The end times, they ain’t what they used to be

Your humble blogger is taking a short vacation, because so much friggin’ stuff has happened in the past half-year.  Indeed, in 2011 to date, the planet has lived up to FP’s motto:  the world is not a boring place.  Wars, revolutions, natural disasters, non-natural disasters, the possibility of sovereign defaults — for a world politics junkie, it’s been very exciting

Does exciting mean the coming of end-times, however?  I ask because the New York Times’ Azam Ahmed observes the latest trendy investment —  Armageddon funds:

Since the financial crisis, many investors have prospered from a rebound in the markets. But recent events have led some to brace for the worst.

“Clients are suddenly realizing the world isn’t as rosy as it’s been,” said Ahmed Fattouh, a hedge fund executive. “It makes a lot of sense to have these tail protections on.”

That is, protections against what Wall Street calls “tail risk” — a disaster that is estimated to have less than half a percent chance of happening….

So how do such Armageddon funds work? Take a situation like the collapse of China’s economy, an event considered highly unlikely. While most American investors do not own Chinese stocks, real estate or currency, the fear is that a shock to China would spread to the rest of the world. As the stock markets fell, a tail risk or black swan fund would profit because it owned the options to sell shares in the Standard & Poor’s 500-stock index at far higher levels. The more the index dropped, the more valuable those options would become.

On a related note, Jay Ulfelder looks at the release of the 2011 Failed States Index and Admiral Mike Mullen’s worries about a possible increase in the number of failed states.  Ulfelder is more sanguine than Mullen:

So, is the world falling apart, or is it settling down? I’m cautiously confident that the optimists have this one right. To my mind, the trends Alan Taylor identifies are the start of the big development story of the 21st century. After a century in which the global political economy was primarily characterized by the yawning gap in wealth and power between the so-called First and Third Worlds, that gap is finally narrowing. Economic growth is accelerating in countries long mired in a “poverty trap,” and the economic and political benefits of that trend are extending to more and more of the world’s human population. Hundreds of millions of people still live in abject poverty, under authoritarian rule, or both, but the share of the global population living in deep poverty is notably lower than it was just a couple of decades ago (see the chart below, from the World Bank), and the economic takeoffs occurring in many long-poor countries suggest that trend is only broadening….

If things are generally looking up, why are people like Adm. Mullen (if I haven’t misunderstood his remarks) still so worried about the coming anarchy? In a bit of armchair psychology, I wonder if the admiral’s gloomy prognosis is partly a result of confusing uncertainty with risk. The encouraging development trends mentioned above are reordering politics at the international and national levels to a degree not seen in several generations, and no one knows when this turbulent period will end and what its results will be. People are inherently uncomfortable with uncertainty, and it seems like that discomfort often inflates our sense of the risk that worst-case scenarios will come to pass. In other words, our fear of dire outcomes seems to cause us to overestimate the probability that they will occur. In this particular case, I sure hope that’s right.

As pessimistic as I am about the ability of great powers to handle end times, I have to side with Ulfelder here.  Nicholas Taleb made a lot of coin by pointing out the ways in which tail risk events happened far more frequently than expected, but I do wonder if expectations of these events are now biased in the opposite direction.  There is a lot of uncertainty in the world — but uncertainty and catastrophic outcomes are not the same thing. 

That said, there is another possibility to consider.  From 1945 onewards, one could argue that the chief sources of uncertainty were located in the developing world.  The developing world is becoming more developed, and the developed world is becoming more politically sclerotic.  It’s possible that, moving forward, the OECD economies become the primary source of uncertainty — but this uncertainty doesn’t faze developing markets all that much. 

What do you think?