The man who predicted the credit crunch

Oliver Kamm has an important post over on his blog. It concerns bankers' pay.

Responding to James Forsyth's proposal to limit pay to the salary of the Prime Minister, Oliver describes the Coffee House man's idea as not outlandish, but not right.

The problem, he seems to me to be arguing, is not that the market produced too high remuneration and needs to replaced by regulation but that there wasn't a proper market in pay. And that there needs to be one.

While reading it, it occured to me how little coverage there has been over the last two weeks of Nicolas Nassim Nicholas Taleb's book The Black Swan.

Taleb's theory is that the world cannot be explained without accepting that from time to time there are events of very low probability but very high impact. If you ignore such events it is possible to hit on all sorts of successful ways of making money that look really clever. But then along will come a black swan and wipe you out.

The events of the last few weeks are a classic black swan.

Here's what Taleb has to say of recent events:

It [the start of the credit crunch in the US] was my greatest vindication. But to me that wasn’t a black swan; it was a white swan. I knew it would happen and I said so. It was a black swan to Ben Bernanke [the chairman of the Federal Reserve]. I wouldn’t use him to drive my car.

These guys are dangerous. They’re not qualified in their own field.

His argument is that you cannot model risk without considering events which are extremely unlikely to happen but will have a big impact. 

The reason why I thought about him when reading about pay is simple. The pay of bankers is structured without consideration of these black swans. There has to be a way of ensuring that their pay takes into account the fact that every so often what they are doing will implode.

The risk these bankers took was not outlandish if the black swan is excluded. But to exclude black swans is an error.

The problem with Taleb's book is that it is hard to know quite what to do with the advice he gives. I certainly found it hard to decide what the correct practical response was.

But that's not good enough. The need to get to grips with the black swan idea and its implications is now undeniable.

Comments

[Bruce Robertson]

Hardly a Black Swan Event. If there's too much debt, eventually a Credit Crunch (not a new concept by any means) will put an end to the party. This has been one hell of a party.

[Cathbad]

How do we know that Dr. Taleb isn't just correct by chance, rather than by skill? If you take a big enough sample of prognosticators, at least one of them will 'choose' correctly.

Ironically, I learned this idea in his writings.

[will]

i seem to remember reading a review of this book in the times a while back. i thought it was obviously clever if you know what i mean. Ie the wheel, obviously clever, but not untill someone has the idea.

ive gotta say though that the house price crash wasnt a black swan, i was advising my friends 2 or 3 years ago not to by property as prices where obviously far too high. fair enough i was a couple of years premature, but anybody with half a brain must have had the incling that a house price boom of like 300% was a bit of a bubble. (unless of course your scottish, live in downing street and did a history degree.)

also the growth in the british ecconomy has seemed to be almost exclusively via the high street and credit cards. do we have a .com sector anywhere near as impressive as americas? our productivity has declined over the past decade and the only investment we seem to have has has been in property and shops. Surely that is not a sustainable model. you need a mixed ecconomy and our ecconomy has has all its eggs in one basket since labour came in an abolished boom and bust

[Peter]

Isn't the thrust of his advice to avoid careers which have much downside potential; invest 85% of your wealth in ultra-safe (low return) places, and the other 15% in cuting edge new technology companies who might just hit on the next big thing without anybody anticipating it.

[jasmin buttar]

Hi Danny - Nassim Nicholas Taleb is on live on Newsnight tonight giving his take on the current crisis. Great minds think alike ! That's Newsnight 10.30pm, BBC TWO.

[Ian Thorpe]

I protest! I predicted the credit crunch on my blog in 2005.

And before that at the time of the Enron and Worldcom collapses.

When stock market values are based on asset valueations that owe more to Hans Christian Andersen than (an ancestor of Arthur Andersen we assume) than to reality collapse is inevitable. The tragedy is that governments allowed a huge increase in personal debt to prop up the bankrupt bankers for so long.

[Steve]

The collapse of the economic system was predictable by anyone who didn't go to a university to learn economics.

The US government changed the rules to allow people who could not afford to put 20% down to buy a house to put 0 down to buy a house with the government guaranteeing the loan. This was inevitable.

black swan is a straw man that hides incompetence and malfeasance by people who used race and MLK's legacy to buy votes and enrich their friends on Wall St. It is sick!

Credit was over-extended for political reasons, mainly to get minorities into homes they were not financially qualified for (but they were racially qualified). That is the whole purpose of Fannie Mae and Freddie Mac: Get people into houses they cannot afford.

All these programs are covert forms of wealth distribution: affirmative action.

Now, we even have unqualified presidential and vice presidential candidates because of affirmative action.

Where will it end?

[Steve]

I don't believe this because:

IF HE KNEW THE MARKET WAS GOING TO CRASH HE WOULD HAVE INVESTED IN THE MARKET AND TAKEN THE FINANCIAL POSITIONS TO PROFIT FROM IT.

But he didn't put his money where his mouth is.

The Black Swan did not kill the Golden Goose.

[Kenneth Long]

I am going on record to predict the next financial crisis. It will happen so long as predatory mortgage loan products with exotic terms are allowed.

