Behold, the Black Swan: Updated

Economist Nassim Nicholas Taleb, author of Black Swan (2007), interviewed on PBS’s “The News Hour” on Tuesday, October 21, said:

The banking system, the way we have it, is a monstrous giant built on feet of clay.  And if that topples, we’re gone.  Never in the history of the world have we faced so much complexity combined with so much incompetence and understanding of its properties. . . We live in a world that is way too complicated for our traditional economic structure (Italics added).  It’s not as resilient as it used to be.  We don’t have slack.  It’s over-optimized. . . Of all the books you read on globalization, they talk about efficiency, all that stuff.  They don’t get the point.  The network effect of that globalization means that a shock in the system can have much larger consequences.

A “Black Swan” event, according to Taleb, is one considered impossible, because no one ever thought of it.

Alan Greenspan, former Fed chairman, testified before the House Committee on Oversight and Government Reform, on Thursday, October 23:

“Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact. . .This modern risk-management paradigm held sway for decades.  The whole intellectual edifice, however, collapsed in the summer of last year. . .This crisis has turned out to be much broader than anything I could have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount.”

Behold, the Black Swan.

UPDATE: New York Times’ columnist, David Brooks’ (previously quoted in this blog) latest piece (27 October) devotes the majority of the column to Nassim Taleb’s economic metaphor of a Black Swan event unfolding before us:

Taleb believes that our brains evolved to suit a world much simpler than the one we now face. His writing is idiosyncratic, but he does touch on many of the perceptual biases that distort our thinking: our tendency to see data that confirm our prejudices more vividly than data that contradict them; our tendency to overvalue recent events when anticipating future possibilities; our tendency to spin concurring facts into a single causal narrative; our tendency to applaud our own supposed skill in circumstances when we’ve actually benefited from dumb luck.

And looking at the financial crisis, it is easy to see dozens of errors of perception. Traders misperceived the possibility of rare events. They got caught in social contagions and reinforced each other’s risk assessments. They failed to perceive how tightly linked global networks can transform small events into big disasters.

Hear, hear!

This concept of “social contagions” and “risk assessment reinforcement” has been explored in organizational theory (now, don’t glaze over on me, here).  Selznick, writing in 1996, termed this process “mimesis” (as in mime) and that it is a response to uncertainty.  The more uncertainty, the more institutions rely on a single model of operating that is perceived as successful.  But there is another side to this.  Organizations, over time, begin to believe their own myths. He wrote:

“In postindustrial society, formal structures, ‘dramatically reflect the myths of their institutional environments instead of the demands of their work activities.’  Furthermore, ‘the more an organization’s structure is derived from institutional myths, the more it maintains elaborate displays of confidence, satisfaction and good faith, internally and externally‘” (quoting Meyer and Rowan, 1991). (Italics added)

For example, a Lehman Brothers myth was they could weather any financial storm, and so they maintained the “elaborate display of confidence” that they could manage their way out of anything, no matter how high the risk.  Or take an AIG, whose myth was they were too big to fail, so pushed fearlessly into derivatives because, well, they were too big to fail.  Risk assessments were trivial or even a barrier to higher profits.

As Taleb points out in The Black Swan, the turkey believes in its personal myth that is has the best of all worlds as it feeds daily without concern, until the Wednesday before Thanksgiving Day.

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