Everyone is prognosticating right now. I’m not immune. In those moments where genuine uncertainty enters the room in an undeniable way, we all desperately want to know what is happening, and what will happen next.
One of my private pleasures as a historian is reading old newspapers in sequence just to see pundits and prognosticators try to guess what is coming next. They almost invariably fail badly, often because they cannot imagine either just how terrible the near-future will become or how wonderful and strange some of the developments just around the corner are going to be.
This is a basic problem with professional futurism as well. However much flummery and fan-dancing it offers about its methods, it is usually mere extrapolation from the history of the previous twenty, thirty, fifty years.
Why do I like reading the wildly wrong views of past people who stand poised on the edge of some major and unguessed-at transformation? Partly because my favorite four words in the English language are, “I told you so.” But it’s also a warning to myself and anyone like me.
Nassim Nicolas Taleb’s The Black Swan is a smart book that centrally engages this basic problem. Taleb focuses on the events which we do not expect because they are improbable, our tendency to make models and theories that domesticate the empirical noise from which improbable events and sudden transformations can emerge. He tries to describe an alternative practice of prognostication, or of managing exposure to “black swans”, these unforeseen, disjunctive moments. In part, he argues, we should “worry less about advertised and sensational risks, more about the more vicious hidden ones” and to “worry less about matters people usually worry about because they are obvious worries, and more about matters that lie outside our consciousness and common discourse”. (p. 296)
I don’t think I get to some of his self-described intellectual practice through the same frameworks (in fact, I think Taleb is sometimes just as indebted to bad theory or bloated abstractions as some of the experts he targets) but I like the ambition. It’s less about trying to make the future a conventionally known object and more about exploring the possibility spaces that I can imagine resulting from the accidental or unplanned interactions of systems and agents. But it’s also being willing to believe that things can happen as a result of those interactions which are not part of my experience nor are mere replays of some known past scenario, to resist easy parallels and metaphors.
So from that angle, how do I think through the present financial crisis? It seems to me both possible to imagine that what appears to be a certain disaster could end as a kind of weird farce wherein all the various players so wrapped up in financial instruments that they themselves don’t understand find as they untangle their knots that all their many bets and insurances and fictions cancel each other out. Fictional money could evaporate, but real assets remain, and it will be only a lesson about speculation for future generations to recall like the tulips of past days.
Or we could find that however real some of the assets down deep at the bottom might be–houses and properties, buildings and factories–that these things only will have value again in a decade, two decades, but that the entire financial system and consumer culture is built on them having the value they were believed to have right this very minute. In the worst case of that direction, we might find that there isn’t enough money in all the world to recapitalize the system right here, right now. In which case, I have no idea what could happen as a consequence, only that it might well be bad at scales and intensities that few of us alive have any benchmark for.
The important thing now seems to me to not domesticate these events, to not try to stuff them back into the box of already-understood models and analogies. Instead we have to try to imagine instead the world becoming strange to us, to think the unthinkable. If enough people had been able to imagine the terror and suffering that industrial weaponry and trench warfare might produce, perhaps World War I would have seemed a much worse gamble than it did seem to those in power at the time. If more people besides Vannevar Bush had been able to see the potential shape and impact of information and computing in the decades after 1945, perhaps a whole generation of thinking about mechanization, computers, and cultural transformation would have taken on a softer, more enticing tone from the outset–and fewer people would have lived in fear of an all-powerful mainframe running human affairs. (This would have deprived Captain Kirk of one set of easy victories, however.)
This is an elaborate way of saying that I don’t know what’s going to happen, and neither do you. But you should neither be too quick to be sanguine and comfort yourself by thoughts of your own financial prudence or inoculation from the problems of others nor should you start looking for the most likely place to pitch a tent in your local Hooverville. Whatever happens, both safety and danger may lie in unexpected places. Taleb has a pretty good bit of advice about this, too: seek wide exposure to potentially positive unexpected events, and clamp down hard on any exposure to the worst of potentially negative ones. The problem, of course, is that the very worst (and best) such transformations make it clear that there is nowhere to hide, no way to be private, no island: that we are always already social, institutional and system-bound, and cannot help being so.
