June 23, 2010 7:48 pm

Not so rare: was the crisis a black swan event?

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Sometimes life reserves the right to give us a nasty surprise. This is true in the physical world and in the world of investments. My own recent painful experience is an example.

About a month ago I was terrified to feel an intense pain in my chest, which radiated down my left arm. Fearing the worst, I was rushed to the nearest hospital emergency room to receive the good news that I was not having a heart attack. I learned that I was, instead, suffering from acute pancreatitis, and would need to be admitted to hospital. It was almost two weeks before I was discharged.

This was all the more shocking as, until a month ago, I was not even clear where the pancreas was, nor what it did. I did not belong in any of the high-risk categories (alcoholics, gallstone sufferers, victims of scorpion stings). All kinds of other health problems worried me, but not the pancreas.

As far as I was concerned, this incident was what investors call a “black swan” – something that previous experience had never suggested was possible, much as Europeans arriving in Australia were amazed to discover some swans are black. But that would be wrong, just as the term “black swan”, popularised by Nassim Nicholas Taleb, has turned into a convenient excuse for investors who did not see the crisis coming.

Much of this year, I was plagued by backache. I often have backache, but this was nastier than before. It turns out back pain is a symptom of problems in the pancreas. I was also very fatigued, but again there seemed to be explanations. I did a lot of travelling, with resultant jet lag, and we have a small baby at home. In hindsight, it seems obvious I was getting ill, but I missed this fact. What happened was surprising, but was not a black swan.

The same applies to the financial crisis, and to protestations from the investment industry that nobody could have predicted it. If people had asked the right questions insistently enough and paid attention to subtle changes in familiar symptoms, there were signs aplenty of impending trouble.

More important are the implications for what we should do to heal the financial system. Changes to regulation are necessary, but tend to be backward-looking – fixing the last problem, rather than the next. The US bank regulations of the 1930s virtually solved what had until then been the endemic problem of bank runs, but financial engineers found new ways to create problems.

So far, the debate on regulation has focused on the banking system and the capital market instruments that in many cases supplanted it. But the banks could not have sold their overpriced wares if someone had not been around to buy them. The bubbles of the past decade could not have happened without something going systematically wrong among the investment managers.

And while bank regulation has been a problem for centuries, the investment industry has only existed in its current form for a few decades. Small changes to the way governments regulate pension funds have had profound effects on the way cash sloshes around.

The symptoms are similar to past banking crises. For all these reasons, public debate should move on to how to regulate the companies that manage our savings.

And without wishing to alarm anyone, true black swans are also rare in other walks of life. However, any change in your symptoms might indicate something more sinister. Either way, it is worth going to see a doctor.

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