Regime Change, Nixon Shock and Mechanics of Extremistan

Sunday witnessed a crucial geopolitical event happening in the neighbouring region of northern India. The event was regime change in Afghanistan post US withdrawal from the country. As geopolitics and economy are intricately connected in myriad ways the development becomes worthy of attention and follow up analysis. Also the suddenness with which the whole chain of events unfolded have important lessons for all of us. The US intelligence assessment before departing the country was that regime change will take around 90 days, US President Biden had even denied such possibility a few days back in a press conference. For it to happen within 3 days was a surprise to put it mildly.

This brings us to the topic of discussion today. Many phenomena like regime change, virus spread, collapse of a company happen on an exponential time scale, which is difficult to grasp intuitively as our minds are programmed to think on a linear time scale not exponential. This is what happened last year when the spread of virus led to a worldwide lockdown or the Lehman collapse during the 2008 GFC. In the book The Black Swan, author and modern philosopher Nassem Taleb introduces us to the concept of mediocristan and extremistan. Taleb describes that mediocristan is a land where things work on the average. Here the things are predictable because all the events follow the gaussian probability curve, you can compute the probability and tail events do not happen. In such a world you can sleep peacefully without being concern of shock hitting you in the night. Extremistan on the other hand is a world where rare and extreme events happen with uncanny regularity, there is no normal gaussian curve to rescue. Things are inherently unpredictable.

The problem which Taleb highlights is that while the modern world extremistan characteristics, the people and the risk managers want to believe that they live in mediocristan and hence the rare and sudden events won't happen. When in 2008 the credit lines to Lehman were cut off amid the concern about its quality of assets and which forced it to fold up, it was not an orderly and linear movement. The flight to the safety door is mostly chaotic and no one could have predicted who would be the next one to fall (until the white knight i.e. Bernanke?came to the rescue). A decade earlier to the GFC, the east asian currency crisis and the LTCM collapse also were sudden and swift,without any warning. From the geo political space, events like the fall of Berlin wall or Arab spring had similar qualities. The essential point which Taleb makes is that our risk sensors should be heightened in extremistan and apparent lack of activity should not dull us into believing that everything is fine. Equities can only go up, currencies can only flex within a band and bond yields are always docile, these are the myths concocted by media chatter and not by some fundamental law. One practical implication of such insight is that option premia as calculated by Black Scholes which uses Gaussian curve as a base, misprice the optionality premium on downside. We live in extremistan believing that it is mediocristan hence the disconnect.

Now an interesting trivia, the regime change event happening on 15th August 2021 has a poignancy from the date aspect. Yesterday was the 50th anniversary of the Nixon shock. Nixon shock was a televised address by the then US President Nixon announcing that the US was reneging on the promise of US Dollar conversion to gold (it was also a sunday evening). This promise which was the result of Brettonwoods negotiation was the primary reason for US ascendancy as a reserve currency. The announcement was also sudden and came as a shock for the US trading partners. The day marked the start of the free floating currency regime from apparent stability?of fix exchange rates. In extremistan,the stability of the past is a dangerous refuge to predict the future, Caveat Emptor as they say!