I don’t know if you’ve seen it, but Taleb had a piece on the current crisis over at Third Culture last month: http://www.edge.org/3rd_culture/taleb08/taleb08_index.html
cgb
I wonder, though, how much of a Black Swan this is. After all, hurling money down a hole is the sort of thing that investors tend to do when there’s a speculative bubble in anything. The only unprecedented thing in all this is the (to me incomprehensible) jiggery-pokery that was going on with a lot of the bad debt.
I think the Black Swan part is tied up in the jiggery-pokery. The empirical question right now is whether there’s more to this than a speculative bubble. I’m beginning to fear very much that there is more to it in that sense, that an entire structure undergirding the global flow of money is being exposed as rotten, and that a great deal of what was understood to be solid will melt into air.
The fundamentals of our financial system are flawed.
As John Quiggin wrote a few days ago — “At this point, the claim (essential to the efficienct markets hypothesis) that market-determined asset prices represent the best available estimate of future values, and therefore that capital markets are the best available method of allocating scarce resources for investment can only be sustained on the basis of the kind of dogmatic belief that asserts that humans and dinosaurs shared the earth 6000 years ago.”
This marks an end for capitalism as we know it.
http://johnquiggin.com/index.php/archives/2008/10/07/the-decline-of-the-dollar/
This is not a speculative bubble in “stuff” like mortgages on property or tulips or dot com companies — in which only a few hundred billions are involved. This is a speculative bubble in financial instruments themselves; derivatives — insurance instruments designed to mitigate risk of failure of uncertain markets that have become culpable in the widespread destruction of markets.
“To be more specific, under the Bush Administration laissez faire policy toward the financial industry, the notional value of the Credit Default Swap market has grown from approximately $900 Billion at the end of the year 2000 to a total of $62.2 trillion at the end of 2007 (according to the International Swaps and Derivatives Association). That is more than four times the U.S. Gross Domestic Product and larger than the entire world stock market.”
http://westonpolicy.wordpress.com/2008/09/19/credit-default-swap-clearinghouse/
The entire global derivatives market is now valued $1.14 Quadrillion.
http://jutiagroup.com/2008/07/24/global-derivatives-market-now-valued-at-114-quadrillion/
I have to say that derivatives are the central thing in all of this that I personally don’t understand. I mean, I understand conceptually what they are on two levels–your description here, and in a more general sense, they’re a kind of wager. But I don’t really understand in a structured way how they exist, how they’re made and traded, all of the tangibles.
The sinking feeling I get in the last two months is that the people who’ve been trading and investing in them don’t understand either.
Buffett hated this stuff — he called them “timebombs” and the profit made by them “sham.”
Two really excellent articles on derivitives here:
http://www.lrb.co.uk/v30/n09/mack01_.html
http://www.nytimes.com/2008/09/28/business/28melt.html?_r=2&oref=slogin&ref=business&pagewanted=print&oref=slogin
Then note the levels of failed due diligence just about everywhere. In 2004 we raised the allowable leverage of the IBanks from 12:1 to 30 and 40 to 1. And we failed to observe that the ratings agencies were taking money from their clients to achieve AAA ratings. And we failed utterly to regulate or even capture statistics on the growth of an exploding market in insurance (which is supposed to be regulated).
The Blog “Limited, Inc.” frames this nicely:
Let??s bracket the idea, for a moment, that collateralizing securities and layering contractual bets on these securities derivatives only exist as rentseeking instruments, ie, have no productive economic use. What, then, is the justification for them?
The only possible justification is that they ameliorated risk, so that lenders, who would otherwise not be able to afford more hazardous loans, are able to make them. And what is the signal for the lenders that the risk is well spread? The signal is prices. So, the only justification for the derivative market, and for the off the books market in collateralized securities, is that they can smooth out the price of risk.
Why, then, does it turn out that nobody can price out these instruments?
I’m inclined to think that a whole way of doing money-business has failed drastically. Just what will arise out of the dust, who knows. It’s clearly a global problem and so will require a global response. But how this will shake out, who knows.
A few years ago a student approached me about co-supervising a thesis on modeling and pricing credit default swaps. (I was supposed to help provide stochastic-process knowledge.) I contemplated it for a while, but decided against it on the grounds that every tractable, estimable model was crap, and that to do it properly you’d need something like a Leontieff input/output matrix for companies to show their linkages.
