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Tuesday, March 10, 2009

Black Swans, Butterflies, and the Economy


From The Freeman
By Max Borders

One side blames the market. The other blames government. We get two causal stories going in opposite directions and a lot of animus. But both perhaps are missing something important in this titanic debate about our current financial crisis. It’s time we exposed a complicated truth about the economy of the 21st century.

Nassim Nicholas Taleb is famous for introducing us to black swans. Though these rare creatures have long been used among academic philosophers to explain the shortcomings of reasoning by induction (“Every swan I’ve ever seen has been white, therefore all swans are white.”), Taleb uses the black swan as a stark metaphor for the inevitability of highly improbable events. In other words, black swans are rare, but one will swim by eventually.

As far as Wall Street—particularly the people with a large stake in getting things right—is concerned, this financial crisis involved a confluence of events. Some of these black swans were set in motion by government, like flexible lending standards to extend home ownership, Fannie and Freddie, and a mortgage-friendly tax code. Others were set in motion by willfully ignorant bankers, big shot risk-modelers, and people believing they could live beyond their means. It all came together in a fantastic cascade of failure. The trouble is, no one—neither government nor market actors—can predict such a large-scale event. Black swans happen.

The other important thing to remember is that the economy is a chaotic system. Most of the time chaotic systems achieve a sweet spot between order and chaos, which is a good thing if an economy is to be robust. Chaotic systems, though, change constantly and involve dynamics that are highly sensitive to initial conditions.

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