The horizon is not so far as we can see, but as far as we can imagine

The Financial Crisis is Not a Black Swan Event

Image By Ennor

Image By Ennor

I have become increasingly concerned that some in the Obama administration are treating this economic crisis as a Black Swan event. Nassim Nicholas Taleb coined the term to describe an event that is very rare, random and unpredictable. The imporant thing about Black Swans is that, because they are random and unpredictable, you can’t stop them from happening; you can only create your systems able to  handle Black Swans if they occur. For example, a flu pandemic that kills tens of millions might be a Black Swan, and it’s one that we’re completely unprepared for, as we don’t have the excess medical capacity to handle it.

The most recent event which made me think of Black Swans is the news thatnew SEC Chair Mary Schapiro doesn’t plan on reforming ratings agencies. Now, ratings agencies were one of the key actors in this mess—they certified mortgage backed securities and other toxic derivatives as AAA quality. If they had not done so, almost no one would have bought them.

The ratings agencies are paid by the companies whose securities they rate. I trust you see the problem.

If you think that the current economic crisis is just random, a once in a century disaster (or at least once every few decades), then you won’t think making major changes is necessary. Get through the problem, go back to how you were doing things before, and everything will be fine.

But, of course, the economic and financial crisis unfolding right now was not random. This crisis was predicted by multiple people, and it was predicted because of policy steps taken by government and widely-known private actions.

We could all read the charts showing a bubble in housing prices and sales. We could all see that derivatives were also in a bubble. We knew that leverage was out of control, ballooning to 30X or in many cases even higher numbers. We knew that with financial deregulation firms had started being involved in multiple types of businesses, putting retail banks at risk from their insurance or brokerage or investment banking arms. We all knew that the US savings rate had hit unsustainable lows and that the trade deficit was too high. We knew that the carry trade was introducing tons of hot money to the system (borrowing for nothing in Japan and using that money for leveraged plays elsewhere).

And, perhaps most importantly, we should have known that executives in the financial sector paying themselves huge bonuses were concentrating on short term gains and did not care about long term viability of their companies or even care about the honesty of what they were doing, because hey, by the time it all fell apart, they’d be rich, rich, rich and never need to work again.

All of which is to say the crisis was caused by a number of factors. It was not random. It was predictable and predicted. If we just muddle through this current meltdown—spend a lot of money bailing out the banks, throw some stimulus around—and don’t fix the fundamentally-flawed incentives and structures of the system, it will likely happen again.

Alas, Mary Schapiro’s actions imply that there was nothing really fundamentally wrong with how business was done.

At the very least, the US needs to make the following changes:

  • Reduce executive compensation—significantly,
  • Bring all securities under regulation (i.e. Credit Default Swaps must be regulated as insurance including reserve requirements and the necessity to use government approved actuarial charts),
  • Reduce overall leverage to 10X for everyone,
  • Break financial companies back into functional firms (i.e. break brokerages and insurance companies and investment banks off of retail banks),
  • Disallow financial innovation which is not expressly approved by regulators and is not then fully regulated,
  • Fix its trade imbalances,
  • Fix its savings rate,
  • Move off of the oil economy,
  • Ensure that lending is done responsibly and at relatively low markups from the Fed Funds rate, and
  • Enact anti-usury laws.

If these changes aren’t made, then you can bet dollars to the donuts that a financial crisis will happen again in some form. This crisis is a structural problem, not a random mess caused by bad luck.

Originally Posted at FDL, February 19th, 2009. I’d say nothing has changed, but in fact it has, we now know pretty much for certain that the Obama administration thinks this is a Black Swan event.  The Geithner plan makes that very clear.


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  1. Gordon

    Hey Ian.

    Here are Mary Schapiro’s words from her testimony:
    I also plan to focus on the critical role played by rating agencies, and to improve the current ratings process. The SEC recently approved additional rules, pursuant to our authority under the Credit Rating Agency Reform Act, to address certain weaknesses in the ratings process. These rules were a step in our continuing efforts to bring transparency and accountability to the ratings process, which plays a critical role in the market’s pricing and allocation of capital. The Securities and Exchange Commission will hold a roundtable on April 15 relating to its oversight of credit rating agencies. Discussion topics will include issues related to recent SEC rulemaking initiatives, such as conflicts of interest, competition, and transparency.

  2. Gordon

    And Here (PDF) is an interview she did in 2005. Ratings agencies come up on pg 22.

  3. Ian Welsh

    Interesting. We’ll see what she does.

