March 19, 2011
By JEFF SOMMER
THE risks are clear enough in hindsight.
The Tokyo Electric Power Company built its Fukushima Daiichi nuclear power plant, nearly 40 years ago, to withstand a powerful earthquake — but not one as big as the 9.0-magnitude quake that struck on March 11. Or the tsunami that followed. Now, the terrible “ifs” accumulate, as Japanese engineers work to bring the station’s reactors under control. The ultimate price, in human life, may not be known for years.
The details of this catastrophe were unforeseeable, leading some to conclude this was a black swan event — something so wildly unexpected, so enormous in its impact, that it seems to defy our understanding and expose the fragility of our knowledge of the world. How could anyone have predicted this?
And yet in 2007, Tokyo Electric Power, or Tepco, escaped a disaster at its huge Kashiwazaki-Kariwa nuclear power station, on the opposite side of Japan, when that plant was damaged by a 6.8-magnitude earthquake — three times as large as what the plant was designed to withstand. Tepco basically lucked out last time.
So perhaps a bigger question is whether the markets — in which we have come to place so much trust — can put a true price on outsize risks like this.
Many have compared the events unfolding in Japan with 9/11, Hurricane Katrina, the financial collapse of 2008 and 2009, the BP oil spill, and the uprisings in the Arab world — in that all have shown the limits of the collective wisdom of the marketplace. For a moment, all the swans seemed black. And those swans seemed blacker still when viewed through the lens of today’s hyperkinetic global markets.
“There are an amazing number of crosscurrents in the world economy right now, more than I’ve seen in 25 years,” said Shawn Reynolds, a co-portfolio manager at Van Eck Associates in New York.
Like everyone else, corporate executives, economists and financial analysts in Tokyo, New York, London and beyond struggled last week to wrap their heads around the scale of this disaster. But, as they so often do, the analysts quickly fell to work assessing the implications for companies, markets and economies. At times, it was almost surreal: On Tuesday, Laszlo Birinyi, a prominent stock market analyst based in Westport, Conn., e-mailed around a succinct report titled “Nuclear Meltdowns at a Glance.”
This is what happens on Wall Street. If you’re not immersed in the culture, it might be hard to understand the cool calculus that is applied to world events, however dire those events might be. After the quake hit on March 11, the CNBC anchor Larry Kudlow told viewers, “The human toll here looks to be much worse than the economic toll, and we can be grateful for that.” He later apologized.
As the week wore on, and prices were gyrating on everything from a share of I.B.M. to a ton of copper, everyone was making back-of-the-envelope calculations. There is still no clear consensus about how far the economic shocks will reverberate. Many analysts are guessing — and then second-guessing — how the disaster will play out in northeast Japan. The first, tentative analysis seemed painfully obvious: the Japanese economy, already weak, perhaps already in a recession before calamity struck, will become even weaker.
On Friday, the Group of 7 industrialized nations took the rare step of intervening on the world’s foreign exchange markets to stem a sudden rise in the value of the yen. The currency had soared all week against the dollar — the exact opposite of what you might expect. But Japanese companies and investors were bringing their money home, to pay for huge rebuilding costs.
After its most harrowing week since the 1987 market crash, the Tokyo Stock Exchange found its footing on Friday. But it was a week like few others on the exchange: the Nikkei 225 stock index, Japan’s equivalent of the Dow Jones industrial average, fell 6.2 percent on Monday, plunged 10.5 percent on Tuesday, rebounded 5.7 percent on Wednesday and sank 1.4 percent on Thursday. It closed up 2.7 percent on Friday, at 9,206.75.
The loss for the week totaled 1,048 points, or 10.2 percent.
IF you happen to visit a Wall Street trading floor, walk over to the nearest Bloomberg terminal, type “WRST” and hit the green key that says “go.”
