Adonis Diaries

Part 2. Applications of Black Swan model to “Spring revolts” and the financial crisis

Posted on: June 4, 2011

Applications of Black Swan model to “Spring revolts” and the financial crisis

It might be good to read the concept of Black Swan before engaging part 2, but I will do my best for this article to be self-contained: https://adonis49.wordpress.com/2011/06/01/part-1-black-swan-model-can-rare-catastrophic-events-of-man-made-systems-be-controlled/

A few captions: “As it was predictable, the unexpected happened”; or “Excuse the catastrophe:  I am still getting familiar with the system”; or the adage: “If an event can occur, it will happen”, meaning, it does not matter how low the predicted probability of occurrence of the rare events, it will strike “unexpectedly”.

In a nutshell, the Black Swan theory states: “In complex systems, especially man-made complex systems, it is not feasible to comprehend all the interactions among the hundred of variables affecting outcomes. In man-made systems, we have to allow natural fluctuations that are at work.  The rare predicted calamitous events  will strike unexpectedly, and we will fail to react accordingly and adequately if we consciously avoid to consistently take them into consideration in our analysis and reports.”

What led manking to progress is due to periods of liberty in thinking, expressions, and free gathering, rather than the enduring periods of peace, as people were constrained to think within dogmatic ideologies (religious or others)

For politicians and decision-makers, risks must be visible and pragmatically pertinent to relay to the voters. The adage “Better fail early if we have to” is accepted by policy makers, but rarely applied in due time:  It is always too late to remedy efficiently and economically.  For example, democratic systems know that they are better off if dictators fall early on, but the powerful financial institutions beg to differ. The elite classes in “democratic systems” opted to negotiate with “reliable” potentates, rather demanding a referendum of the people on key issues.  For example, the Romans would not sign a contract except with “free men”, behaving according to Roman civil laws, but western democracies felt comfortable and expedient consorting with dictators and absolute monarchs.

We are better equipped to predicting lunar eclipses, but not stock evolution, or foreign political upheavals.  It is NOT the “last grain of sand that crashed the structure or the bridge…”  The last grain was the catalyst for the failure but not the cause.  The fault is in the designed system, and not in its components.

First case-example: The financial crisis of 2008 and its repercussions.  The “subprime” was not the cause of the financial crisis in 2008: It was just the latest among the catalysts of financial tools.  The last two decades witnessed several successive financial crisis that affected most States around the world: Latin America (Argentina), East Asia in the 90’s, Russia…

Actually, if the western European States decided to adopt a unique currency for the EU in 2000, it was because, given the political trend in the US refusing to regulate the financial institutions, they expected a major financial crisis and decided to face it as one block with one currency.

The cause was a faulty financial system that the political decision-makers failed to redesign in due time, requiring courageous and determined positions to ironing-out the serious problems growing out of proportions in risky behaviors, in an unregulated system, and in instantaneous pouring of massive liquidity to “stabilizing” a fragile outmoded designed and faulty system.

The first bias is our illusion in our capacity to control volatility in man-made complex systems. For example, we focus on the “normal working” of a system and we delete from our analysis and reports the minor fluctuations or rare events that are occasionally occurring.  In a sense, if there are no variations, there are no information worth controlling.  This tendency of feeling very comfortable dealing with only a “stable” system leads to forgetting the consequences of calamitous rare events.

The second psychological bias is the illusion that acting on a factor is better than doing nothing and letting the system work-out its fluctuations.  For example, authorities think or are pressured to think that they were elected or appointed to act and react on any variations, instead of doing nothing when fluctuations are within the norm.  Consequently, it is these actions that usually exacerbate a system going bad and out of proportion.  For example, Alan Greenspan and later Ben Bernanke lowering the central bank interest rates to almost negative rates in order to “stabilize” a fragile faulty financial system that needed major redesign.

Second case-example:  The “Arab Spring” revolts.  The upheaval started in Tunisia and Egypt and spread to other “Arabic” societies and overflew to European States.  President barack Obama blamed the incapacity of the CIA to failure to foresee the coming turmoils.  The CIA, as any other public institutions, works within the larger framework of focusing attention on models of “Big moderation”, and the illusion of being in control of the models they are using and have conceived and tampered with.

Since any complex model has inherent fluctuations, total and permanent control on power could not be maintained. In dictator regimes, opposition parties are repressed.  Consequently, democratic oppositions were demobilized, opposition activists seeked exile to resume their engagement from the outside, every expression, association, and community gathering were to be prohibited or tightly controlled. History demonstrates that the more constraints are imposed on naturally volatile society, the more radical are the changes.

