Nassim Nicholas Taleb, author of last year’s bestseller The Black Swan: The Impact of the Highly Improbable, feels no small sense of vindication with the current financial crash.

  Writing on his website, he observes:

For the last 12 years, I have been telling anyone who would listen to me that we are taking huge risks and massive exposure to rare events. I isolated some areas in which people make bogus claims –epistemologically unsound. The Black Swan is a philosophy book (epistemology, philosophy of history & philosophy of science), but I used banks as a particularly worrisome case of epistemic arrogance –and the use of “science” to measure the risk of rare events, making society dependent on very spurious measurements. To me a banking crisis –worse than what we have ever seen — was unavoidable and NOT A BLACK SWAN, just as a drunk and incompetent pilot would eventually crash the plane. And I kept receiving insults for 12 years!

He points us to an interview he gave to Derivitives Strategy published in the December 1996/January 1997 issue.  In it, he repeatedly warns against over-reliance on mathematical modeling in finance.  An example:

DS: What do you think of value-at-risk?

NT: VAR has made us replace about 2,500 years of market experience with a co-variance matrix that is still in its infancy. We made a tabula rasa of years of market lore that was picked up from trader to trader and crammed everything into a co-variance matrix. Why? So a management consultant or an unemployed electrical engineer can understand financial market risks.

To me, VAR is charlatanism because it tries to estimate something that is not scientifically possible to estimate, namely the risks of rare events. It gives people misleading precision that could lead to the buildup of positions by hedgers. It lulls people to sleep. All that because there are financial stakes involved.

To know the VAR you need the probabilities of events. To get the probabilities right you need to forecast volatility and correlations. I spent close to a decade and a half trying to guess volatility, the volatility of volatility, and correlations, and I sometimes shiver at the mere remembrance of my past miscalculations. Wounds from correlation matrices are still sore.

DS: Proponents of VAR will argue that it has its shortcomings but it’s better than what you had before.

NT: That’s completely wrong. It’s not better than what you had because you are relying on something with false confidence and running larger positions than you would have otherwise. You’re worse off relying on misleading information than on not having any information at all. If you give a pilot an altimeter that is sometimes defective he will crash the plane. Give him nothing and he will look out the window. Technology is only safe if it is flawless.

He also quotes from his famous book, which he notes was written from 2003 to 2006. 

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 crises 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.

Banks hire dull people and train them to be even more dull. If they look conservative, it’s only because their loans go bust on rare, very rare occasions. But (…)bankers are not conservative at all. They are just phenomenally skilled at self-deception by burying the possibility of a large, devastating loss under the rug.

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 deemed these events “unlikely”.

There’s much more of that sort of thing at both links.  Clearly, the man’s an expert on the financial markets — at the time of the 1996 interview, he had already had a distinguished career, described as “one of the world’s leading quantitative traders” and was completing his PhD dissertation on option pricing — and he got this one very much right. 

Indeed, in hindsight, his logic is inescapable.  Even those of us who are by no means experts at either trading or advanced mathematics understand that we simply don’t have the data to do very useful predictive analysis in social science or any other endeavor where human behavior is a key variable. 

I must admit, however, to some small amusement from a man who simultaneously brags that, “My major hobby is teasing people who take themselves & the quality of their knowledge too seriously & those who don’t have the courage to sometimes say: I don’t know” while repeatedly referring to those who disagree with him as “Imbeciles.”   That’s perhaps not the best stance to take if one wishes to persuade.

James Joyner is managing editor of the Atlantic Council.  

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