WRST — that is short for “worst,” as in, “worst-case scenario.” The program enables Wall Street types to measure the level of risk in their investment portfolios under a variety of scary circumstances modeled on past crises, including the attacks of Sept. 11, 2001, the bankruptcy of WorldCom in 2002 and the devaluation of the Thailand’s currency, the baht, in 1997.
Such “what if” scripts are the stuff of modern Wall Street. Everyone runs them. Entire schools of financial analysis are devoted to examining historical market patterns in the belief that those patterns can predict the future.
Such analysis, of course, depends on — and perhaps even encourages — our belief that tomorrow will be much like today. And all that despite the fine-print caveat on your 401(k) statement that reads, “Past performance is no guarantee of future success.”
Nassim Taleb, the author and market theorist who popularized the phrase “black swan” in his 2007 best seller, argues that we have psychological biases that blind us to the enormous role played by rare events — like a 9.0-magnitude earthquake. And yet we rely on history for guidance. On Wednesday, Mr. Birinyi’s research firm sent out another report, this one titled “S.& P. 500 Enters Modest Correction.” His firm predicted a slight decline in the American stock market.
“If the averages hold,” the report said, “the S.& P. 500 will bottom at 1,232 on 3/31/11.” On Friday, the S.& P. 500 closed at 1,279.19, down 1.9 percent for the week.
Whatever else they may be, markets are immensely complex counting machines. They assign values to products, whether computer chips or potato chips, based on the canny appraisals and gut beliefs of people around the planet. From day to day, it is often hard, if not impossible, to know exactly why a certain price moved the way it did. Those daily movements are often just the white noise of global capitalism.
Then there are stretches of extreme volatility, periods when no one quite seems to agree about where anything is going. That may be part of what occurred last week: in the face of such a disaster, not even a short-term trend could congeal.
As yet, no one has reliable numbers about the scope of the destruction, said Al Tobin, who heads the property practice at Aon Risk Solutions, the risk management brokerage business of the Aon Corporation. The human toll, the economic toll — “no one knows the answer to that question,” he said.
Given such uncertainty, the markets could remain even more volatile than usual, said Mohamed A. El-Erian, chief executive of Pimco, the world’s largest bond manager. “The market right now is trying to wrap its arms around the enormity,” he said.
The verdict is not yet in.
Mr. El-Erian divided market strategists into two camps. The first, he says, views the events in Japan as “more than just a massive human tragedy; it also has significant implications for the global economy.” The second, he says, believes that the effects of this disaster, however heart-rending, will be transitory for most of us.
But he doesn’t yet know which camp is right. “I don’t understand it fully yet,” he said, “but I am worried about it.”
Big economic questions remain unanswered. How would a severe slowdown in Japan, the world’s third-largest economy, affect the rest of the globe? How will Japan, which is already deeply in debt, pay for the reconstruction? Some are already arguing that the enormous, high-cost task of rebuilding could, over time, snap Japan out of its long economic funk.
MARKET strategists pride themselves on being able to digest vast quantities of data quickly. They tend to be practical and versatile people, the kind who can put aside emotions and philosophical questions when business calls.
On Thursday, a sunny St. Patrick’s Day in Manhattan, Jonathan Golub, the chief equity strategist for the giant Swiss bank UBS, said he was trying to master some of the intricacies of nuclear technology. “Now I find myself talking about fuel rods and cooling pools,” he said. It was, he said, not an uncommon type of experience: Before the financial crisis, even many people on Wall Street didn’t quite know what a credit default swap was. Before long, everyone was throwing around terms like “swaps” and “C.D.S.”
Mr. Golub said he felt for the people of Japan. He then went on to say, at a news briefing, that once the current market volatility subsided, this crisis should have only a marginal impact on America’s economy and stock market, whose prospects were quite good. He predicted that the S.& P. 500 would reach 1,425 by the end of the year.
