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The Black Swan and Really, Really Dumb Smart People

Sorry but I am in Manhattan Market Overview high gear prep mode – the report will be published later this week – so I am pretty lame on the content side for Matrix at the moment.

One of my semi-regular podcast downloads is Russ Robert’s EconTalk [1]. This week he interviews Nassim Taleb [2] , the author of Fooled by Randomness and the Black Swan [3] of a few years ago. I own the latter, but I think the former is over my head. I’ve never heard him speak before. I have now listened to this podcast 3 times already and thoroughly enjoyed it. Also make sure you read the slew of comments posted to their site.

Nassim Taleb talks about the financial crisis, how we misunderstand rare events, the fragility of the banking system, the moral hazard of government bailouts, the unprecedented nature of really, really bad events, the contribution of human psychology to misinterpreting probability and the dangers of hubris. The conversation closes with a discussion of religion and probability.

On one hand I am very leery of people who suggest they have all the answers to a problem but not the solutions – Nouriel Roubini is another example – but Taleb’s arguments are compelling. After all, I think we all want to understand how so many smart people could be so utterly stupid for so long. If it wasn’t mortgages as a vehicle, it would have been something else.

I loved the ten year flood example given in the notes of the interview:

A ten year flood has a higher probability than a 100 year flood, but the 100 year flood will be massively more consequential. You care about the probability times the size of the impact, the expectation of these events. Small-probability events can have in some domains, fat-tailed domains, a big impact and we don’t know how to estimate them.

Here’s the compensation scenario and moral hazard – notes from the interview:

Were heads of Bear Stearns and Lehman Brothers not aware of how much they were gambling or did they not care how much they were gambling? Combination. Three things: 1. fooling themselves, psychological dimension. 2. Had an interest in building huge risks and tail because if you blow up every 10 years, you will make 9 bonuses and the 10th year someone will pay the cost, not you. Vicious: taxpayers are paying retrospectively for the bonuses of the first 9 years. Banks are insolvent, have lost more than their capital base, but managers have kept their bonuses. Some of them have been wiped out because they went a little further than normal blow-up cycle. What about the ones who didn’t do it? Lower returns year after year; now should be doing extremely well, but now unable to buy up some of the firms that have made the mistakes because the government is propping them up.

Aside: Speaking of dumb, how about the new space station named “Colbert” [4] and video [5]. To see the vote page and the number one suggested name – go here [6].