Thursday, 8 April 2010

Black swan theory

Easter’s over and I can return to one of my favourite topics – today, if you carry on reading, you’ll dwell with me on the causes and dealing with the current financial crisis. This time the new light will be cast by a Black Swan Theory, a term coined by Nassim Taleb to describe rare, but significant events which hit out of the blue. The phrase applies to all spheres of life, but events called black swans occur disturbingly often on financial markets. Stock market crash in 1987, LTCM collapse, dotcom bubble, or mortgage crisis are the events which should happen in theory once in a lifetime, but they all happened within the last quarter of century – much too often. The wikipedia entry linked above gives a fairly comprehensive overview of the Black Swan Theory, but in line with the rules of the portal it has to present a neutral view. The blog is subjective and gives room for biting comments. I’ll refer only to one part of the entry – principles which set simple guidelines on how to create a system resilient to black swans.

1. What is fragile should break early while it is still small. Nothing should ever become too big too fail.

Adam Smith was the first to say banks should be small enough to go bust easily and without causing major harm to the economy. Banking behemoths as we see them today are prone to a big moral hazard – costs of bailing them out are lower than total costs of their potential collapse, what gives a lot of incentives for blackmailing – bankers can tell the government: “rescue us, unless you want to have even bigger troubles”.

2. No socialisation of losses and privatisation of gains.

Generally the game financial institutions, governments and taxpayers have been playing before and during the crisis is like tossing a coin. If head, we get sky-high bonuses, if tail, taxpayers pay.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

In reality those who make mistakes usually stay on and are not held to account for their misdeeds. It’s not only about taking responsibility, but mostly about avoiding the same mistakes in the future.

4. Do not let someone making an "incentive" bonus manage a nuclear plant – or your financial risks.

Incentive bonuses usually encourage people to take greater risks. They are eager to do so because remuneration schemes are flawed (see comment to rule no. 2). Before the crisis CEOs of banks would get bonuses for making high profits resulting only from taking excessive risks, this was possible only in golden years, but the managers took no responsibility for the losses. I still wonders why shareholders agreed for it. Another aspect is the pressure from stakeholders. Banks which held back from aggressive and risky investments lost clients who had expected them to make more and more money.

5. Counter-balance complexity with simplicity.

“It doesn’t matter that we don’t understand how it works, the rating agency gave it AAA so we’re playing safe”. I still can’t understand how according to one of mathematical models, worked out by David X. Li, a few thousand subprime loans packed together and securitised can give prime quality securities. A good financial system should offer transparency to its participants. If you don’t understand something you should back down and not put your money in it. But it’s convenient to pretend that you don’t see something is amiss as long as you’re cashing in on it.

6. Do not give children sticks of dynamite, even if they come with a warning.

Unfortunately people who don’t know how to handle risks should not do it. This in my interpretations greatly refers to adjustable-rate subprime mortgages which turned out to be a time bomb for mortgagers. I don’t know if they came with a warning, even if they did, everyone ignored the obvious danger.

7. Only Ponzi schemes should depend on confidence. Governments should never need to "restore confidence"

The rule above describes the biggest fault of central banks and governments during the crisis. Restoring confidence means eliminating fear, which is one of the biggest evils that might happen. Of courses uncle Ben and cousin Barack saw it as lesser of two evils. In the short run it helped put out the fire, in the long run history will repeat itself and people won’t learn from their own mistakes. When the financial markets shook off they began aggressive speculation anew.

8. Do not give an addict more drugs if he has withdrawal pains

It’s an universal rule, not only in terms of paying the price of one’s own failures. Whenever something got wrong and begins to fall down, we should let it collapse. Giving more drugs is like prolonging the agony, it’s a temporary measure to solve a problem, but in the long term it only heightens problems. Suffering after doing wrong is like a penance, it clears the air.

9. Citizens should not depend on financial assets or fallible "expert" advice for their retirement

Isn’t it about Poland? Or am I hypersensitive?

10. Make an omelette with the broken eggs.

I don’t get this one, it must be something about absurdities, departure from rules, or maybe just ten is a round number.

Who should be familiar with Black Swan Theory?
Bankers? Maybe.
Taxpayers / citizens / voters? It wouldn’t hurt.
Politicians? They should for should, but would they follow?
Regulators? For damn sure!

Those principles have struck a chord with me because of their simplicity. They also fall into line with common sense and general sense of morality. A world for upstanding people could be easily driven by them and it doesn’t mean it would have be exist without stock exchanges and derivatives. Everything’s for people, including speculation. The point is that if you take risk, you should do it voluntary and you should be ready to suffer consequences. And advisably, you should be afraid. Fear should not paralyse you but should keep you sane.

For those always insatiable two links ->
1. Alan Greenspan refuses to admit loose monetary policy led to the crisis
2. Roger Lowerstein's article - guy thinks grandpa Alan and uncle Ben screwed it up all the way!


Island1 said...

Ah! 'All swans are white' my favourite epistemological brain bender.

In fact, it's a poor analogy: the events Taleb is talking about are unpredictable but not unknown (like black swans were, until they were discovered).

What you should really worry about are Outside Context Problems (or possibly grue and breen emeralds).

10) is clearly a play on the idiom: "You can't make an omelette without breaking eggs." "Make an omelette with the broken eggs," is probably meant to mean: "If something falls apart, at least make something useful from the pieces."

student SGH said...

good point about the omelette and broken eggs Jamie, I didn't hit upon it - some things are not easy to grasp for non-native speakers.

I think black swan is only about rarity, black swans are not dangerous, nor herald something scary (or I know too little about Anglo-saxon superstitions).