  4. Gordon

    “Interesting”? When the entire premise of the post is based on Jane exaggerating a FT post that contains no quotes or sources and which is contradicted by direct on the record evidence? Shouldn’t that be “Oops”?

  5. Jim

    Robotics, labor theory of value, and falling rate of profit. The material bases for the current and future economic crisis.

    On reform. Can you reform a volcano before it is ready to explode?

  6. Ian Welsh



    However, the premise of the post stands because I could have written it using any number of other examples, like Geithner’s plan, Obama’s stimulus, healthcare “reform”, tax policy and so on.

    I am quite confident that the necessary reforms aren’t going to made. Tax rates are not going to be increased properly. Health care is not going to be done properly. The banks are not going to be regulated properly. Etc../ If they are, I shall be quite happy to offer a mea culpa on the overall thesis. As for the specifics, mea culpa, shouldn’t have trusted that Jane was correct in this case.


  7. Terry

    “I am quite confident that the necessary reforms aren’t going to made.”

    And why do you think this is? I think you have answered that also in your post:

    “..executives in the financial sector paying themselves huge bonuses were concentrating on short term gains and did not care about long term viability of their companies or even care about the honesty of what they were doing, because hey, by the time it all fell apart, they’d be rich, rich, rich and never need to work again.”

    They will not make the necessary reforms because they don’t want to.
    Now, you can dress this up and say “the political will doesn’t exist”, or “affected industries are liable to battle further regulation in court” or whatever, but that’s the essence of it. Who the heck are they fooling?

    No, the game is to lay low, find someone else who has poop on them to feed to the lynch mobs, and when things calm down start quietly looking for loopholes that allow you to evade scrutiny to pursue another round of unethical (if barely legal) but lucrative strategies.

    So, they get $1 trillion from us, the taxpayers, and divert attention to $165 million to bonuses of money taken from the taxpayer to pay people to close up the divisions of AIG that failed (that is, people who didn’t cause the problem, and have a perfectly legal negotiated business contract to be paid that money, which the US government is going to break). Even if you get that money back, the net gain to the taxpayer is still a $1 trillion dollar loss, that is, take the $100 million and multiply it by a factor of 100,000.

    We should be worried about getting back the $1 trillion in my estimation. Instead corporate financial hacks and their pocketed politicians are trying to get us to chase after a consolation prize that is 100,000 times smaller than the actual amount of money they are responsible to the taxpayer for. Think about that.

    What angers and worries me is not that there’s systemic problems. We have a lot of really smart people who can fix systemic problems.

    No, what angers and worries me is that the people who caused these problems through their greedy and reckless exploitation have no intention of changing their ethics, and even if a significant percentage of them have made their money and gotten away, there will be a new generation of unethical financiers and politicians to replace them.

    So who are we looking to for the “fixes”? The big financiers and politicians, of course.

    As you said, I trust you see the problem.

  8. Gordon

    On Obama says “This crisis did not happen solely by some accident of history or normal turn of the business cycle, and we won’t get out of it by simply waiting for a better day to come, or relying on the worn-out dogmas of the past.” Sounds pretty close to saying “systemic problems”, doesn’t it?

    And from the WaPo today: “President Obama began by speaking about his concern for the continuing fragility of the financial system and his desire to find long-term solutions so that renewed lending could spark economic growth. He also said that systemic risks had been overlooked during the boom, and that there was a need for corrective action, a reference to the administration’s blueprint for regulatory reform. ”

    So no. If reform fails to get passed, it’s not because Obama thinks this was a black swan event. It will be because he can’t get the votes in the Senate. And that would yield a very, very differnt post, wouldn’t it? One that puts pressure on centrist Dems and moderate Repubs to get real.

  9. Ian Welsh

    Words. Actions.

    The second speak louder to me. I don’t give a damn what Obama says, I care what he does. His reform details are due out next week, I believe. If they are good enough, I’ll say so. Until then, what I see is a giant bailout of the banks, while leaving the people in charge who caused the crisis. I see a stimulus bill which is frankly inadequate, with too many tax cuts and not enough tax increases on the right people and during the stimulus debate he pushed for the worse Senate bill (which was closer to his original proposal) over the better House bill. Etc…

    Talk is cheap. If Obama, Geithner, Summers and yes, Schapiro, want to convince me and people like Krugman and Stiglitz and Dean and so on, ie. the people who called most of this right, unlike most of the people he put in charge of the economy and the markets who called most of it wrong, well, actions are what will convince us.

