Surviving the Black Swan

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA
Who, if anyone, can say “I told you so” a year after the fall of Lehman Brothers? There is actually one person, believe it or not: Nassim Taleb, author of “Fooled by Randomness and The Black Swan: The Impact of the Highly Improbable.” Taleb is a researcher, a one-time successful derivatives trader, and lately a quant (a practitioner of mathematical finance) and a financial philosopher of sorts. For about 10 years, Taleb wrote extensively about the global economy and how susceptible it is to unpredictable, yet singularly catastrophic events (i.e. black swans). He is also probably the one and only person who foresaw the blackness of the credit crunch swan that threatened to devour us for breakfast about a year ago.

 

Since he became a full-time author and scholar, Taleb has switched his focus to studying the philosophy of randomness and its role in history on science and society. He is particularly interested in what he calls the “black swans,” or the high-impact random events that may be fortunate, but are more often than not quite unfortunate. He believes that the possibility of black swans does not scare people, because black swans are invisible in our highly structured, ordinary and, easily comprehensible world until they stretch their wings. He calls this willful blindness the “Platonic fallacy” that distorts our reality and leaves us utterly unprepared for micro- and macroeconomic, geopolitical and even actual tsunamis.

To give you just a taste of his reasoning, here is an excerpt from “The Black Swan,” which he published in 2007, warning of the global banking crisis: “Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans.

We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks — when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen, they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur…I shiver at the thought.

The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: Their large staffs of scientists deem these events ‘unlikely.'”

Taleb is still wary and quite certain that the global financial systems have not purged themselves from evils past. Additionally, according to Taleb, while the fall of Lehman Brothers clearly belongs to the category of black swans, the financial crisis, which served as a trigger for the former, actually does not. Leverage has been building up in the global systems at unprecedented rates and in phenomenal amounts since 1980. It’s just that central bankers chose to ignore it. And not only that, but they also chose to ignore the monstrous build-up of risk-taking.

Taleb’s reasoning seems to be going along with mine, doubting that all those bailouts that were pumped into the financial and credit systems were the best solution for the crisis. But, unlike me, who didn’t have the guts to promote the blood, sweat and tears alternative openly, Taleb was a huge proponent of the “suck-it-up” strategy. He explains that the economic growth rates within developed companies have largely been carried by excess debt and maintaining the perpetually fragile balance between the foreign debt and domestic consumption, thus creating only the illusion of growth. What central bankers and politicians should have done was swallow their pride, swallow the losses, purge themselves from “growth fakers,” endure a decade or so of punishment and humiliation, and move on.

For obvious reasons, it is too late to change the events and decisions made in the past year or so, but what about going forward? Taleb has a vision about that, too, one that involves creating a system that is not prone to human errors, which will create a society not prone to risks. One of the first steps would be to ensure that no financial institution is too big to fall. Also, governments must abandon their love affair with big corporations and infatuation with economists. According to Taleb, economists these days are the new astrologers, with a similar success rate, only capable of doing so much more damage.

Surviving the Black Swan

Who, if anyone, can say “I told you so” a year after the fall of Lehman Brothers? There is actually one person, believe it or not: Nassim Taleb, author of “Fooled by Randomness and The Black Swan: The Impact of the Highly Improbable.” Taleb is a researcher, a one-time successful derivatives trader, and lately a quant (a practitioner of mathematical finance) and a financial philosopher of sorts. For about 10 years, Taleb wrote extensively about the global economy and how susceptible it is to unpredictable, yet singularly catastrophic events (i.e. black swans). He is also probably the one and only person who foresaw the blackness of the credit crunch swan that threatened to devour us for breakfast about a year ago.

 

Since he became a full-time author and scholar, Taleb has switched his focus to studying the philosophy of randomness and its role in history on science and society. He is particularly interested in what he calls the “black swans,” or the high-impact random events that may be fortunate, but are more often than not quite unfortunate. He believes that the possibility of black swans does not scare people, because black swans are invisible in our highly structured, ordinary and, easily comprehensible world until they stretch their wings. He calls this willful blindness the “Platonic fallacy” that distorts our reality and leaves us utterly unprepared for micro- and macroeconomic, geopolitical and even actual tsunamis.

To give you just a taste of his reasoning, here is an excerpt from “The Black Swan,” which he published in 2007, warning of the global banking crisis: “Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans.

We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks — when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen, they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur…I shiver at the thought.

The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: Their large staffs of scientists deem these events ‘unlikely.'”

Taleb is still wary and quite certain that the global financial systems have not purged themselves from evils past. Additionally, according to Taleb, while the fall of Lehman Brothers clearly belongs to the category of black swans, the financial crisis, which served as a trigger for the former, actually does not. Leverage has been building up in the global systems at unprecedented rates and in phenomenal amounts since 1980. It’s just that central bankers chose to ignore it. And not only that, but they also chose to ignore the monstrous build-up of risk-taking.

Taleb’s reasoning seems to be going along with mine, doubting that all those bailouts that were pumped into the financial and credit systems were the best solution for the crisis. But, unlike me, who didn’t have the guts to promote the blood, sweat and tears alternative openly, Taleb was a huge proponent of the “suck-it-up” strategy. He explains that the economic growth rates within developed companies have largely been carried by excess debt and maintaining the perpetually fragile balance between the foreign debt and domestic consumption, thus creating only the illusion of growth. What central bankers and politicians should have done was swallow their pride, swallow the losses, purge themselves from “growth fakers,” endure a decade or so of punishment and humiliation, and move on.

For obvious reasons, it is too late to change the events and decisions made in the past year or so, but what about going forward? Taleb has a vision about that, too, one that involves creating a system that is not prone to human errors, which will create a society not prone to risks. One of the first steps would be to ensure that no financial institution is too big to fall. Also, governments must abandon their love affair with big corporations and infatuation with economists. According to Taleb, economists these days are the new astrologers, with a similar success rate, only capable of doing so much more damage.