I wonder nowadays whether we shouldn’t have pressed ahead anyway… and whether I should be worried that the student’s fall-back plan was modeling commodities futures markets.
Galbraith – I guess nowadays I should say “the elder Galbriath” – says somewhere that all financial bubbles are basically the same: people rediscover that highly leveraged bets can provide really high returns, and concoct some story to persuade others (and even themselves) that that’s not all they’re doing. This works, until some of the bets go bad and they go bust. This seems to be our situation in a nutshell.
Let me second the recommendation for Mackenzie’s LRB essay on derivatives; it’s great.
Goodness gracious! It appears that we are trying to express and formalize a “Lesson of History,” with an eye toward defining an algorithm or a system for turning it to our future advantage.
What are the odds we will quit before we nail it down?
Let’s say “suggestions from history”.
I’ll think the unthinkable if I have to, but mindful of that phrase’s origins in Herman Kahn’s planning for thermonuclear war I’d rather not if I don’t have to.
Jim Livingstone has some suggestions from history based on his reanalysis of the great depression in Pragmatism and the Political Economy of Cultural Revolution. Briefly, he argues that the depression was a conjuncture in which capitalism was newly driven by consumer durables, yet capitalists were successful in shifting income shares away from wages towards profits; creating a glut of capital that, because the demand side was choked off by the shift, had nowhere to go but speculative investment.
As we know, real wages have been stagnant or falling for quite some time, a factor that has been masked by the expansion of consumer credit. Unions have declined and been mostly powerless to reverse this trend. The ‘credit crisis’ is thus a sideshow to the real issues. Jim’s point is that the real engine of growth is not profit but consumption, so bailing out the banks is beside the point. In the 30s it wasn’t until the government went into deficit to support consumer spending and encouraged collective bargaining that healthy balance of production and consumption was restored.
These things always have a way of looking like fables that should have a moral, but I find this one good to think with.
I think the Black Swan analogy doesn’t quite work for me in the current financial collapse except in comparing this to the Great Depression. Examining the Great Depression won’t necessarily have much to do with predicting the immediate future but there’s no Black Swan present what has lead to the current financial collapse. I think there have been many voices, both public and private, warning of a global economy collapse for a long time.
I think there’s few people, at this point, who would ask the question, “How did this happen?” Taleb, in his introduction to the Black Swan, mentions the relative unpredictability of the 9/11 events. That’s an excellent point. Before that happened, when people hijacked planes they typically had demands. The idea of simply crashing planes into buildings simply wasn’t on the radar. That’s a Black Swan.
The idea that a financial market that has been primarily growing due to decades of household credit spending radically outpacing income growth and productivity isn’t a Black Swan–it’s a Ponzi Scheme. All Ponzi Schemes eventually collapse on themselves. I think most of us knew that this day was coming.
The question, in my mind, isn’t so much about predicting what will happen next. Maybe there’s a Black Swan in all of that. Global currencies might collapse and we’ll have to invent new systems of value. And this is where I think you make a good point about keeping a nimble attitude towards the events going forward. Whatever happens next, characterizing it as a disaster or something wonderful all depends on your perspective. Huge changes such as this are either an end to everything you valued or grand opportunities to discover a new role in the universe. If the global economy collapses profoundly, maybe that’s a grand opportunity to examine our notion of the free market and its relationship (or lack of relationship) to democracy. That’s a healthy discussion.
That’s nicely put, and clarifies my own thinking in useful ways. I think you’re right that it’s not collapse itself that’s a Black Swan (though I think the precise manner of the interaction of many financial subsystems is a bit of one), it’s the way in which various national and international actors work out some new system in the aftermath.
In Nassim Nicolas Taleb’s “fooled by randomness” his point was not just that unpredictable events happen, but that you can make money by betting on such rare events. He had some sort of hedge fund that was making those kinds of bets. I don’t think that worked out.
Wikipedia does have some prescient quotes from him though:
Warning of the Global Banking Crisis
in 2006, in The Black Swan[14]
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 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 now have fewer failures, but when they occur ??.I shiver at the thought.
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 deem these events “unlikely”.
Yeah, this is where I’m even more fastidious than he is, by a long shot–I don’t think he takes unpredictability seriously enough because he’s still in the business of selling advice to people.