By Mark S. Mellman - 05/11/10 11:18 PM EDT
Were we to label decades the way the Chinese name years — by reference to animals — this would qualify as the Decade of the Black Swan.
In Roman times, a black swan signified an impossibility — as all swans were white. That is, until Dutch explorers came upon black swans in Western Australia in 1697. Then, naturally, the meaning of the term was transformed into the description of something that once had been deemed impossible but now was found to exist after all.
Nassim Taleb transformed the term again, is his book by that title, to refer to events that are both rare and extremely consequential. We have had our fill of those in recent years — from Sept. 11 to the financial crisis to the Gulf oil spill. All were very unlikely, yet all occurred, with devastating impact. Our responses to all three reveal we are still struggling to understand and guard against such events.
Economists said the financial crisis could not happen — a conclusion reached by assumption. Economists assumed securities prices vary according to a normal, bell curve — lots of little changes and very few big ones. Two Nobel laureates prefigured our most recent debacle, going bankrupt and creating a financial crisis all their own in the ’90s, based on the assumption these risks could be managed by statistical modeling.
Bell curves are handy devices. They nicely describe height and weight. Very few are far from the averages, and even they are not terribly far. Take a sample of 1,000 adult American men and their total weight will be about 191,000 pounds. Add the heaviest American man ever (who tipped the scale at 1,400 pounds) and you have changed the weight of the sample by seven-tenths of 1 percent.
But bell curves don’t work everywhere. Move from weight to wealth. A sample of 1,000 Americans would have a combined net worth of about $120 million. Add Bill Gates to the sample and you have increased the net worth of the sample by some 440 times. No bell curve there.
So it is with stocks. On average, the Dow Jones increases by about 0.25 percent per day. A few months ago it plummeted by over 300 times that amount. According to some, in the course of a few months, banks lost more than the total of all the money they had ever made from investing. Rare and unlikely — with consequences beyond our wildest imaginings.
A Gulf oil spill was also judged as exceedingly unlikely. How do they compute the odds? Oversimplifying only slightly, count up the instances and divide by something. Since 1972 there have been just eight major platform spills in the Gulf — the largest discharged less than 20,000 barrels of oil. History suggests big spills are unlikely. It’s akin to saying Muhammad Ali has been alive for each of nearly 25,000 days — he must be immortal. All those wells pumping and never a spill of more than 20,000 barrels. Despite the “odds,” by early June, Deepwater Horizon will likely have deposited some 260,000 barrels into the ocean.
Black swans are, by definition, difficult problems, but these events should lead us in at least two directions.
First, be modest in assessing risk. In truth, we have little idea just how risky most courses of action actually are, and pretending to know more than we do renders us all less safe.
Second, limit the potential size of impacts. If a financial institution is too big to fail, it should be too big to exist. The broader its reach, the more likely we all are to suffer from its demise. The more we drill and the more we pump from each well, the more vulnerable we are to blowouts.
Oil is not the only dangerous source of energy. The nuclear industry touts its safety record — more plant days without incident than Ali has lived. But, if one day a nuclear plant suffers a major accident, those black swans could all be turning green.
Mellman is president of The Mellman Group and has worked for Democratic candidates and causes since 1982. Current clients include the majority leaders of both the House and Senate.