For example, Italy has witnessed more government changes in the last century than any other democratic systems, but the changes oscillated stably around a point of equilibrium:  A change in power rapport among coalition forces could not annihilate the other opposition forces. Italy has true political parties with programs and policies.  The election laws in Italy are among the fairest and most equitable in the western States.  Frequent changes in governments didn’t prevent Italy to continue being among the leading economic powers in the world.  Italy is very generous in investing in the poorer nations and its grants are relied upon in most States around the Mediterranean Sea basin.  Italy has many contingents in the various UN peace-keeping forces…

The case of Lebanon is not as straightforward as Talib would like us to believe.  Lebanon is basically a non-State country with governments playing take-care functions.  There is no stable and consistent central government:  The real power is held by the 18 officially recognized religious sects and the financial institutions (banks).  The citizen is identified by his religious affiliation from birth to death, and the only sign of citizenship is represented by the passport. Read my post https://adonis49.wordpress.com/2011/06/03/is-lebanon-political-system-immune-to-radical-non-violent-revolts-think-again/

The case of Israel is different:  Israel has a system that required frequent change of government, but its “stability” is based on the total support of the USA and western European States, infusing Israel with billion of dollars and free military hardware…One characteristic of Israel system is that previous treaties are cancelled if the new government was opposed to the treaty.  Continuity was possible within the policies that all parties agreed with.  For example, treaties with Palestinians for establishment of a State were sidetracked with impossible constraints by the following government.  Israel is quickly converging toward a theocratic Jewish State because the old guards for a secular Israel are cowering in their comfort zones and refusing to fight the young zealots.

Third case-example: The Fukushima disaster.   The melting down of three nuclear reactors is a typical example.  It is NOT the earthquake and the tsunami that are the causes of the meltdown:  They were the catalysts.  The cause is a faulty designed system for generating electricity that is highly dangerous and built in a region frequently exposed to high levels of earthquakes and tsunami.  The economic-risk tradeoff was meant for normal functioning of a nuclear plant, and the consequences of  a serious event striking was swept under the carpet for three decades.

The owner of the power nuclear plant and the government blamed natural phenomena as the causes and toned down the lethal exposure to radiation for over a month.  Why?  It is better not scare the people! What?  It is better to let people die peacefully than give them the proper information to decide on their own plan of actions?

It is normal for mankind to be wary of the volatile aspects in life.  In the past, mankind managed to block-out drastic fluctuations from their consciousness in order to survive:  Mankind figured out the major trends in the hazards of life in order to foresee and adopt simple models they could control for administering and managing their lives and the survival of the community. The behavioral model should allow normal fluctuations in behavior to react within normal realities.

Simple models have been replaced by complex models, but within the past linear mentality and comprehension.  You may understand a few interactions among three main variables, but when man-made design inserted hundreds of volatile factors in a system, we should no longer expect to have total control on the complex system.

If we are not ready to design reasonable fluctuations in a system, and be ready to take seriously the problems of rare occurrences, and be trained to react to calamitous rare events, then it is wise to stick to simple systems that individual operators can understand and can control.

A man-made system should not be designed to eliminate all the faults, ill-behavior, and limitations of mankind, but to factor them in, and be trained to react adequately to these variations:  The operator has to be constantly motivated to learn and be vigilant to minor fluctuations and comprehend the main interactions.

Note 1: Nassim Taleb, a mathematician, was a trader and worked for 20 years as consultant to large investment banks in New York and London. He created Empirica LLC for trading.  He is engineering professor at the polytechnic institute at the University of New York.  Taleb published “Savage hazard” and “The Black Swan:  The power of the unpredictable.”

Note 2: Mark Blyth is a Scottish professor of international political economy at the university of Brown (Rhode Island).  He published “Great Transformation: Economic ideas and institutional change in the 20th century”.  A new book is to be released “Austerity: The history of a dangerous idea”

Note 3: Black Swan is a term coined after discovering a black swan a couple of years ago.  People firmly believed that all swans were white:  A few might have observed a black swan but refused to identify it as a swan; or black swans are common sight in particular regions and people had no idea that black swans are considered rarity all over the world and might be purchased for their weight in gold to be raised in zoos!

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adonis49

adonis49

adonis49

June 2011
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