Tuesday, September 30, 2008

The Black Swan

Since we seem to be headed into the Black lagoon, I am reminded of the Black Swan. If you don't know what a Black Swan event is, here is some background from the Observer:

The New Sage of Wall Street
The trader turned author has emerged as the guru of the global financial meltdown. Not only is he riding high in the bestseller lists, his theory of black swan events has become the most seductive guide to our uncertain times
The Observer,
Sunday September 28 2008
Edward Helmore

On Friday afternoon, Nassim Nicholas Taleb could be found on the veranda of a hotel bar in Louisville, Kentucky, knocking back bourbon in the warm afternoon sunlight. No wonder the Lebanese-born trader turned author feels like relaxing: his book, The Black Swan: The Impact of the Highly Improbable, has become a huge success. A book of economics and philosophy, it's found a vast audience, speaks to its time and has become something of a key text to help understand the crisis in market capitalism. (clip)

Taleb's central thesis is that a small number of unexpected events - the black swans - explains much of import that goes on in the world. We need to understand just how much we will never understand is the line. 'The world we live in,' he likes to say, 'is vastly different from the world we think we live in.'

The title refers to the medieval belief that all swans were white, hence black swan was a metaphor for something that could not exist, a metaphor that shifted into a perceived impossibility that came to pass when black swans were discovered in the 17th century. (clip)

We are, he believes, suckers. 'The tools we have to understand what's happening on Wall Street were developed over the last couple of centuries,' he told the audience at Kentucky's Idea Festival last week. 'We need new tools. We will have to finance the losses because of a huge misunderstanding.'

That misunderstanding, he explains in his book, is partly based on our belief that bankers and financial analysts are somehow blessed with superior knowledge. While 'peasants know they can't predict the future', Wall Street bankers believe they can.

In his estimation of the scale of the disaster: 'The banking system, betting against black swans, has lost more than $1 trillion - more than was ever made in the history of banking.' (clip)

In Taleb's coinages, most people live in 'Mediocristan,' a fake model of reality where no rare events occur, and not in 'Extremistan', the complex real world where unpredictable and devastating events can dictate the outcome.

One of Taleb's favourite allegorical tales is the story of the turkey and the butcher. As previously described by Bertrand Russell, a turkey may get used to the idea of being fed but when, the day before Christmas, it is slaughtered, it will incur 'a revision of belief'. (clip)

To establish his credentials as sage of our current predicament, Taleb frequently refers to an August 2003 article in the New York Times in which he correctly predicted the quasi-governmental US insurance giant Fannie Mae had underestimated the risk of a rise in interest rates that would destroy the value of their portfolios. 'The fact that they have not blown up in the past doesn't mean that they're not going to blow up in the future,' he said. 'The math is bogus.' (clip)

'Economics is a tragedy for me. Because look at how the whole world now is designed according to some ideas that have not proved adequate. The whole financial system. We don't understand economic policy, do you realise that? (clip)

In other words, while most human thought has focused us on how to turn knowledge into decisions, Taleb is interested in how to live in a world we don't understand very well, how to turn lack of information, lack of understanding, and lack of "knowledge" into decisions."

How not to be a "turkey",

When the Black Swan lands on your pond.

Then again, some might say this is no black swan.
No, it is more like a rooster that has come home.

It's a predictable natural result of risky loans and easy money,

and the kind of deregulated wild west banking environment

that pretty much always leads to disaster.

It's what you should expect from a banking industry

that drops lending standards,

securitises bad loans without transparency

and sells them on to massively leveraged institutions and hedge funds.

No wonder no one wants to vote for this icky bail out.

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Anonymous Anonymous said...

Love the "rooster coming home to roost" metaphor...

We sure don't understand energy economic policy either!! Maybe the good thing that will come of the global economic meltdown is that we will get a new story of economics that supports a healthy global climate, environment and energy use.


12:18 PM  

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