according again to Professor Mises means:

We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.

Case probability has nothing in common with class probability but the incompleteness of our knowledge. In every other regard the two are entirely different.

Let me apply these probabilities to the recent typhoon that hit Metro Manila. [As a caveat I don’t know exactly the details of the typhoon but am comparing the major hits from a typhoon in the metropolis.]

Class probability means that we know some generalized information of the risk event.

-Typhoons can result to loss of lives, injuries or damage to properties as a result of flooding, strong winds and other related or ancilliary consequences (landslide, health hazards as leptospirosis, snake bites, E. coli and etc..).

-We can predict the path of typhoons using satellites.

-We know for instance that around 19 cyclones or tropical storms enter the Philippine area of responsibility every year[3].

From the above, we can even parallel class probabilities or “the behavior of a whole class of events or phenomena” to former US secretary of defense Donald Rumsfeld theory of uncertainty called ‘known knowns’[4]

Yet if there are ‘known knowns’ then the antipode would be the ‘unknown unknowns’.

This would represent as the Case probabilities or fragmented, dispersed and localized information on specific risk events.

Back to typhoons, we don’t know the exactitude and the variability of the typhoon’s strength (only estimates) and or its impact to particular affected localities.

While the Typhoon Nesat[5] [code name: Pedring] recently hit Northern Luzon’s Aurora and Isabela provinces the hardest, in Metro Manila, the famous Manila district of Roxas Boulevard got slammed by a barrage of extremely high storm surges that caused flooding at a public hospital, a five-star hotel and the US embassy.

This is in contrast to Typhoon Ketsana[6] [code name: Ondoy] in 2009 where strong continuous rains basically submerged Metro Manila’s Marikina City that led to many fatalities.

Think of it, about 19 typhoons hit the Philippines every year, yet we hardly know much about the prospective destruction or the scale of calamity these typhoons would bring about and where they will hit for us to apply precautionary measures.

But if you listen to the self-righteous blarneys of prominent media broadcasters, who base their comments on ex post analysis of ‘case’ events, you’d bear the impression that if the government only does as they propose the next typhoon won’t have an impact to the nation at all. Duh!

Yet fallacies from such presumptive omniscient gibberish can be applied to the most recent triple whammy calamity of Japan: the 2011 Tohoku earthquake, tsunami and the nuclear reactor meltdown[7].

Japan’s geographical location[8] makes her exceedingly vulnerable or prone to earthquakes. Thus Japan has lavished in putting up scientific prediction models, which only has proven to be a massive failure in predicting the latest catastrophe[9].

The moral: While it would seem as intellectually comforting to be guided by math based models in predicting the probabilities of the markets or the economy or of any people based risk events, unfortunately, they almost always fail to achieve their goals. The problem is that the social science isn’t physics or natural sciences that are quantifiable and work on some constants.

As Professor Mises wrote[10],

People would like to find in an economics book knowledge that perfectly fits into their preconceived image of what economics ought to be, viz., a discipline shaped according to the logical structure of physics or of biology. They are bewildered and desist from seriously grappling with problems the analysis of which requires an unwonted mental exertion.

Another notable example would be how the 2008 crisis exposed the travesty of quant[11] models[12]. UK’s Queen Elizabeth even questioned the economic profession[13] on why they haven’t seen the crisis coming.

To insist on applying something that doesn’t work is an exercise of self-deception or delusion.

Using Methodological Individualism on Uncertainty

The best methodology will always be to apply the understanding of human action or methodological individualism on social problems

Again from Professor Ludwig von Mises, (bold highlights mine)

Praxeological knowledge makes it possible to predict with apodictic certainty the outcome of various modes of action. But, of course, such prediction can never imply anything regarding quantitative matters. Quantitative problems are in the field of human action open to no other elucidation than that by understanding.

We can predict, as will be shown later, that — other things being equal — a fall in the demand for a will result in a drop in the price of a. But we cannot predict the extent of this drop. This question can be answered only by understanding.

The fundamental deficiency implied in every quantitative approach to economic problems consists in the neglect of the fact that there are no constant relations between what are called economic dimensions. There is neither constancy nor continuity in the valuations and in the formation of exchange ratios between various commodities. Every new datum brings about a reshuffling of the whole price structure. Understanding, by trying to grasp what is going on in the minds of the men concerned, can approach the problem of forecasting future conditions. We may call its methods unsatisfactory and the positivists may arrogantly scorn it. But such arbitrary judgments must not and cannot obscure the fact that understanding is the only appropriate method of dealing with the uncertainty of future conditions.

Understanding of how individuals interact with one another and with the environment should give us a better insight than sloppy thinking based on hypothetical numerical aggregates which attempts to substitute for people’s choices.

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[1] Intrade.com The US Economy will go into Recession during 2012

[2] Mises Ludwig von Uncertainty Mises.org

[3] Wikipedia.org Typhoons in the Philippines

[4] Wikipedia.org There are known knowns

[5] Wikipedia.org Typhoon Nesat (2011), Philippines

[6] Wikipedia.org Typhoon Ketsana

[7] Wikipedia.org 2011 Tōhoku earthquake and tsunami

[8] Wikipedia.org Seismicity in Japan

[9] See Science Models Fail To Predict Japan’s Earthquake, March 12, 2011

[10] Mises Ludwig von Blue-Collar Anticapitalism, Mises.org

[11] See How Math Models Can Lead To Disaster, February 25, 2009

[12] See Beware Of Economists Bearing Predictions From Models, May 27 2009

[13] The Telegraph The Queen asks why no one saw the credit crunch coming, November 5, 2008

Managing Risk and Uncertainty With Emotional Intelligence

If your emotional abilities aren't in hand, if you don't have self-awareness, if you are not able to manage your distressing emotions, if you can't have empathy and have effective relationships, then no matter how smart you are, you are not going to get very far.-Daniel Goleman, Emotional Intelligence

Markets thrive on information. Information is processed as knowledge. Thus knowledge which coordinates people’s actions through prices, determines the risk-reward tradeoff.

