Bad analogy

Or perhaps a very good one. Larry Elliott.

Picture the scene. A whizz-kid chemist from the food laboratory department provides a report to the chief executive of a leading supermarket. The boffins, he says, have developed a wonderful new pork pie, which is marvellously tasty and could make the company a mint.

The chief executive, who came from the finance department and knows far more about balance sheets than he does about pork pies, asks what the catch is. The only catch, the guy in the white coat replies, is that each pork pie contains a small amount of a toxic ingredient – but it is so tiny that there is no real risk. What\’s more, it is the toxic element that gives the pie its unique and irresistible flavour.

Given the all-clear by the board, the company starts selling pies by the shed load because, at first, they are hugely popular. All the other supermarket companies follow suit, and soon there is a full-blown craze for them. Warnings that there could be side-effects are ignored, and even when there are unconfirmed reports that people are starting to get sick, the supermarkets keep flogging them.

Eventually, customers die and the roof falls in.

This, of course, is an allegorical tale. The supermarket are the world\’s big banks. The pork pies are the unfathomable financial instruments that have poisoned the global markets. The boffins are the financial "rocket scientists" who constructed their complex – and useless – mathematical models to show that risk was infinitessimally small.

The reason it\’s a very bad analogy is that of course all pork pies do indeed contain small amounts of toxins. So does everything else in the world. As Paracelsus told us, it is the dose which is the poison.

Which of course makes it a very good analogy, for in every financial product there is indeed risk, just as there is toxin in every pork pie.

But that\’s not the way Larry wants us to take his analogy of course.

10 thoughts on “Bad analogy”

  1. And it is not that the risk was “infinitessimally small” – there were two, quite separate effects.

    One is that risk was spread, the second is that organisations could hide, in the sheer complexity of the instruments, that actually there were risk components which were quite high.

    Then, not obviously, the risk models did not allow for (actually, I’ll disagree with myself, did not bother to point out the impacts of) a generic downturn in the world economic situation – the credit ‘crunch’, the fall in residential property values in numerous major economies, the rise in global energy prices. Therefore the spread of risk has affected organisations worldwide – which was the point?

    So the derivatives market has done what it intended to – spread the pain worldwide. Okay, we are seeing more impact in London, New York and Tokyo than anywhere else but where are the world’s three largest financial markets – the places you would expect the risk-taking organisations to congregate?

  2. Given that similar and indeed far worse economic travails occured before complex derivatives products were introduced, may I kindly suggest that 99% of all pontificating on the current situation is absolute bollocks.

  3. @Surreptitious Evil
    the risk models ..( did not bother to point out the impacts of) a generic downturn in the world economic situation..

    This wasn’t news to most of the people who worked with them though. I did a brief stint in the IT department of a hedge fund and one of the traders summed it up as “..of course, in a falling market, everything gets correlated to shit..”

  4. How about an allegorical tale with some climate change “rocket scientists” who constructed their complex – and useless – mathematical models to show that risk was infinitessimally high?

    Oh sorry, that’s not a tale, it’s the IPCC.

  5. is anyone here old enough to recall the secondary banking crisis of 1973? Now the markets are so diversified that the systemic risk is much less. Those were truly scary times. The markets have shrugged off them collapse of major institutions. The markets have worked so far. They have upped their game since 1973. Murphy, Toynbee, and most financial journalists (presumably including Balls) have not progressed beyond 1929.

  6. “The markets have shrugged off them collapse of major institutions. The markets have worked so far.”

    And without any government intervention!

  7. “The markets have shrugged off them collapse of major institutions. The markets have worked so far.”

    And without any government intervention!

    Just don’t tell the Fed!

    The fact is that the derivatives market dwarfs the stock market by a magnitude. Risk may be spread, but it is also grown massively.

    So the Fed Reserve (read: the US Government) is trying to stop the dominoes from beginning to fall.

    I’d call that systemic risk…and its government intervention in the markets to prevent collapse.

  8. to continue the analogy an official food ‘ratings agency’ told everyone it was very important (and indeed low risk) to consume these pies, so huge amounts were made and stockpiled. Then it changed its mind and said that no-one should touch them. Then another agency said that all the supermarkets had to throw away their existing stocks of pies. Then the government came to help……

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