Sunday, April 20, 2008

On Black Swans

"In two bestselling books, Fooled by Randomness and The Black Swan, Nassim Nicholas Taleb has explored the ways people misunderstand randomness and risk. ... What I call a Black Swan is a surprise event--like the discovery of the black bird in Australia, which was unpredicable because swans in the Old World were all white. But unlike the bird, my Black Swan carries large consequences. ... Your dentist's income will not disappear on a single day: No single event will carry big consequences for her. ... The Black Swan is a matter of perspective. A turkey is fed for 1,000 days--every day lulling it more and more into the feeling that the human feeders are acting in its best interest. ... Anyone who knows anything about the history of banking (or remembers the 1982 Latin American debt crisis of the 1990s savings and loan collapse) will tell you that the subprime crisis was bound to happen. Banks are exposed to such blowups. Bankers have been the turkey historically. ... I've been telling anyone willing to listen that banks have a tendency to sit on time bombs while convincing themselves that they are conservative and nonvolatile. ... It is the 'science' of risk management that effectively turned everyone involved into a turkey. ... We replaced so much experience and common sense with 'models' that work worse than astrology, because they assume that the Black Swan does not exist. Trying to model something that escapes modelization is the heart of the problem. We like models because they do not require experience and can be taught by a 33-year-old assistant professor. Sometimes you need to say, 'No model is better than a faulty model' ... Let me blame the business schools and the financial economics establishment--they have a vested interest in promoting models and devaluing common sense. ... The problem may also be the Nobel in economics that gave a stamp to these junky theories. ... Occasional blowups are good if they are small and recurrent. ... In the past, the financial world had a very diversified ecology: banks going bust on a steady basis", my emphasis, Nassim Taleb (NT) interview by Eric Gelman at Fortune, 14 April 2008.

I agree with almost everything NT said. In the pre-Fed days we had more bank failures than now. However they were smaller and did little damage to the economy. Banks are not today's turkey. With the advent of the Fed and perpetual inflation, holders of dollar assets are. NT likens model building to astrology. I compared it to alchemy, see my 23 August 2007 post. I presume NT is criticizing the 1997 Nobels to Robert Merton and Myron Scholes. I also criticize the 1973 Nobel to Wassily Leontief.

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