Black Swans and ideological shifts

Rare and catastrophic events, so called Black Swans, have a way of re-aligning the political landscape. 9/11 turned many a moderate into a conservative, as it did I. But the financial crisis of 2008 threatens to undo my conservative identity, for what alternative I am yet unaware. A case in point is this line of conservative cant in defense of the deregulated financial markets which takes this year's Leonard Cohen award for tone-deafness:

This reaction is a bit like protesting against patching the hole in an ocean liner because doing so will save those who made the crucial navigational errors. Watching the navigator sink beneath the waves might be fun, but one's pleasure will be short and gurgly. So let's get real. While some unjustified enrichment is possible, for the most part, if the financial institutions survive and prosper it will not be because they have been "bailed out" but because the system has been saved. So take a deep breath and say "This is good." In the Midwesternism of my youth, "Don't cut off your nose to spite your face."

Another reason for rational restraint is that there are fewer villains in this tale than the news and the political campaigns would lead one to believe. Three basically good things - the securitization of consumer credit, the extension of credit down the economic ladder, and the invention of derivatives - have combined, and the resulting mix turned out to be explosive. Well, live and learn, and do better next time. But first, ensure there is a next time.

Bringing the world financial system to the point of collapse is not an event that can be shrugged off with a "live and learn" nonchalance. This is not a matter of small miscalculations, but systemic ignorance on the part of the entire financial community, both from the public and private sector. If conservatives and free market libertarians think that political confidence can be restored without any recriminations or blame seeking, they will have ensured a statist political hegemony for the next fifty years. To paraphrase Ricky Ricardo, there is a whole lot of 'splaining to be done.

Nassim Nicholas Taleb has, I think, correctly figured out who the guilty are, and they are not the government regulators.

Statistical and applied probabilistic knowledge is the core of knowledge; statistics is what tells you if something is true, false, or merely anecdotal; it is the "logic of science"; it is the instrument of risk-taking; it is the applied tools of epistemology; you can't be a modern intellectual and not think probabilistically—but... let's not be suckers. The problem is much more complicated than it seems to the casual, mechanistic user who picked it up in graduate school. Statistics can fool you. In fact it is fooling your government right now. It can even bankrupt the system (let's face it: use of probabilistic methods for the estimation of risks did just blow up the banking system).

The current subprime crisis has been doing wonders for the reception of any ideas about probability-driven claims in science, particularly in social science, economics, and "econometrics" (quantitative economics). Clearly, with current International Monetary Fund estimates of the costs of the 2007-2008 subprime crisis, the banking system seems to have lost more on risk taking (from the failures of quantitative risk management) than every penny banks ever earned taking risks. But it was easy to see from the past that the pilot did not have the qualifications to fly the plane and was using the wrong navigation tools: The same happened in 1983 with money center banks losing cumulatively every penny ever made, and in 1991-1992 when the Savings and Loans industry became history.

It appears that financial institutions earn money on transactions (say fees on your mother-in-law's checking account) and lose everything taking risks they don't understand. I want this to stop, and stop now—the current patching by the banking establishment worldwide is akin to using the same doctor to cure the patient when the doctor has a track record of systematically killing them. And this is not limited to banking—I generalize to an entire class of random variables that do not have the structure we think they have, in which we can be suckers.

And we are beyond suckers: not only, for socio-economic and other nonlinear, complicated variables, are we are riding in a bus driven by a blindfolded driver, but we refuse to acknowledge it in spite of the evidence, which to me is a pathological problem with academia. After 1998, when a "Nobel-crowned" collection of people (and the crème de la crème of the financial economics establishment) blew up Long Term Capital Management, a hedge fund, because the "scientific" methods they used misestimated the role of the rare event, such methodologies and such claims on understanding risks of rare events should have been discredited. Yet the Fed helped their bailout and exposure to rare events (and model error) patently increased exponentially (as we can see from banks' swelling portfolios of derivatives that we do not understand).

I think the first mistake with deregulation has been to pretend that the financial sector can be treated as private. The financial system is infrastructure, just like roads and bridges. It is an enabler of commerce, a resource that must be in place and must be standardized to allow any economic activity to take place.

The second mistake is to treat financial activity as wealth-producing. When the financial sector leads the economy in profit growth, it is at the expense of real wealth production. Allowing banks to engage in speculative "investment" activity, fueled by leverage, was not only a disaster in the making, but it was a misallocation of capital from truly wealth generating opportunities such as energy and resource production. We have too few oil wells but way too many houses right now because we allowed our financial institutions to play the roulette wheel with leveraged bets backed by the Federal Reserve.

I'm not sure what form future regulations of the financial system should take, but I am in no doubt that the conservative pipe-dream of unregulated financial markets is as dead as Pauly Shore's Oscar ambitions. I only hope that we can direct the bulk of the regulations toward the financial sector and leave the productive sectors of our economy free enough to preserve and enhance our standard of living going forward.

Update: For those who doubt that the current moment represents a potential catastrophe, I refer you to these words from tax law professor Theodore Soto:

In addition, at least $500 billion more of teaser-rate mortgages are scheduled to reset over the next several years. In all likelihood, they too will go into default and become toxic waste. Nothing in Mr. Paulson’s original proposal was intended to do anything about this next $500 billion installment – or, indeed, to prevent lenders from making more teaser-rate mortgages in the future.

Similarly, Mr. Paulson’s proposal was not intended as a general Wall Street bail-out, although to some extent it would have had that effect. Note that the outstanding overhang of credit default swaps alone is estimated to be between $45 and $60 trillion – three to four times the size of our annual gross domestic product. The requested $700 billion, although the single biggest appropriation request in U.S. history, was miniscule when compared with the toxic waste problem as a whole. Mr. Paulson’s proposed solution was to cost just 1% of the size of the problem and was aimed only at a small part of that problem. (It is unnerving to realize that the U.S. government – the “beast” we have been starving for so long – may now lack the borrowing capacity to solve the problem as a whole. We need to get our financial house in order.)