One area in which I'd like to give further thought is looking at the formal (logical) language in which we can discuss risk. First order predicate calculus seems too powerful. My gut feel is that first order multiplicative intuitionistic linear logic would be suitable. In this logic, when you have riskA and riskB, then there are things that can happen that are not just the standard interactions of riskA and riskB. For a physical analogy, consider entangled photons, which can arise when we physically have a state of two photons, but there is no way in classical physics that we can model what entangled photons do. In fact, in classical physics they can't exist. Quantum physics has a similar structure to intuitionistic linear logic. The possible states with two photons "photonA and photonB" are more than you can get by just looking at the individual states of photonA and photon B - "riskA and riskB" is different from "riskA and riskB" (See the difference in the logical operator? The "and" is not the same.)

Lots more thinking to do.

What is risk?

For some reason I've been involved in discussions, over the last couple of days, as to what risk is. Some say its an event, some describe it as an emergent process from a complex organisation (Milliman), ISO31000:2009 say it's the effect of uncertainty on objectives. I think we need to make sure that we don't have a category error creeping into our thinking. A suitably generic notion of risk is that it's exposure to something that may be disadvantageous in some way. We can then start from here.

Just-in-time and manufacturing declines

What happens if lots of companies have tightened up their supply chains to cut down on inventory costs, and the economy goes into a severe recession? The shock of lower sales should be transmitted through the supply chain much more quickly than it has been in earlier bad recessions. Maybe the big, sudden drop in manufacturing output is partly driven by this factor. In which case, what we're doing is getting to the bottom of the cycle much quicker than before.

With any luck, the bounce out will be equally quick. I'm not holding my breath.

Some Boards are getting up my nose!

It is very difficult for the general body of shareholders to affect the Board in any meaningful way. While nominally being elected by the shareholders, a Board is self-propagating unless something seriously bad happens.

Despite all the best will in the world, such an environment is dynamically unstable. A good Board would ensure it has regular external and independent reviews of its structure, capabilities, and mechanisms. It would embrace robust discussions at AGMs and would welcome feedback from shareholders and a constructive dialogue (with the shareholders' mostly determining what is constructive). Because of the dangers of ossification, there would be a regular turnover of Board membership.

This process is unstable because in the absence of shareholders being able to affect the Board, any sufficiently large departure of the Board from its exacting standards causes its self-correction mechanisms to fail. Self-serving rationalisations can be made for why the independent Board review got it wrong, or the Board reviewer may not be changed regularly enough and so loses their external and independent nature (no matter how good you are, a close working relationship over a number of years destroys the independence - we have tons of psychological evidence for this in general, and I can't see why Board reviewing (and company auditing for that matter) would be any different). A small departure from good behaviour allows slightly larger departures, and so on in ever widening spiral of departure from best practice. And all the time the Board is arguing it's doing a good job, and steadily entrenching themselves - for the good of the company! And they believe it.

OK, so how to fix it. We know how - a mechanism whereby the beneficiaries of the company (the owners) can exercise control over the executive function, which is essentially by electing the Board. While I object to some of the activities of proxy advisors, they are doing a good job by getting more coordinated action by the end shareholders.

A nice piece from the FT on the level of losses from the "AAA" rated tranches of the sub-prime linked CDOs. There is still going to be a lot more losses to be revealed presumably.

http://www.ft.com/cms/s/0/2970532c-0421-11de-845b-000077b07658.html

Case-Shiller index

The Case-Shiller index for house prices shows a marked difference between the 10 cities with the highest returns between 2002 and 2005, and the 10 cities with the lowest returns over that period. (Index values as released at 24 Feb 09)

It's obvious that in the "non-boom" cities the price declines have been much more muted than in the boom cities. What is worrying is that the recession has now hit the prices of cities that didn't boom. Declines in these prices is now as fast as for the boom cities.

But the behaviour of the non-boom cities was also more muted back in the early 1990s. We definitely have a heterogenous group of cities.

Copies of spreadsheet available for those interested.

Keynes and the Great Depression

With all the mention of JM Keynes and his analysis of the 1930s Depression, it's interesting to note that his father was on a Royal Commission analysing the 1890s economic depression.