    And, more importantly, we’ll see how the economy plays out. It’s the ultimate arbiter, after all.

    So… is he going to move to highly progressive taxation?

    Is he going to regulate CDS’s like insurance?
    Probably not.

    Is he going to limit leverage properly.
    Maybe, maybe not.

    Is he going to properly regulate securitization?
    We’ll see.

    Is he going to move to a financial transactions tax?
    Doubt it.

    Is he going to break up the “too big to fail” banks and other financial firms?
    Don’t make me laugh.

    Is he going to reinstitute the Glass-Steagall provisions not allow brokers, investment banks, commercial banks and insurance companies to conglomerate?


    He’s going to do some half assed reforms.

    Actions, not words.

  10. Gordon

    “Is he going to…” That’s all you ask. And your evidence is “he hasn’t yet”, and your conclusion is “so he never will”.

    You don’t see a certain circularity to your reasoning?

    Oh that’s right. I’m panglossian. Which apparently means someone who recognizes that policy and politics are different things.

    I’ll leave you alone to your misery now.

  11. Parviz, Tehran

    I disagree with Ian Welsh completely on his not considering the financial crisis a Black Swan event. I´ve read Taleb´s book (it´s repetitive, but brilliant) and nowhere does he write that Black Swan events need to be unavoidable to qualify as Black Swans.

    A Black Swan event might just as easily be the appearance of a genuine alien on the White House Lawn (unavoidable, unpredictable) as a once-in-a-lifetime financial crisis resulting from totally preventable human greed and negligence.

  12. Ian Welsh

    It’s not necessarily a once in a lifetime event. Something very similar will happen again if they don’t do reform properly.

  13. pk

    Hmmm, I think the point is that the financial mess was NOT UNPREDICTABLE because it was predicted, and quite loudly, by a number of people who were called cute little names like “Dr. Doom” and mostly marinalized as nut pots. How can you expect solutions from people who claim that they never saw it coming? I have ZERO education in economics and finance and it took about six weeks of reading and research from a lot of different sources to say “Holy Crap! this is a house of cards, smoke and mirrors, ponzi scheme on steroids.” This was 3 years ago, but the “experts” only saw smooth sailing.

  14. rapt

    pk: “NOT PREDICTABLE”. But it really was, at least to anyone with sense in the last few years.

    I didn’t see Ian mention INTENTIONAL though, or any commenters so far either. Lets face it, these boyz are not that supid; it couldn’t have happened except intentionally. Go from there and figure out why. I don’t claim to know the answer to that one.

  15. Parviz, Tehran

    Ian, you might be interested in my comments on the MoA Blog that featured your article and led me to your site:

    Taleb doesn´t actually define his concept very precisely, but I personally concluded that there are two main criteria for an event to be defined as a Black Swan event:

    1. It has to be totally unexpected:
    The very event that gave Taleb his inspiration for the name of his book, namely, the discovery of black swans in Australia, was socially/economically/politically insignificant: What was significant was the discrediting of millenia of popular assumption (everywhere except obviously in Australia!).

    2. The discovery must be devastating in its suddenness and unexpectedness and far-reaching in its effect:
    Now, this may seem to contradict 1. above, but in fact it complements the first criterion.

    The collapse of the USSR in just 72 hours was definitely a Black Swan event, wholely unexpected (1. above) and a game-changer that left one sole superpower (2. above).

    Now, some brilliant minds (like Brzezinski) forecasted the collapse of the USSR, just like some brilliant economists forecasted (and profited from) Great Depression II. What is important is that, no matter how long the economic tsunami had been building up, and no matter how many sages predicted Armageddon, when it finally came its depth and strength took almost ever banker and politician and corporate chief by surprise. Overnight a ´ billion´ suddenly became a ´trillion´, which is in and of itself a mind-boggling event. Overnight the entire concept of ´Capitalism´ was thrown into doubt, and with it the concept of U.S. economic supremacy.

    There are people who not only predict the existence of Martians in outer space but even claim to have met them already. Now, if Martians do start picknicking on the White House lawn it will still be a Black Swan event even in spite of the claims and/or predictions of some who said they had predicted this all along!

    There are more obvious Black Swan events that might occur, like a mile-wide meteor hitting Earth that would disrupt life as we know it, but what Taleb is actually focussing on are matters closer to home, past events on which we base future theories, things like the Bell-Curve which he disparages every other page, and the concept that recessions will always be followed by economic booms and that “economists have everything under control”.

