Wednesday, January 18, 2012

Risk, Uncertainty, And Modernity

If there's one topic that FLG is completely fascinated by in all its forms, then it's risk and uncertainty. Consequently, FLG was very excited to see that Nassim Taleb was on EconTalk. Now, Taleb has his critics and he has a very healthy ego, but there's no way in hell FLG isn't going to be interested in somebody who talks about risk and uncertainty using both mathematics and the Wisdom of the Ancients.

Taleb's concept of antifragility, which he described as a system that, rather than simply surviving, gets stronger when it comes under stress. He gave the example of the Hydra; when you chop off one head, two grow back. Anyway, it was an interesting podcast.

But what really interested FLG are two particular insights, and one that he himself has been trying to articulate for some time, even before he had heard of Taleb, but Taleb explains much better. Unfortunately, FLG is just going to explain them himself right now.

First, there are some fundamental problems with using statistical models to predict the future because, as Taleb entitled his previous book, there are Black Swans. Basically, just because the only swans that are known to exist are white, doesn't mean black swans don't exist. Or to put it slightly differently, just because nobody has ever seen a black swan in the past doesn't mean that nobody will see a black swan in the future. And so you have this problem of using statistical models, which by definition use historical data, to predict the future.

FLG got really interested when Taleb started discussing how in statistical models there is always an error term. That's pretty much the definition of a statistical model. If there were no error term, then you have a deterministic, not probabilistic model. In the ordinary least squares model, the error term is a normal distribution with an expected mean of zero and some constant standard deviation. Those are part of the key assumptions of the model. But Taleb raised something that has always interested FLG. That estimation of the error term through the parameter of the variance of the sample itself has an error. He then started going on about how the error of the error is a power series or something that FLG didn't quite catch.

Second, the idea that there are people who benefit from the fragility of the system because they shift the risk onto others. Taleb's terminology is a bit confusing and seemed to blend together in a podcast, but it will probably be more lucid in book form, but anyway here's a defintion he has:
Fragilista: Someone who causes fragility because of his naive rationalism. Also usually lacks sense of humor. See Iatrogenics. Often fragilistas fragilize by depriving variability-loving systems of variability and error-loving systems of errors.

But in the podcast it seemed like there was more than just naivete. There was an element of pushing risk onto another party such that one had an option. For example, banks took risks, but because of the actions of the Fed, they knew their downside risk was largely covered. Thus, they had a long option.

Taleb goes on to say that this is a thoroughly modern problem in all its consequences and nuances, social science, experts, bureaucracy, etc. FLG concurs completely. It coincides with his oft-stated position that the start of modernity was Machiavelli. In particular, this passage marks the birth of modernity for FLG:
Fortune is the arbiter of one-half of our actions, but that she still leaves us to direct the other half, or perhaps a little less.

I compare her to one of those raging rivers, which when in flood overflows the plains, sweeping away trees and buildings, bearing away the soil from place to place; everything flies before it, all yield to its violence, without being able in any way to withstand it; and yet, though its nature be such, it does not follow therefore that men, when the weather becomes fair, shall not make provision, both with defences and barriers, in such a manner that, rising again, the waters may pass away by canal, and their force be neither so unrestrained nor so dangerous. So it happens with fortune, who shows her power where valour has not prepared to resist her, and thither she turns her forces where she knows that barriers and defences have not been raised to constrain her.

That one passage, at least for FLG, contains the seeds of the modern world, including the birth of the scientific method, social science, experts, bureaucracy, etc, etc. Somebody has to design, build, fund, and oversee the project. Somebody has to try and predict how high the waters will rise. Moreover, FLG thinks it's telling that Machiavelli uses the word Fortune or Fortuna and not Fate. Fortune is the roll of the dice, the spin of the wheel. It's statistics.

Think back to the ancients. For them, it was Fate. Fate was sealed. If you were destined to kill your father and marry your mother, then that's that. In fact, any effort to avoid your Fate seemed to make it worse.

And so it's not surprising that Taleb would say that he looks to the ancients for a solution to the problem of an always and forever uncertain future. He says that they left us not so much a bunch of rules about what to do, but about what not to do. For example, he says almost all traditions warn against going into debt. But the Ten Commandments and the seemingly constant admonition against Pride immediately sprung into FLG's mind. In any case, FLG thinks that passage in The Prince holds the key to understanding the problems of modernity.

BTW, FLG wants to be clear that he thinks modernity and science and rationalism and all this stuff has benefits too. Modern medicine and technology is fantastic. It's just that we have too much faith in these methods and tools and apply them incorrectly in areas that make less sense, for example, social science in general gives FLG the hibbie jibbies. Damn you, August Comte!

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