Thursday, 19 February 2009

The Black Swan

Before the discovery of Australia, Europeans were convinced that all swans were white, based on empirical evidence. The discovery of the first black swan in Australia, therefore, was a major surprise because it contradicted the general theory. The occurrence of unexpected, random events that underlie our lives (or “Black Swans”) is the theme of the international best-selling book “The Black Swan” by Nissim Nicholas Taleb. I am currently reading this book, and I’m only up to chapter 3 but I’m riveted.

Taleb uses events such as 9/11, the market crash of 1987, the Asian tsunami of December 2004, the demise of the Soviet Union, etc to demonstrate the occurrence of Black Swans in our everyday life. He says:

“A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our personal lives.”

Since the industrial revolution, the occurrence of Black Swans has been increasing. He believes the more progress we make, the more Black Swans we are likely to encounter and the more unpredictable life will be.

Taleb is from a Greek Orthodox Levantine family in what is now known as Lebanon. He recalls how for centuries, different ethnic and religious communities in the Levant had managed to co-exist quite peacefully. Whatever occasional conflict there was was usually within Muslim and Christian communities, but rarely between Muslims and Christians. The Lebanese “paradise” suddenly evaporated in the mid-seventies when a bitter, bloody civil war between the Maronite Christians and the Muslim communities broke out and lasted a decade and a half. Hardly anyone saw the war coming or imagined it would last as long as it did. Taleb was just a teenager when the war broke out, but it is clear the war had a major impact on his mind and his subsequent interest in the highly improbable.

Taleb is convinced that it is virtually impossible for anyone, however learned they may be, to predict with any certainty the course of events due to the possibility of Black Swans. We have a tendency to “focus on those pure, well-defined, and easily discernible objects like triangles, or more social notions like friendship or love, at the cost of ignoring those objects of seemingly messier and less tractable structures”, a trait which Taleb describes as “Platonicity”. We adjust to the highly improbable only after it occurs, while the “experts” among us, believing they are experts in their fields, are as baffled like the rest of us, except that they are able to narrate what happened better than the general population. The irony is that these experts are usually more highly paid than the rest us.

The current financial crisis that is affecting us, commonly known as “the credit crunch”, is an example of a Black Swan. In its wake, we have seen the collapse of large seemingly solid financial institutions, companies going bust, redundancies increasing, and social tensions rising. People are comparing it to the Great Depression of the 1930s. Yet one person, an economist called Dean Baker, did forewarn of an impending crisis in August 2002, basing his analysis on the US-government house-price-data from 1953 to 1995. He correctly pointed out that the US housing market was over-inflated but, despite his repeated attempts, he was unable to convince the Board of Governors of the Federal Reserve for the need for action. The sub-prime lending crisis, which was initially blamed for causing the crisis, was only part of a bigger problem affecting the $20 trillion US housing market.

If a security analyst had warned on 10 September 2001 of the need for all cockpits to have bulletproof in planes, 9/11 could have been averted, but it is likely that the analyst would have suffered the same fate as Dean Baker. The airlines and authorities, because of the huge costs and inconvenience involved in undertaking such a scheme, would have ignored his warnings.

Almost every day, as I listen to the radio, I hear news presenters asking experts how long and how deep the current recession will last. Some say one year, some two years. Even the Governor of the Bank of England cannot give a definitive answer. Initially, many experts predicted UK would suffer a shallow recession; now they talk of a deep recession. What is indisputable is that very few people never expected the current crisis to affect us in such a dramatic way. It is probably wise, therefore, to avoid making predictions on when we will come out of this recession and let events take their course which, unfortunately, will entail more pain for many households. We are remarkably poor at making predictions in a complex world because we consistently fail to factor in the possibility of Black Swans. I may as well avoid listening to those experts on the radio and use my time more wisely instead.

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