The Black Swan Of Cairo

Out of the crooked timber of humanity, no straight thing was ever made
   —Immanuel Kant

In The Black Swan Of Cairo, published this year in the journal Foreign Affairs, Nassim Taleb and Mark Blythe attempt to answer one simple question:

Why is surprise the permanent condition of the U.S. political and economic elite? In 2007–8, when the global financial system imploded, the cry that no one could have seen this coming was heard everywhere, despite the existence of numerous analyses showing that a crisis was unavoidable. It is no surprise that one hears precisely the same response today regarding the current turmoil in the Middle East.

Their answer can be found in the article's subtitle: How Suppressing Volatility Makes the World Less
Predictable and More Dangerous. If you are familiar with Taleb's books, including the The Black Swan, you will not be surprised by this answer, which the authors elaborate here.

Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite.

These artificially constrained systems become prone to “Black Swans”—that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers. Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems.

Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups. And it is the same misperception of the properties of natural systems that led to both the economic crisis of 2007–8 and the current turmoil in the Arab world. The policy implications are identical: to make systems robust, all risks must be visible and out in the open— fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying.

This view of complex systems has some merit. Surely we can all agree that complex human-created economies have a life of their own which, when artificially manipulated by policy, tend to fail rather spectacularly as we saw in 2007-2008. Consider this long term chart from Doug Short.

Although Short is more interested in plotting the exponential regression of the stock market over the long term (blue line, log scale left), we are more interested in the frequency of recessions (vertical gray bars). In the late 19th and early 20th centuries, the American economy was characterized by frequent booms and busts (called panics). After the Great Depression and World War II, the United States exhibited a more stable economic growth pattern characterized by strong growth interrupted by less frequent "business cycle" recessions. After the severe recession of the early 1980s, we entered Ben Bernanke's "Great Moderation" in which central bankers attempted to manage the economy by manipulating interest rates. The Fed itself was created in 1913 to protect banking interests and suppress volatility. As Short notes in the text box, recessions became less frequent over time.

Taleb and Blythe advocate allowing "early failure" in complex systems.

Just as a robust economic system is one that encourages early failures (the concepts of “fail small” and “fail fast”), the U.S. government should stop supporting dictatorial regimes for the sake of pseudostability and instead allow political noise to rise to the surface. Making an economy robust in the face of business swings requires allowing risk to be visible; the same is true in politics...

Seduced By Stability

... For example, the U.S. banking system became very fragile following a succession of progressively larger bailouts and government interventions, particularly after the 1983 rescue of major banks (ironically, by the same Reagan administration that trumpeted free markets). In the United States, promoting these bad policies has been a bipartisan effort throughout.

Republicans have been good at fragilizing large corporations through bailouts, and Democrats have been good at fragilizing the government.

At the same time, the financial system as a whole exhibited little volatility; it kept getting weaker while providing policymakers with the illusion of stability, illustrated most notably when Ben Bernanke, who was then a member of the Board of Governors of the U.S. Federal Reserve, declared the era of “the great moderation” in 2004. Putatively independent central bankers fell into the same trap. During the 1990s, U.S. Federal Reserve Chair Alan Greenspan wanted to iron out the economic cycle’s booms and busts, and he sought to control economic swings with interest-rate reductions at the slightest sign of a downward tick in the economic data. Furthermore, he adapted his economic policy to guarantee bank rescues, with implicit promises of a backstop—the now infamous “Greenspan put.”

These policies proved to have grave delayed side effects. Washington stabilized the market with bailouts and by allowing certain companies to grow “too big to fail.” Because policymakers believed it was better to do something than to do nothing, they felt obligated to heal the economy rather than wait and see if it healed on its own.

It is easy to be seduced by Taleb and Blythe's story. Don't be. You can start to see in the just-quoted passage that there are major cracks in the facade. Although we can agree that the financial system became more complex and fragile over time—too big to fail—we start to see in the Reagan era more frequent government intervention on behalf of large financial institutions (bail-outs). Why wouldn't this be due to corruption, rather than a natural desire for stability? We might call this the fallacy of attributing good intentions.

