Belmont Club

Taleb's warning

Nassim Nicolas Taleb, the author of the Black Swan, quotes from his own book to show that he has been warning against a systematic collapse of the banking system for a long time.  But the collapse was not an instance of a Black Swan, which is an unpredictable rare event. Instead he has long maintained that the collapse we are now witnessing was the result of epistemic arrogance which he defines as “a measure of the difference between what someone actually knows and how much he thinks he knows.” Taleb wrote: “to me a banking crisis –worse than what we have ever seen — was unavoidable and NOT A BLACK SWAN, just as a drunk and incompetent pilot would eventually crash the plane. And I kept receiving insults for 12 years!” His own book had this to say about Fannie Mae, bankers and epistemic arrogance. It was devastatingly cutting writing and now seems justified by events.

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 crises 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.

Banks hire dull people and train them to be even more dull. If they look conservative, it’s only because their loans go bust on rare, very rare occasions. But (…)bankers are not conservative at all. They are just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug.

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 staff of scientists deemed these events “unlikely”.

There is no way to gauge the effectiveness of their lending activity by observing it over a day, a week, a month, or . . . even a century!

(…)  the real- estate collapse of the early 1990s in which the now defunct savings and loan industry required a taxpayer-funded bailout of more than half a trillion dollars. The Federal Reserve bank protected them at our expense: when “conservative” bankers make profits, they get the benefits; when they are hurt, we pay the costs.

Once again, recall the story of banks hiding explosive risks in their portfolios. It is not a good idea to trust corporations with matters such as rare events because the performance of these executives is not observable on a short-term basis, and they will game the system by showing good performance so they can get their yearly bonus. The Achilles’ heel of capitalism is that if you make corporations compete, it is sometimes the one that is most exposed to the negative Black Swan that will appear to be the most fit for survival.

As if we did not have enough problems, banks are now more vulnerable to the Black Swan and the ludic fallacy than ever before with “scientists” among their staff taking care of exposures. The giant firm J. P. Morgan put the entire world at risk by introducing in the nineties RiskMetrics, a phony method aiming at managing people’s risks, causing the generalized use of the ludic fallacy, and bringing Dr. Johns into power in place of the skeptical Fat Tonys. (A related method called “Value-at-Risk,” which relies on the quantitative measurement of risk, has been spreading.)

My own insight, admittedly less inspired and rigorous than Taleb’s was to liken what we are witnessing as an unfolding chaotic system which we think we can control with linear measures like the bailout long after it has strayed into nonlinear territory. I wrote in the Second Debate that:

It used to be a case that if you did X then Y resulted. If 2X then 2Y. But the old certainties don’t hold any more. Maybe part of the problem, if there is still some linearity as I have written elsewhere, is that the bailout efforts don’t clearly signal that the bad old ways of doing business have ended. During World War 1, the more troops the generals fed into the machine guns the less confident the home publics were of victory. Only when they started doing things differently was confidence somewhat restored. To some extent the circumstance that governments are resorting to these desperate rescue packages conveys more clearly than anything else that they are firing into the dark; and the market understands this, even if the politicians don’t. They’ve tried the rescue packages. Now maybe they should try handcuffing a couple of dozen senior politicians and sending them to the graybar inn. That might restore confidence in a way untold trillions won’t.

The relationship between my critique and Taleb’s is this: our institutions haven’t fessed up to their epistemic arrogance. They’re still “firing into the dark” while maintaining that they know what they’re doing. The very same people who led the global system into disaster are pretending to lead it into safety. Barney Frank, for example, is as honored as ever. Barack Obama was known to take calls from Franklin Raines on housing and mortgage policy matters. Raines “graduated from Harvard University, Harvard Law School; and Magdalen College, Oxford University as a Rhodes Scholar.” He was just the sort of guy who knew what he was doing.

Adding resources to a disaster is like reinforcing failure on the battlefield. It doesn’t help. That’s why “during World War 1, the more troops the generals fed into the machine guns the less confident the home publics were of victory.” Adding resources to a broken system only meant you killed more people. Things have to be done differently to make any headway. We’re not going to do that because we already know what we’re doing, right? In a few weeks, if the polls are to be believed, we are going to entrust the safety of everything to a new administration which believes the government knows best. Expect more “epistemic arrogance”, not less.

There was a time when people explicitly understood their ignorance. And they defended against uncertainty by relying on simpler, less interdependent systems for survival.  In case snow blocked the roads they had hams, canned goods, dried beans and sacks of flour in the storeroom. In the event 911 didn’t answer they had a shotgun in back.  Family was the insurance against unforeseen crisis. Nation was the refuge against enemies. Culture provided a standard operating procedure which everyone was expected to know.

We have abolished much of that because in our foolish pride, it became an article of faith that we no longer needed them.  Canned food is now shunned for the preservatives that it contains. Bacon is bad because it has salt. Allah forbid that there’s a gun in the house. And who could be less ‘with it’ than a woman with five children and a husband who drives a snowmobile. Sarah Palin is hated by sophisticates because she is almost a cliched example of this kind of simplicity. Ha ha ha. Today really cool people live in big cities, dependent on power grids, power circles and power lunches. They imagine there’s no heaven, no countries, nothing to kill or die for and no religion too. Today the truly cultured person is expected to know nothing of his own culture and smattering of everyone else’s. Because they’re certain in their epistemological arrogance they’ll never need any of the things they’ve safely abandoned. Who needs a family when you’ve got a retirement fund?

Lenin once described Communism as “socialism plus electricity”. The modern version of Nirvana is “socialism plus Google”. When will we learn? Never, I fear, while pride and the desire for power rule the human breast.

Tip Jar.