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  • Knowledge, Stability, and Black Swans

    Posted by David Foster on December 4th, 2011 (All posts by )

    The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.

    –George Eliot in Silas Marner

    I was reminded of the above passage by a couple of recent posts:

    Claire Berlinski excerpts some thoughts by Hernando De Soto, asking “Is the knowledge system broken?” Some good discussion in the thread at Claire’s post; see especially the concept of a “knowledge bubble” in the comment by Late Boomer. Although I’d say that it’s more a matter of an assumed-knowledge bubble.

    Richard Fernandez suggests that “too big to fail” really means “wait for it,” where “it” means a failure on a very large scale. He cites Nassim Taleb:

    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.

    Both of the above are very worthwhile reading. See also my related post penny in the fusebox.

     

    12 Responses to “Knowledge, Stability, and Black Swans”

    1. David Foster Says:

      See also Peter Robinson’s post citing Michael Crichton on the irreducible complexity of the natural world.

    2. Tatyana Says:

      Curious how the word “stability’ jumped at me from the page. I just finished memoir of Friederike Zweig, where she reprints his last letter to her, few days before suicide: the word “security” appears several times, as in “lack of s.”, “lost s.”, “unattainable s”.

    3. tyouth Says:

      “broken knowledge system” and “assumed-knowledge bubble”….We could say “the feedback loop is being corrupted which is resulting in noise (or non-knowledge)”.

    4. Robert Schwartz Says:

      At least one contemporary author is explicitly addressing the need for a less fragile political economy:

      “Book review: Mark Pennington’s Robust Political Economy” by Lynne Kiesling August 4, 2011
      http://knowledgeproblem.com/2011/08/04/book-review-mark-penningtons-robust-political-economy/

      Kiesling’s link to the lecture at CATO (2 thumbs up) in NG. Use this one:
      http://www.cato.org/event.php?eventid=7872

    5. Lexington Green Says:

      David, thanks. These are both excellent.

    6. David Foster Says:

      Rules, rules, rules

    7. Cousin Dave Says:

      I don’t think the knowledge system is broken. I do think there are groups who, consciously or unconsciously, are attempting to sabotage it. For the past century or so, most people have relied on academic and media gatekeepers to do the error correction and filter out the false transmissions. But as has been much discussed here and elsewhere, those mechanisms are no longer reliable, and everyone is on their own. Some people have learned good error-detecting and error-correcting mechanisms, and some haven’t. I can make an argument that the single largest divide in Western society today is between the people who have learned those skills, and the people who haven’t.

    8. Shannon Love Says:

      I don’t think the information system is broken. I think to many people don’t understand what information is.

      The key failure in both the US real estate boom-bust and European Soveign debt crisis is the failure to realized that prices are flowing information in the economic internet and any fiat manipulation of prices destroys information. The price information destroyed in both of these cases was the price of borrowing money i.e. interest rates.

      Banks only make money by getting paid back for loans so the only reason they won’t make a loan is because they or their depositors and lenders (other banks) judge the loan as to risky. As the risk goes up, so does the interest rate. As the risk goes down, so does the interest rate. The interest rate will communicate to all borrowers and all lenders the risk of any particular loan. Interest rates in aggregate communicate vital information about the risk of loans in specific communities or regions.

      Any government fiat that reduces interest rates by any means other than improving the ability of borrowers to pay back loans, destroys vital information in the financial system. Loans will be judge less risky, more risky loans will be made and eventually the risky loans will pile up and collapse the system.

      This is what happened with the US residential mortgage market. The US government intervened on a massive scale to lower interest rates by transferring the risk of repayment failure off banks and onto the US Federal government. Just as it was designed to do, the system encouraged banks to make loans that the free-market judged to risky.

      Risky loans beget risky loans because the information about total risk had been destroyed. Any attempt to return such information to the system was blocked (primarily by Leftists) who claimed accurately that doing so would result in fewer housing loans. The amount of “noise” in the system grew and grew until eventually the system was making loans that seemed obviously insane to almost everyone.

      Eventually, the scale of the misinformation grew to large even for the US Federal government to buffers and a relatively minor economic downturn caused by high oil prices caused the fragile system to undergo a near instant catastrophic collapse.

      All subsequent attempts to correct the problem without letting interest rates adjust to their real rate, just exacerbate the problem.

      Likewise, the European collapse was caused by the Eurozone lowering cost of high debt states to borrow. As such it destroyed information about how much could be safely loaned to such states and how much the states themselves could wisely borrow.

      In short, the financial information system is broken but why it’s broken isn’t a mystery. Everyone, especially the elites, adopt the mystified poise of roughhousing children caught by a parent in a room with a broken vase. The children will likely try to convince the parent that unknown and inexplicable forces shattered the vase but the parent knows the children were just thoughtless and careless.

      We broke the system trying to get loans for less than what they actually cost. We tried to get something for nothing. We will fix the system by letting interest rates, the price signals for the cost of capital and the most important information in the financial system return to their free-market rates.

    9. Slumlord Says:

      The problem is not a problem of knowledge as much as it is a problem of refusing to know.

      David Walker, the former U.S Comptroller General, has been banging the drum for years trying to raise some awareness that the U.S. debt is unsustainable. No one wanted or wants to know.

      The problem isn’t that the financial system is broken, rather the problem is that the correctives necessary to restore the financial system to health are painful and will result in political suicide, therefore all efforts are aimed at avoiding the inevitable. An elementary understanding of mathematics and demographics leads to the conclusion that the financial system cannot be “grown” out of the current predicament. There is no painless curative.

      The problem is our political economy. It is a positive feedback system; and positive feedback systems are inherently unstable. It is the will of the people (expressed in the electoral cycle) that there be no recessions. Hence there is a strong prejudice against any painful corrective, and thus kicking the can down the road becomes the pragmatic policy of the the political cycle.

      The can has gone as far as it can.

      It’s all over.

    10. David Foster Says:

      Shannon…indeed, the low interest rates had a lot to do with the problem. Another major factor was the acceptance of statistical models which claimed to accurately assess the risk of aggregated mortgage portfolios. A knowledge bubble occurs when people think they know a lot more than they actually do.

      To further develop your base analogy….the kids were throwing the vases to each other, and are confident their athletic ability will always allow them to catch them before they hit the ground. The adults were egging them on, encouraging them to keep more and more vases in play. But when the first vase was dropped, the chain reaction began.

    11. tyouth Says:

      – The prospective home buyer and the mortgage broker (both believing in rising home prices forever) lie about the buyer’s ability to pay for the home (after the loan balloons). The feedback loop to the lender and note holder is broken.

      – The bad loans form the basis of bonds that are given (with motivation incentives from the financial institutions that want to sell them) AAA ratings when they are junk. The feed back loop to the potential buyers of the bonds is broken.

      – Financial institutions that lose big money on the bonds are bailed out and not allowed to fail. New blood, and new products are not allowed to enter the system. Ineffectual and fraudulent (and near-fraudulent) individuals and organizations are allowed to stay on and even prosper. The feedback loop that is the basis of the capitalistic model is broken.

    12. Cousin Dave Says:

      Indeed, Shannon, and we also know that in both Europe and America, governments are still resisting allowing the free market to work, although they are rapidly running out of the means to do so.