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Why is surprise the permanent condition of the U.S. political and economic elite? In 2007–8, when the global financial system imploded, the cry that no one could have seen this coming was heard everywhere, despite the existence of numerous analyses showing that a crisis was unavoidable.
The critical issue is the artificial suppression of volatility—the ups and downs of life—in the name of stability. It is both misguided and dangerous to push unobserved risks further into the statistical tails of the probability distribution of outcomes and allow these high-impact, low-probability “tail risks” to disappear from policymakers’ fields of observation.
What the world is witnessing is simply what happens when highly constrained systems explode. Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface.
Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to “Black Swans”—that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers. Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems.
Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups. And it is the same misperception of the properties of natural systems that led the economic crisis of 2007–8.
The policy implications are: to make systems robust, all risks must be visible and out in the open— fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying. Just as a robust economic system is one that encourages early failures (the concepts of “fail small” and “fail fast”), the U.S. government should stop supporting dictatorial regimes for the sake of pseudostability and instead allow political noise to rise to the surface. Making an economy robust in the face of business swings requires allowing risk to be visible; the same is true in politics.
SEDUCED BY STABILITY Both the recent financial crisis and the political crises in the Middle East are grounded in the rise of complexity, interdependence, and unpredictability. Policymakers in the UK and the USA have long promoted policies aimed at eliminating fluctuation— no more booms and busts in the economy, no more “Iranian surprises” in foreign policy. These policies have almost always produced undesirable outcomes.
For example, the U.S. banking system became very fragile following a succession of progressively larger bailouts and government interventions, particularly after the 1983 rescue of major banks (ironically, by the same Reagan administration that trumpeted free markets).
In the United States, promoting these bad policies has been a bipartisan effort throughout. Republicans have been good at fragilizing large corporations through bailouts, and Democrats have been good at fragilizing the government.
At the same time, the financial system as a whole exhibited little volatility; it kept getting weaker while providing policymakers with the illusion of stability, illustrated most notably when Ben Bernanke, who was then a member of the Board of Governors of the U.S. Federal Reserve, declared the era of “the great moderation” in 2004.
Putatively independent central bankers fell into the same trap. During the 1990s, U.S. Federal Reserve Chair Alan Greenspan wanted to iron out the economic cycle’s booms and busts, and he sought to control economic swings with interest-rate reductions at the slightest sign of a downward tick in the economic data. Furthermore, he adapted his economic policy to guarantee bank rescues, with implicit promises of a backstop—the now infamous “Greenspan put.”
These policies proved to have grave delayed side effects. Washington stabilized the market with bailouts and by allowing certain companies to grow “too big to fail.” Because policymakers believed it was better to do something than to do nothing, they felt obligated to heal the economy rather than wait and see if it healed on its own.
The foreign policy equivalent is to support the incumbent no matter what. And just as banks took wild risks thanks to Greenspan’s implicit insurance policy, client governments such as Hosni Mubarak’s in Egypt for years engaged in overt plunder thanks to similarly reliable U.S. support.
Those who seek to prevent volatility on the grounds that any and all bumps in the road must be avoided paradoxically increase the probability that a tail risk will cause a major explosion.
Consider a thought experiment, a man placed in an artificially sterilized environment for a decade and then invited to take a ride on a crowded subway; he would be expected to die quickly. Likewise, preventing small forest fires can cause larger forest fires to become devastating. This property is shared by all complex systems.
In the realm of economics, price controls are designed to constrain volatility on the grounds that stable prices are a good thing. But although these controls might work in some rare situations, the long-term effect of any such system is an eventual and extremely costly blowup whose cleanup costs can far exceed the benefits accrued.
The risks of a dictatorship, no matter how seemingly stable, are no different, in the long run, from those of an artificially controlled price. Such attempts to institutionally engineer the world come in two types: those that conform to the world as it is and those that attempt to reform the world. The nature of humans, quite reasonably, is to intervene in an effort to alter their world and the outcomes it produces. But government interventions are laden with unintended— and unforeseen—consequences, particularly in complex systems, so humans must work with nature by tolerating systems that absorb human imperfections rather than seek to change them.
Take, for example, the recent celebrated documentary on the financial crisis, Inside Job, which blames the crisis on the malfeasance and dishonesty of bankers and the incompetence of regulators. Although it is morally satisfying, the film naively overlooks the fact that humans have always been dishonest and regulators have always been behind the curve. The only difference this time around was the unprecedented magnitude of the hidden risks and a misunderstanding of the statistical properties of the system.
What is needed is a system that can prevent the harm done to citizens by the dishonesty of business elites; the limited competence of forecasters, economists, and statisticians; and the imperfections of regulation, not one that aims to eliminate these flaws.
Humans must try to resist the illusion of control: just as foreign policy should be intelligence-proof (it should minimize its reliance on the competence of information-gathering organizations and the predictions of “experts” in what are inherently unpredictable domains), the economy should be regulator-proof, given that some regulations simply make the system itself more fragile. Due to the complexity of markets, intricate regulations simply serve to generate fees for lawyers and profits for sophisticated derivatives traders who can build complicated financial products that skirt those regulations.
DON’T BE A TURKEY The life of a turkey before Thanksgiving is illustrative: the turkey is fed for 1,000 days and every day seems to confirm that the farmer cares for it—until the last day, when confidence is maximal. The “turkey problem” occurs when a naive analysis of stability is derived from the absence of past variations. Likewise, confidence in stability was maximal at the onset of the financial crisis in 2007.
The turkey problem for humans is the result of mistaking one environment for another.
Humans simultaneously inhabit two systems: the linear and the complex.
The linear domain is characterized by its predictability and the low degree of interaction among its components, which allows the use of mathematical methods that make forecasts reliable.
In complex systems, there is an absence of visible causal links between the elements, masking a high degree of interdependence and extremely low predictability.
Nonlinear elements are also present, such as those commonly known, and generally misunderstood, as “tipping points.” Imagine someone who keeps adding sand to a sand pile without any visible consequence, until suddenly the entire pile crumbles. It would be foolish to blame the collapse on the last grain of sand rather than the s...
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