Volatility And The Allegory Of The Prisoner’s Dilemma

Volatility And The Allegory Of The Prisoner’s Dilemma

Volatility And The Allegory Of The Prisoner’s Dilemma: False Peace, Moral Hazard, and Shadow Convexity

Dorothy Thompson once said “peace is not the absence of conflict”. Never forget there is a form of peace and stability reinforced by a foundation of underlying volatility. Game theorists call this the paradox of the Prisoner’s Dilemma, and it describes a dangerously fragile equilibrium achieved only through brutal competition. The Prisoner’s Dilemma is the most important paradigm for understanding shadow risk in modern financial markets at the pinnacle of a multi-generational debt cycle unparalleled in the history of finance.

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In their masterwork tapestry entitled ”Allegory of the Prisoner’s Dilemma” the artists Diaz Hope and Roth visually depict a great tower of civilization that rests upon a bedrock of human cooperation and competition across history. The artists force us to confront the fact that after 10,000 years of human civilization we are now at a cross-roads. Today we have the highest living standards in human history that co-exist with an ability to destroy our planet ecologically and ourselves through nuclear war. We are in the greatest period of stability with the largest probabilistic tail risk ever. The majority of Americans have lived their entire lives without ever experiencing a direct war and this is, by all accounts, rare in the history of humankind. Does this mean we are safe from the risk of devastating conflict on our own soil? In 1961, at the height of the Cold War, a B-52 bomber carrying two Mark 39 thermonuclear bombs accidentally crashed in rural North Carolina. A low technology voltage switch was the only thing that prevented a 4-megaton nuclear bomb with 250 times the yield of the bomb dropped on Hiroshima from detonating on American soil. In addition to killing everyone within the vicinity of the blast, the winds would have carried radioactive fallout over Washington D.C., Baltimore, Philadelphia, and New York City”). It is not inconceivable to imagine that, at the height of cold war, a weapon of that magnitude exploding randomly on the eastern seaboard would have triggered immediate accidental retaliation against the Soviets resulting in full scale Armageddon and the end of humankind as we know it. This is just one of many nuclear accidents during the cold war. Peace has a dark side. Peace can exist due to hidden conflict in the Prisoner’s Dilemma.

Global Capitalism is trapped in its own Prisoner’s Dilemma; forty four years after the end of the Bretton Woods System global central banks have manipulated the cost of risk in a competition of devaluation leading to a dangerous build up in debt and leverage, lower risk premiums, income disparity, and greater probability of tail events on both sides of the return distribution. Truth is being suppressed by the tools of money. Market behavior has now fully adapted to the expectation of pre-emptive central bank action to crisis creating a dangerous self-reflexivity and moral hazard. Volatility markets are warped in this new reality routinely exhibiting schizophrenic behavior. The tremendous growth of the short volatility complex across all assets, combined with self-reflexive investment strategies, are creating a dangerous ’shadow convexity’ that will fuel the next hyper-crash. Central banks in the US, Europe, Japan, and China now own substantial portions of their own bond or equity markets. We are nearing the end of a thirty year “monetary super-cycle” that created a ”debt super-cycle”, a giant tower of babel in the capitalist system. As markets now fully price the expectation of central bank control we are now only one voltage switch away from the razors edge of risk. Do not fool yourself – peace is not the absence of conflict – peace can exist on the very edge of volatility.

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Prisoner’s Dilemma describes when two purely rational entities may not cooperate even if it is in their best interests to do so, thereby replacing known risks for unknown risks. In an arms race when two superpowers possess the ability to destroy each other, the optimal solution is disarmament and peace. If the superpowers do not trust one another completely, the natural course of action is proliferation of conflict through nuclear armament despite great peril to all. This non-cooperation, selfishness, and conflict, ironically results in an equilibrium of peace, but with massive risk.

Global central banks are engaged in an arms race of devaluation resulting in suboptimal outcomes for all parties and greater systemic risk. In this year alone 49 central banks have cut rates or devalued their currencies to gain a competitive edge and since 2008 there have been over 600 rate cuts worldwide”). Globally we have printed over 14 trillion dollars since the end of the financial crisis”). The global economy did not de-leverage from the 2008 crash but instead doubled down as global debt has increased a staggering 40% since 2007(4). The pace of global growth is slowing with the World Bank lowering GDP projections from 3% to 2.5%, and emerging economies from China to Brazil are struggling“). Global currency reserves outside the US have declined over $1 trillion USD from their peak in August 2014 as foreign central banks have sold dollars to offset the ill effects of capital flight and commodity declines). The last time the world economy experienced declines in reserves of this magnitude was right before the crash of 2008. Cross-asset volatility is rising from the lowest levels in three decades yet markets remain complacent with the expectation that central banks will always support asset prices. Volatility regime change is happening now and is a bad omen for a global recession and bear market.

As global central banks compete in an endless cycle of fiat devaluation an economic doomsday clock ticks closer and closer to midnight. The flames of volatility regime change and an emerging markets crisis ignited on the mere expectation of a minor increase in the US federal funds rate that never came to be. The negative global market reaction to this token removal of liquidity was remarkable. Central banks are fearful and unwilling to normalize but artificially high valuations across asset classes cannot be sustained indefinitely absent fundamental global growth. Central banks are in a prison of their own design and we are trapped with them. The next great crash will occur when we collectively realize that the institutions that we trusted to remove risk are actually the source of it. The truth is that global central banks cannot remove extraordinary monetary accommodation without risking a complete collapse of the system, but the longer they wait the more they risk their own credibility, and the worse that inevitable collapse will be.

In the Prisoner’s Dilemma, global central banks have set up the greatest volatility trade in history.

Volatility And The Allegory Of The Prisoner's DilemmaVolatility And The Allegory Of The Prisoner's Dilemma 3

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