Amgydala’s Fight or Flight Response[1]

When uncertainties or the prospect of peril emerges, our brain’s amygdala responds by impelling us either to fight or to take flight. That’s because our brain has been hardwired from our ancestor’s desire for survival—they didn’t want to be the next meal for predators in the wild.

Applied to the present state of the markets, the legacy of our ancestor’s base instincts still remains with us.

Yet in face of market turmoil, some would say “when in doubt get out”. But that’s an absurd statement to begin with.

First, there is hardly any market that operates without a doubt. Markets exist exactly with the aim to reduce such uncertainties, risk and or doubts.

As the great Ludwig von Mises pointed there is nothing certain, and everything is subject to speculation[2]

Future needs and valuations, the reaction of men to changes in conditions, future scientific and technological knowledge, future ideologies and policies can never be foretold with more than a greater or smaller degree of probability. Every action refers to an unknown future. It is in this sense always a risky speculation.

Two, the sheer prospects of black swan event (low probability, high magnitude impact) like Japan’s nuclear crisis always lurks somewhere.

Again, our understanding is always based on incomplete knowledge.

In contrast to the act of taking flight, doubts are where profits reside.

It’s basically a battle between the emotional and the rational. This is magnificently encapsulated by the Wall Street axiom “Bears and Bulls make money Pigs get slaughtered”.

Pigs get slaughtered because they depend on the amygdala to direct their actions. In short, when emotions hijack our rationality then we react senselessly and increase our risks.

Emotional Phases of Investing

The chart above illustrates how overconfidence or extreme depressions mark the inflection points of major market trends. In other words, when the consensus reveals certainty about a specific trend, that’s the time to take the classic contrarian stance—stay on the opposite side of the trade!

As author and economist the late Peter Bernstein wrote[3], (bold highlights mine)

In their calmer moments, investors recognize their inability to know what the future holds. In moments of extreme panic or enthusiasm, however, they become remarkably bold in their predictions; they act as though uncertainty has vanished and the outcome is beyond doubt. Reality is abruptly transformed into that hypothetical future where the outcome is known. These are rare occasions, but they are also unforgettable: major tops and bottoms in markets are defined by this switch from doubt to certainty.

Three, when dealing with the financial markets, it is the Emotional Intelligence (EI)—or the argued ability, capacity, skill or, in the case of the trait EI model, a self-perceived ability to identify, assess, and control the emotions of oneself, of others, and of groups[4]--that is essential.

The management of the emotions is critical to weighing risk-reward tradeoff.

Psychologist and author Daniel Goleman offers 4 main ways to manage Emotional Intelligence:

-Self-awareness – the ability to read one's emotions and recognize their impact while using gut feelings to guide decisions.

-Self-management – involves controlling one's emotions and impulses and adapting to changing circumstances.

-Social awareness – the ability to sense, understand, and react to others' emotions while comprehending social networks.

-Relationship management – the ability to inspire, influence, and develop others while managing conflict.

Thus when the stream of information suggests that the ensuing problems, like Japan’s nuclear crisis, are becoming less uncertain, what then we have is a transformation of uncertainty (immeasurable risk) to a quantified risk environment (measurable losses). Thus, the market starts to discount the ‘negative’ information.

And that’s why the effect of calamities on the financial markets has usually had limited impact[5].

Let me add that the problems that beset Japan today has been one of technical (how to control the risk of contamination from the affected nuclear power and the disaster rehabilitation or rebuilding) more than about sociology (social relations).

This makes the ongoing interventions in the Middle East by the Saudi Arabia-led GCC forces on Bahrain[6] and UN sanctioned military strikes in Libya[7] as having the probability of more lasting adverse impact than Japan because the MENA events represents social problems.

What would pose as the uncertainty factor would be the consequences or the possible unforeseen events from these interventions, e.g. how will Iran (Shiite) respond to Saudi’s (Sunni) aggressive actions given the sphere of influence conflict between Islam sect Shia-Sunni? Will Iran’s response be benign or will it provoke or parlay into a regional armed conflict which should drag the entire world with it?

The point here is to distinguish the source of uncertainty and ascertain how will it be resolved or dealt with. The events in itself do not constitute as market risks, it is the chain of 'stimulus-response' and 'action-reaction' based on the interpretations of the consequences of these events that constitutes as uncertainties or risks.

I close this with a quote from the great Professor Ludwig von Mises[8], (bold highlights mine)

In the real world acting man is faced with the fact that there are fellow men acting on their own behalf as he himself acts. The necessity to adjust his actions to other people's actions makes him a speculator for whom success and failure depend on his greater or lesser ability to understand the future. Every action is speculation. There is in the course of human events no stability and consequently no safety

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[1] Royal Air Force, On Field Discipline 2004

[2] Mises, Ludwig von VI. UNCERTAINTY: Uncertainty and Acting Chapter 6 Section 1, Human Action

[3] Bernstein Peter, quoted from A Study Of Market History And Valuation Through Graham And Buffett And Others By John Chew, istockanalyst.com

[4] Wikipedia.org Emotional intelligence

[5] See Will Japan’s Earthquake-Tsunami Be Market Bearish Or Bullish? March 13, 2011

[6] See Saudi Arabia Led GCC Intervention In Bahrain March 15, 2011

[7] See Fearing A Slap On The Face, UN Sanctions A No-Fly Zone, March 18, 2011

[8] Mises, Ludwig von VI. UNCERTAINTY: Case Probability; Chapter 6 Section 4 Human Action