Buying into this fallacy is where the complexity/fragility story goes off the rails, for you can not banish humans from human-created systems. Taleb and Blythe know they are vulnerable to this criticism, as they make clear in the following text—

Attempts to institutionally engineer the world come in two types: those that conform to the world as it is and those that attempt to reform the world. The nature of humans, quite reasonably, is to intervene in an effort to alter their world and the outcomes it produces. But government interventions are laden with unintended—and unforeseen—consequences, particularly in complex systems, so humans must work with nature by tolerating systems that absorb human imperfections rather than seek to change them.

Take, for example, the recent celebrated documentary on the financial crisis, Inside Job, which blames the crisis on the malfeasance and dishonesty of bankers and the incompetence of regulators. Although it is morally satisfying, the film naively overlooks the fact that humans have always been dishonest and regulators have always been behind the curve. The only difference this time around was the unprecedented magnitude the hidden risks and a misunderstanding of the statistical properties of the system.

What is needed is a system that can prevent the harm done to citizens by the dishonesty of business elites; the limited competence of forecasters, economists, and statisticians; and the imperfections of regulation, not one that aims to eliminate these flaws. Humans must try to resist the illusion of control...

Ah, the Utopian Dream—what is needed is a system that can prevent the harm done by citizens by the dishonesty of business elites (not to mention government elites). That is what is needed, but it will never be achieved.

Yes, humans have always been dishonest and regulators have always been behind the curve, but it is a matter of degree. It is quite clear that the rule of law (or where the law does not apply, ethical standards) has almost completely broken down in the United States among both the business and government elites. Not only was this true when the most recent bailouts occurred in 2008-2009, but also in the preceding twelve years of what I call the Bubble Era (1995-2007). And as the authors note, but do not acknowledge, systematic corruption actually starts with Reagan's presidency. (It was no accident that we got the Savings & Loan swindles of the mid-to-late 1980s.)

Examples of destructive corruption abound. Take, for example, the midnight repeal of Glass-Steagall in early 2000 and the push-back against Brooksley Born, who wanted to control over-the-counter, privately negotiated derivatives trading, including various financial "innovations" like collateralized debt obligations (CDOs). The financial meltdown of late 2008 was triggered when these "innovations" blew-up. Several such deals were designed to fail by dishonest brokers like hedge fund manager John Paulson (with help from Goldman Sachs) or Citigroup. (These brokers would profit by shorting them.) You can not have early failure in a system which has been rigged to "succeed" spectacularly and then fail specutacularly.

In the end, the "Great Moderation" was revealed as almost entirely fraudulent. We got the internet and smart phones, and not much else.

Ironically, it was the lack of intervention in the housing market that led to its catastrophic collapse. And in the end, the bankers operated without much risk because somewhere in the back of their "minds" they knew they would not be allowed to fail. Thus we got the shock of the Lehman collapse, but all the other banks survived or were absorbed by other banks. Now they are Too-Bigger-To Fail. This is commonly referred to as moral hazard.

Although the collapse of the Housing Bubble revealed the complexity and fragility of the financial system, it was largely an outcome determined by human shortcomings. Nobody had to encourage those bankers to lever-up, or homebuyers to buy more house than they could afford. These participants did it all by themselves, based on the illusion that prices would rise forever and Gordon Gekko's Greed Is Good view of Capitalism. It has always been this way, whether it is Dutch tulips in the 1600s or American houses in the 2000s.

I would only add that Empires, just like economies, become increasingly more complex and fragile, as Joseph Tainter has written about in The Collapse Of Complex Societies. Empires can fail catastrophically after long periods of apparent stability. The United States appears to be a case in point. Although a collapse does not seem apparent yet on the limited human time-scale, which creates the sense of a slow-motion crisis, it does seem quite possible that in a mere 10 or 15 years, this country will be all but finished as an economic (if not a military) power.

