Disaster myopia in the economy

In an article yesterday in the Financial Times“Error-laden machine,” John Plender in part blames a phenomenon called “disaster myopia.”

Plender defines disaster myopia as “the tendency to underestimate the probability of disastrous outcomes, especially for low frequency events last experienced in the distant past.”

This sounds like a good term to describe the reason people live next to volcanos or in Los Angeles, as well as the thinking of many 23-year-olds who brag, “Don’t preach to me. I’ve been driving this way all my life, and I haven’t had an accident yet!”

But according to Plender, it also explains investor behavior over the past several years:

The risk of falling victim to this syndrome was particularly acute in the recent period of unusual economic stability known as the “great moderation”. Investors were confronted by falling yields against a background of declining volatility in markets. Many concluded that a new era of low risk and high returns had dawned. Their response was to search for yield in riskier areas of the market and then try to enhance returns through leverage, or borrowings.

Equally popular were trading strategies such as carry trades, which involved borrowing at low interest rates and investing at higher rates, especially via the currency markets. Favourite trades included borrowing in Japanese yen to invest in Australia or New Zealand, and borrowing in Swiss francs to invest in Icelandic assets.

This was dangerous because the interest rate spread could be wiped out in short order by volatile currency movements. Yet because volatility remained low for so long, disaster myopia prevailed. Carry traders were lulled into a false sense of security, while more sceptical competitors joined in for fear of underperforming.

Plender says disaster myopia is a term used by academics, which got me curious. Along with other references, I found that disaster myopia is covered in Asset Price Bubbles, edited by William C. Hunter, George G. Kaufman, and Michael Pomerleano.

AB — 4 March 2009

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