Don Ludwig on the Black Swan

The applied mathematician and scholar of uncertainty Don Ludwig reflects on the financial crisis, resilience, and The Black Swan:

This is a sort of book review. By now you may have heard of The Black Swan: the impact of the highly inprobable by Nassim Nicholas Taleb published by Random House (2007).

Taleb is from Lebanon, but he prefers to be called a Levantine. He worked as a trader in currencies, and maybe also derivatives. He claims that nothing of importance in finance can be predicted, except its unpredictability. His book will undoubtedly attract attention for its claim of an inevitable financial collapse, like the one we are experiencing.

He writes on p. 225:
I spoke about globalization in Chapter 3; it is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans [events that are extremely rare and important]. 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 now interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks (often Gaussianized [assuming normal deviations] in their risk measurement) — when one falls, they all fall. [lengthy footnote here, which includes the statement that "Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite"] The increased concentration among banks seems to have the effect of making financial crisis 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 have fewer failures, but when they occur … [no deletion here] I shiver at  the thought. I rephrase here: we will have fewer but more severe crises. The rarer the event, the less we know about its odds. It mean[s] that we know less and less about the possibility of a crisis.

Taleb goes on to mention the power blackout of 2003 as an example of what happens when things are tied too closely together.  Taleb points out that all the experts use Gaussian assumptions for risk analysis, which delivers precisely the wrong answer. Hence I think that it is extremely likely that the favored solution to the world financial crisis will be to tie the financial system even more tightly together, thus ensuring an even bigger collapse next time. It seems to be happening already. There is no sign that Obama has twigged to the hazards of greater financial integration. There is no sign that the experts can learn from collapses: they don’t seem to have learned from past collapses, as Taleb points out.

I think we can learn from Taleb: he writes very forcefully, but exaggerates his points too much. It may be that if we confine ourselves to financial situations, then his statements are valid, even though they are extreme. Taleb seems to have been treated very nastily by the financial establishment: Scholes, Merton & Co. He seems to be both hurt and angry. Perhaps this causes his arrogance as well. I had to grit my teeth to get through to the later chapters, which have most of the substance.

Taleb offers some financial advice:
1. Above all try to protect yourself from the big drops that are coming (have already come). This implies investing a very high percentage in lower risk securities such as government bonds.

2. Try to participate in the big booms that are also sure to come. Taleb advises spreading some stuff in venture capital. In view of the behavior of the Vancouver stock exchange, I should think that it would be necessary to try to avoid scams. See David Baines in the Vancouver Sun for details (e.g.).

What has this to do with ecology?

Buzz Holling has been talking for years about “surprise”, which is just another name for Black Swans. Anyone who has ever looked at ecological data knows that deviations are not Gaussian. Of course, if we drop the Gaussian or some similar assumption, we lose most of statistics, and we lose all of “risk analysis”. So we lose just about all theory. Experts can’t function without theory, so they make unrealistic assumptions, and come up with the wrong answers in Black Swan situations.

Since Black Swans are rare, ordinary experience doesn’t show any, and the experts are confirmed in their misleading assumptions, until the next time.

We can use analogies instead of theory. I recall the raft analogy we used years ago to illustrate resilience: in order to survive on rough seas, we use loose coupling rather than strong coupling. Likewise, we guard against overconfidence: another of Buzz’ favorite themes. Managing for resilience involves guarding against collapses, even though they might be rare: it implies a precautionary principle. In light of the recent financial collapse, this latter point might finally be accepted for ecological management.

2 thoughts on “Don Ludwig on the Black Swan”

  1. Garry,

    Keep these posts coming. Connecting the recent turmoil in the financial world to the governance of all complex systems will hopefully wake up folks both inside and outside of the ecological world.

  2. “Resilience,” I assume, would be exemplified by a practice of not leveraging financial investments too much or by having collateral for loans or by not invading too many countries at the same time (keeping some troops at home in case a new enemy suddenly appears on the horizon).

    We have been choosing to discard resilience, or in different language, choosing to live on the very exciting and profitable edge of chaos because of our expanding hubris (I think – please comment!).

    If the financial crisis teaches us to slow down and become just a bit modest, it will be worth the pain it is causing. So far, I don’t see much indication that decision makers are getting this message.

    Is there any organized effort to get this message through to them? If not, we should organize something.

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