Wednesday, November 04, 2009

# Posted 9:29 AM by Ariel David Adesnik  

THE MAN WHO PREDICTED THE FINANCIAL CRISIS, PART III: I'm not an aggressive consumer of financial journalism, so it has to be something of a coincidence that I've come across three separate items that chronicle the dark predictions of three separate men who warned of an impending financial crisis.

The first two are discussed below. The third is Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Highly Improbable. The Black Swan was published in 2007 and written in the preceding years. Here are a few quotes that jumped out at me:
Once again, recall the story of banks hiding explosive risks in their portfolios. It is not a good idea to trust corporations with matters such as rare events because the performance of these executives is not observable on a short-term basis, and they will game the system by showing good performance so they can get their yearly bonus. The Achilles’ heel of capitalism is that if you make corporations compete, it is sometimes the one that is most exposed to the negative Black Swan [extreme event] that will appear to be the most fit for survival. (pp.209)

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 (often Gaussianized in their risk measurement) -- when one falls, they all fall. The increased concentration among banks seems to have the effect of making financial criseis 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. (pp.225-226)
While apparently talented in terms of financial analysis, Mr. Taleb is awful when it comes to web page design. His home page is confusing and cluttered. He provides a list of prophetic quotes from The Black Swan, but no page numbers -- which I added myself. I also had to correct the typos in his quotations from his own book.

Anyhow, enough aesthetic complaints. The substance is interesting. Will the Cassandras I've blogged about become financial celebrities now that they've been vindicated? Were they vindicated because they were lucky or because they were smart? I have no idea, but given that the value of my pension and my home may depend on this sort of thing, it may be a good idea to figure it all out. Then again, we got to where we are today because all sorts of brilliant people who study this stuff for a living still couldn't figure it out. So what good can I do by dabbling in financial analysis?

(PS I definitely recommend Taleb's book. Neither a mathematician nor an economist, I can't vouch for its contents. But Taleb is both very entertaining and very erudite. On the downside, he is impossibly self-satisfied, profoundly enjoys settling scores with his rivals, and you have to read forty pages before getting to the good stuff.)

Cross-posted at Conventional Folly
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