    I found the book fascinating.

  16. Ian Welsh


    the thing is many people forecast what has happened. I was one of them, but there were mainstream economists like Stiglitz and Krugman and Roubini and Dean who did as well. These aren’t marginal people, these are high profile, respected economists working at prestigious institutions. They aren’t “martian kooks”. This is the brain trust. And in many cases we predicted how bad it would be, I know I used the words “could cause a new Great depression” on occasion, so did others. So I think by the “couldn’t be predicted” metric it fails.

    Now, I suppose one could say “wasn’t predicted by decision makers”, but frankly if that’s the metric, well, black swans are pretty common, because most decision makers lack objectivity about systemic risks.

    But perhaps that is the definition, in which case maybe it was a Black Swan. But the larger point is this:

    it was easy to predict. It didn’t take brilliance. What it took was intellectual courage – the ability to read very basic numbers and charts and believe that they meant what they said – that you had multiple bubbles. That’s all it took. I’m not an economist (though I know a reasonable amount of economics) and I figured it out. Heck I knew we were bucking for a housing bubble in 2002, and I wasn’t the only one because I was talking to others who saw it coming.

    And, from a practical point of view, I knew it was coming because of system factors. If those systemic factors which gave rise to fraud and bubbles are not corrected, we will have another financial/economic black swan. If this is treated as a one off event, then something like it will occur again.

    The people in charge didn’t see it because they steadfastly refused to see it, because they were getting filthy rich by not seeing it.

  17. Parviz, Tehran

    Ian, I believe you´re severely underestimating the scope and depth of the current economic crisis. Triple A companies that survived the Great Depression didn´t survive this one, the world´s biggest insurance company (AIG) has been nationalized to save it from bankruptcy, flagship U.S. enterprises like GM are de facto bankrupt, the $ 50 billion Madoff scandal dwarfs all previous Ponzi schemes and, last but not least, the Capitalist philosophy has probably been dealt a mortal blow that will never again see corporations running democracies.

    If the above cataclysm (and I´ve mentioned only a fraction of its features) doesn´t represent a Black Swan, I don´t know what does.

    Many of us (including myself under my real name) predicted a U.S. crash, but I never in my wildest nightmares believed that the derivatives House of Cards had a value exceeding $ 50 trillion (and counting). This is far higher than the Great Depression debacle even when measured in 1929 Dollars.

    In the end, we´re merely splitting hairs, like trying to define “amazing” or “awesome” which are both overused. Maybe it´s better to reserve the Black Swan expression only for events of the Martian kind, to avoid its similar overuse!

  18. Parviz, Tehran

    Postscript: Just for argument´s sake, a 10-Richter earthquake in California is theoretically possible, something that would make Texas sea-front property. But while we accept that it could happen I believe it´s actual occurrence would qualify it as a Black Swan event ……..

  19. Brandon

    I also hope that the Obama administration will not deal with the economic crisis as a “once in a century disaster”. There were many experts who predicted the crisis and pointed out how serious the situation is. A CEO Magazine interview with the economic oracle Med Yones, who accurately predicted the economic crisis in January 2007, emphasizes the bad health of the American economy. Solutions that are being suggested are for example, changing the income tax to flat sales tax or value added tax (VAT) to encourage investments and discourage consumerism, instituting term limits on the Congress and Senate to reduce the abuse of power and the long-term access of lobbyists to politicians, tax holidays for new industries and raising banks’ mandatory reserves. For further information see

  20. Well, as you say, splitting hairs. My point is just “it was predicted”. I may misunderstand what the strict definition of Black Swan is, the point I wanted to make is that it was predicted and that if we treat it as some sort of random event we just have to get through, rather than something which requires a fundamental reorganization of both economy and society, then even if we “get through it”, we’re just setting ourselves up for another one.

    This is a discussion I have constantly – is this the big one, or the crisis before the big one. One side of the argument is that there’s enough credit and money out there to paper this one over enough to stumble through. The other is “it’s too big”. I’m currently going with the first, but it’s a loosely held prediction, as it were, and I waver.

    What I do believe is that fundamental changes are needed, in either case and that if we try and go back to the paper/oil/goods economy we’re making a very big mistake.

    In terms of the great Depression (aside), well, Union Carbide went under then, but more to the point, even in equivalent terms unemployment, real food scarcity etc… is not yet at those levels.

    Yet, of course, could be the operative word…

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