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Swarm of the Black Swans

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Moving to Southwest Washington State where I built a house on the beach with my hands and the skill and hands of a couple of excellent German expatriates, I was struck with the attitude of locals toward storm surge and possible tsunami. It had never happened the locals said, dismissively. Last week a tsunami happened, and, thankfully, we were spared. We weren't so in 2007 when a hurricane force storm hit and denuded the surrounding tree farms of hundred year old trees and took 30 feet out of the barrier dunes. Luckily, it hit at low tide.

They have no name classification for a storm like that in this place because there's no cultural memory for it -- it's named by the date, December 7, 2007. Fortunately I built an octagon house to slip through the wind and to withstand it with integral shear walls, thick and wide earthquake foundation footers, hurricane rafter ties, a 140 mph roof and a backup generator. In the aftermath, my neighbors wandered around picking up parts of their houses and burning them for heat and light for five days until power was restored. All roads in or out were blocked by thousands of fallen 100' fir trees.

Record snows and flooding and record heat and drought stalk the land in the same year now. Call it climate change or an act of God or whatever you want. Tornadoes and wildfires in the winter?

But I'm not here to argue climate change. Whether it's manmade or not or whether it even exists. I'm here to argue that unexpected things happen to people who refuse to expect them.

Nassim Nicholas Taleb coined the term Black Swan as a metaphor of something so unexpected in markets and finance that it was generally considered to be statistically impossible, like the birth of a black swan to snow white parent swans. His point was that if it were statistically so unlikely that it seemed it shouldn't happen that would not mean that it couldn't happen. What they try and stress in statistics theory is that likelihood is not preventative, not a shelter. Standing away from a tree during a lightening storm is preventative. Not betting you can fill an inside straight in draw poker is preventative. Probability is not an affirmative defense.

Hedge funds were built on the unlikelihood of combinations of events ever happening. Hedge funds eventually evolved, by intentional design effort, insurance policies against unlikely things happening because of the actuarial unlikeliness of those things happening. The volumes in derivatives seems to indicate that everybody with a net worth of or operating expenses of $10 million bought them to hedge against unforeseeable disaster. Trouble was, the disaster that would follow was because the actuarial assumptions didn't account for the unforeseeable, they accounted for the foreseeable and the statistical likelihood of the foreseeable. Disasters routinely smack actuarials in the face with a brick.

A "hurricane" in the Pacific Northwest was foreseeable but it had been discounted by folk wisdom. A hurricane of the force and site of Katrina was foreseeable but had been statistically discounted in likelihood the way my neighbors had discounted the largest storm anyone had ever seen in their lifetimes. Hundred year floods and hundred year snows and hundred year heat waves and droughts had not happened in the Midwest and east for lifetimes, let alone in the same year.

The oil rig with the best performance record in the fleet had the worst oil spill since drilling for oil became a practice of humans. A little extra pressure on the crew and management to meet a schedule in a difficult bore caused the accident that killed 11 and saturated a quarter of the Gulf with crude. That little extra performance pressure was not foreseen because no one had ever pushed the limits of performance like that before. The consensus of the foreseeable was that no such thing could happen. Somehow, and for some time, someone, perhaps a driller (master foreman) or a roughneck, had punched an ambitious corporate prick in the face to stop a disaster, again and again. That last safety valve didn't work this time.

The consensus foreseeable had been designed into Fukushima nuclear facilities. Likely earthquake intensities were designed into the structures. A tsunami sea wall had been built for the likely size of tsunami. But intensity and tsunami were surpassed at once, and the redundant systems failed to arrest the dangers of damaged nuclear facilities. Obvious design flaws in those backup systems were excused by assumptions of what is probable given the sea wall and earthquake measures.

The housing bubble collapsed, and because of assumptions that all risk had been taken out of the system by laying it off on counterparties to bad loan practices, it became a disaster in catastrophic scale. No one foresaw that the counterparties couldn't absorb the scale of claims against them. The consensus wisdom was that they could underwrite it all, the consensus not knowing the depths of exposure they were buying into because of the lack of transparency in the private equities markets. The perfect financial tsunami took out the engine of American finance in a sequence of events not unlike events that triggered the melting down of Fukushima nuclear reactors.

9/11 happened because even the small measures necessary to stop it weren't considered by reason of the likelihood of it being so small. When the personal ego ambitions of George W. Bush were added to the catastrophe, it was multiplied into 1,000 times the original tragedy to persons and properties and our international standing. Bush's ambition to be a "war president" was not calculated into the risk assessments. A conflagration could have been stopped by measures at airport check in, and would have had we foreseen the magnitude of the eventual outcome.

Black Swans.

The world is so big, so volatile, there are so many people living on the edge of volcanoes both natural and manmade, it's impossible to excuse the thinking that governments are not responsible, or that governments are not needed to correct their own irresponsibility and the irresponsibility of their private enterprises. The American housing bubble collapse triggered the near failure of global finance. Only government, by harnessing the power of the worlds largest economy through borrowing, saved the globe from total financial meltdown. Only governments can repair the damages of events so calamitous that they swallow up private capital's ability to underwrite the risks. To make governments smaller is to take the biggest risk of all. That risk is that nothing will happen that it will take a government to fix.

Bad decisions are made by governments. Bad decisions are made by private enterprise. Independent of each other, they would still both make bad decisions. But together, enterprise looks to influence government to sanction their mistakes and correct them if they go terribly wrong. Government makes fewer mistakes unencumbered by the influence of private enterprise to backstop enterprise's willingness to take risks or it's just plain stupidity. Government and business is a union that is mutually and universally destructive because of the quid pro quo of campaign finance. Business influences government to think poorly, an outcome which abrogates it's charter to "promote the general welfare."

The ability to foresee is not that hard. I figured to build a house that would stand a 100 years in an environment of horizontal rain and an unpredictable sea and sand. So what could happen in a 100 years was input into how I built it. Unfortunately, this is a skill of foresight lost by politicians, most particularly those on the right. My house may yet not survive a 100 years. But it will not be for the lack of the foresight I had while building it. It will be lost for the risk of a foreseen earthquake in the subduction fault just a few miles off shore, the last rupture of which happened 300 years ago.

The Monday Morning Economist