As I said, it is easy to be seduced by powerful narratives like the one Taleb and Blythe offer up. But it would be a grievous mistake to take them at their word.

Comments

[xraymike79]

"What is needed is a system that can prevent the harm done to citizens by the dishonesty of business elites"
--- So do they explain what this magical system is? It sounds like a setup for even more Ayn Rand free market capitalism with less regulation, precisely what we've gotten since Reagan. This seems to be an argument that Conservatives/Libertarians/Republicans continually make: that what we have is not true free market capitalism, but too much government intervention. I guess all those corporate lobbyists aren't giving them their money's worth.

[John Hemington]

Dave, if I understand what it is that Talib and Blythe are saying here, and I have read Talib, it's not so much stability which is the problem, but the illusion of stability. When stability is falsely created by participants as an illusion it almost inevitably results in delusional behavior on the part of participants in the system. As you say, there were numerous astute observers who recognized years prior to the crisis that it was building and had been for a number of years.

It was, in fact, a deliberately structured delusional system of economic theology (neoclassical economics, a la Milton Freidman, et. al.) which permitted the theives and Ponzi-scamers to fuel themselves on the ready cash to be stolen while most everyone dozed on believing faked government statistics and private sector lies about the strength of the U.S. economy.

Yes, human are certainly prone to corruption and self-dealing when given the opportunity, but when the opportunity is deliberately designed into the system as a means of simulating stability and then the natural consequences of the innate instability occur (collapse of corrupt institutions) and are not permitted to be effectuated (bailouts permit the corruption to continue and increase) there is no possible outcome but final collapse of the system itself. But this is not, in my opinion, a function of stability or even the illusion of stability. It is a simple and pure function of corruption triumphing over rational organization.

You are no doubt correct in stating that this is probably an unavoidable end-point of any empire, but it is also the result of any society attempting the pretense of empire. Empire building, in and of itself, is a corrupt and corrupting activity which requires exponential acquisition of resources and wealth at the expense of the dominated. For most of its brief existence the American empire was much more subtle than most of its predecessors in this process. But, as you have repeatedly said, once the Reagan administration declared that subtlety was no longer in fashion and brute force and criminal acquisition of wealth was acceptable, the rush forward for power was on sans restraint.

While this may be inevitable it is not necessarily uncontrollable provided society is alert to the signs and signals of corruption. Unfortunately, the fruits of corruption disguised and free market capitalism in a military dominated empiric environment have proven too tempting to resist and we will now pay the price for buying into the delusion. The inevitability is housed in the nature of empires as well as the nature of humankind. Once delusional behavior dominates all is lost.

The unfortunate thing is that you are one of the very few individuals out there who understands just how this quirk of human nature plays out over time. Humans, I believe, instinctively understand this frailty in societies of contained size and can take rational actions to control deviant behavior.

But empires always foster the illusion of omnipitant and delusions of grandure in which the participants come to believe that whatever they choose to do is right and correct just because they can get away with it for the time being. It is thus the grand delusion of humanity of which you so eloquently speak.

[russell1200]

Taleb has one tool: a wrench. He keeps looking for bolts to tighten. You look like you might have a hammer.

You both appear to be overstating your case.

For myself, I have a pry bar: it's called leverage. Leverage makes the world fall down. Doesn't matter how you get there.

[John Hemington]

Yes russell1200 leverage is certainly one of the key factors, but the overall problem is unrestrained private debt (some certainly keyed by excessive leverage) that ultimately brings the system to its knees. Such excessive private debt requires some form of corrupt regulatory capture to come into existence -- as does too much leverage. It is possible to control this process, but not once the regulated gain total control over the regulators, which is where we now live.

Dave's point, I believe is that this is an inevitability given the basic nature of the human animal and I am inclined to agree. However, it seems to me that the basic fight for beneficial regulatory management is worth working for -- at least until mankind gets over the falacious idea the infinite growth is somehow possible to maintain within the confines of a finite planet.