Still, because supply chains have gone global like so much else, the disaster has already had a very real impact in the United States. Last week, Subaru slowed operations of its auto plant in Indiana because it could not obtain key parts from Japan. General Motors said it would shut a truck plant in Louisiana because of a shortage of parts. The semiconductor industry has also slowed because Japan is a major supplier of silicon wafers and other components.
Despite its position as the world’s No. 3 economy, Japan actually accounts for a relatively small — and shrinking — amount of the world’s collective economic output. It contributes about 9 percent of global gross domestic product, down from about 18 percent in the 1990s. And because of the rapid acceleration of the so-called BRIC countries — Brazil, Russia, India and China — and of other emerging markets, Japan’s contribution to growth of global G.D.P. is marginal.
Lakshman Achuthan, the managing director of the Economic Cycle Research Institute, a private forecasting group with an excellent track record, says that Japan’s economy, which he believes is already in recession, won’t appreciably affect the direction of the economy in the United States. The disaster, however, “ensures that Japan is in a recession,” he said.
All of this, of course, assumes that the nuclear disaster, already the biggest since Chernobyl, doesn’t get too much worse.
THE financial markets have always had a difficult relationship with nuclear power, largely because the costs — and potential risks — associated with nuclear plants are so huge. Day to day, nuclear power is cheap. But it is unclear how to accurately assess the cost of disposing of nuclear waste over the long run — or, perhaps, the cost of disasters like the one in Japan.
Robert N. Stavins, a professor at the Kennedy School of Government at Harvard and director of the university’s environmental economics program, has studied this issue for years. In an article in the centennial edition of the American Economic View in February, Professor Stavins said that economists had not yet solved the “tragedy of the commons,” the quandaries that arise when many people, acting in their own self-interest, ultimately pose a threat to the common good. For instance, how should we allocate environmental costs to power producers? How should the environmental costs of various fuels — fossil or nuclear — be calculated?
So far, the markets seem to have failed to provide an answer to all of those questions. A National Research Council study last year tallied up environmental costs for various fossil fuels but did not even try to do so for nuclear power because the “power-plant risk modeling and spent-fuel transportation modeling” required was beyond the scope of the council’s study.
In the United States and elsewhere, governments have capped the liability of nuclear power producers. As a result, Professor Stavins said, “You can argue that the markets have never really had a chance to price nuclear power.”
In the face of black swans — also known as fat-tail events, for the way their occurrences are distributed along a probability curve — market pricing may be impossible.
Martin Weitzman, another Harvard economist, wonders, for example, how Wall Street or anyone else could place an accurate price on the risk that an asteroid would crash into a major population center. In a controversial mathematical proof called, perhaps appropriately, the Dismal Theorem, he found that “it’s very hard to make reliable inferences about rare events on the tails of probability distributions.”
Is the nuclear disaster under way in Japan such a rare event, one that economists cannot accurately price? It is too early to say, Professor Weitzman said. “It might be.”
IT has been more than 30 years since Three Mile Island, and 25 since Chernobyl.
In the ensuing years, one nuclear plant was completed in the United States and shut down before ever going into commercial operation. That was the Shoreham plant, on Long Island, which cost roughly $6 billion. Its fate was decided in 1989, when state officials concluded that Long Island could never be evacuated in case of a disaster.
The Fukushima accident has already caused a temporary slowdown in the nuclear industry. Officials in India and China said last week that they would re-evaluate their plans for building plants. Germany announced that it would temporarily shut seven nuclear plants that went online before 1980. The European Union made plans to test all the other nuclear power plants within its member countries.
In the United States, President Obama, who has promoted building new nuclear power plants, asked the Nuclear Regulatory Commission last week to review the safety of all United States plants.
However imperfectly, the market will pass judgment.
Mr. El-Erian of Pimco says the outlook is unusually uncertain. Investors, like everyone else, should understand that the world is a risky place.
“You need to use a whole range of approaches to understand the market in a situation like this,” he says, “and you need to be humble.”
And, perhaps, accept a sober reality: the next black swan is out there somewhere.
March 15, 2011