Additionally, the government facilitates the problems by guaranteeing such bad loans, thus increasing the tolerance for lenders to underwrite such junk loans.

[Frank]

"... it is hard to know quite what to do with the advice he gives." How about insurance? Risk taking is just fine if only you suffer when the black swan comes along. But the risk takers have taken everyone down. Levy a surtax off their compensation in the good years to cover (some of) the damage they do in the bad.

[Matt]

Who didnt predict the crisis? I was saying five years ago that all this free money with 'pay now pay when you are 90' was going to be disasterous! This was followed by Blairs vision of globalisation and a general greed fuelled orgy based on dishonesty and corruption. After 10 years of this type of Government, it is now part of our way of thinking and it will be diffiucult to turn things around. The only way is down and there is nobody with the moral fibre or the compentency to get us out of it.

[Jamaica]

Having seen; and being A VICTIM of Sleeze, also conspiracy/ corruption ongoing in our own country which =10 of Millions £'s much of which was EEC money; (that's not even been investigated; yet reported to the Police and certain MP's plus other Public Authorities, and The Law society from 1995, yet such serious matters, remains cloaked from the public Domain in this country,)also look at corruption that's happening in other countries around the world by the certain people who are supposed to Run These various Countries!! Is there any wonder at what greed and dodgy dealings have done,and now taking place in our midst and around the world ruining the stability and wealth of certain Countries ??

[Ian Thorpe]

I don't know much about The Black Swan, I tend to stick with Terry Pratchett (check out his Making Money BTW, prescient and very funny) but earlier this week MP Tonly Baldry suggested we look to onother black book, The Bible, for answers.

In other words "Invest in the word of The Lord." Sound advice...unless of course the Lord he speaks of is Peter Mandelson.

[JAMES-GUY JACOBS]

Hi Danny, Happy New Year to you. Super blog. The Black Swan is a truly great work and should be mandatory reading for all economists and politicians. Did you see Nassim Nicholas Taleem on Newsnight? If you read the Black Swan, you'll see NNT gives very practical advice, at the end of the book, as to how an investor can utilise The Black Swan phenomenon to their advantage. By the way, I also quoted The Black Swan in an aricle being published in Estates Review next week (please see http://jamesguyjacobs.blogspot.com/2008/09/thoughts-on-eastenders-and-credit.html)

[Steve W]

Hi

To label this a Black Swan is akin to admitting surprise when a bubble bursts. I don't see a parallel universe where this crisis doesn't happen.There are no close-call counterfactual realities here. It's simply bad business. Worst still, if the industry thinks it was unlucky, they might just do the same again, whilst ringing all the necks of said black swans.

Taleb says little new, people understand these things. To my mind he has becomne a messenger, not an original thinker. A lot of what he states his highly apparent to anyone who has read the groundbreaking work of Daniel Kaheman and Amos Tversky.

September 11th was a 'Black Swan', actually, there was already language at the time to describe such events, they were call HILP's (High Impact Low Probability).

On newsnight, he was next to useless (the question as to what to do now was levelled at him). A parody on his response:

Imagine a building on fire, people on the roof, hanging out of the windows. Below folk try to establish ways to break the fall of the desperate. Taleb arrives at the scene. 'Taleb, Taleb, what are we do?' cries one. Without hesitation Taleb responds: 'We must immediately, immediately, immediately repair the faulty wiring'.

Thanks Taleb.

This guy is not some maverick genius. He has no solutions, or no secret formula for making a lot of money. He shouts loudly about a lot of things people already knew. Admittedly, the economic environment may be blind to such things.

He mocks Markovic for getting the Nobel prize for the deriviative formula. Well, they may just wind up getting the Peace prize for instigating economic mutually assured destruction.

Steve

[Dan, Sydney]

As has been mentioned below what has happened is hardly a black swan. Various people predicted precisely what has just happened but people were too greedy to take note.

[Featherstonehaugh]

The only person who accurately predicted the crisis -in detail-is Nouriel Roubini of Columbia. No vagueness every step predicted and every step taken!

[Graeme Archer]

I suggest folk take a look at the extensive statistical literature on extreme value distributions before they start getting over-excited at another economist re-inventing the wheel. It's the same question as "How often will there be an earthquake?" -nothing to do with black swans, a famous problem in inductive logic, I imagine chosen for the book's title for cod reasons. And Mr F, you account for rare, bad outcomes exactly the same way you do in any other decision theoretic setting: characterise the probability distribution, set a cost for potential outcomes, then choose the decision to maximize your expected utility. Unfortunately this can easily lead to the hideous precautionary principle, whereby one does nothing in case of something awful. The central limit theorem might not be sexy but it's a better guide to choosing actions than worrying about the sky falling down. As others have noted, ramping up the levels of cheap bad debt led to an outcome that was neither improbable, nor unpredictable, nor unpredicted.

[narcissa]

Lots of people saw this coming. We were given a very clear analysis of the situation by George Parr last year. http://www.brasschecktv.com/page/187.html