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Top Theorists Examine Rippling Economic Turbulence

October 21, 2008 at 6:15 PM EDT
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As the financial sector shifts, so does the reach of the jolt to economic structures around the world. Economist Nassim Nicholas Taleb and his mentor, mathematician Benoit Mandelbrot, speak with Paul Solman about chain reactions and predicting the financial crisis.
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RAY SUAREZ: Finally tonight, we return to a subject on many minds these days: the financial crisis. Our economics correspondent, Paul Solman, checked back in with one particularly prominent voice in the investment world and his colleague, who guided his thinking.

Here is the pair’s sobering conversation on what may lie ahead.

PAUL SOLMAN, NewsHour Economics Correspondent: One of the world’s hottest investment advisers these days, Nassim Nicholas Taleb, author of “The Black Swan,” who’s been warning of a crash for years, betting on one, and winning big.

He’s been ubiquitous in the financial media of late, from cable TV’s “Colbert Report” to the BBC’s “Newsnight,” where he was infuriated by what he called “bogus accounting.”

NASSIM NICHOLAS TALEB, Scholar and Author: The first thing I would get immediately, immediately, I would suspend something called value at risk, quantitative measures of risk used by banks, immediately.

PAUL SOLMAN: We sat down with Taleb and the man he calls his mentor, mathematician Benoit Mandelbrot, pioneer of fractal geometry and chaos theory. And even more than feeling vindicated, they’re both scared.

NASSIM NICHOLAS TALEB: I don’t know if we’re entering the most difficult period since — not since the Great Depression, since the American Revolution.

PAUL SOLMAN: The most serious situation we’ve been in since the American Revolution?

NASSIM NICHOLAS TALEB: Yes.

PAUL SOLMAN: Professor Mandelbrot, can that possibly be true?

BENOIT MANDELBROT, Mathematician: It’s very serious.

PAUL SOLMAN: More serious than the Great Depression, possibly?

BENOIT MANDELBROT: Possibly. I hope not.

Complexities of the banking system

PAUL SOLMAN: Mandelbrot's key insight came in the '60s with a study of cotton price surges and plunges, suggesting the world moves in fits and starts, especially the human world.

Decades later, after the stock market crash of 1987, Taleb came to the same conclusion. He appeared on the NewsHour two years ago to help explain the death of a hedge fund before the current crisis. He dubbed the event "a black swan," impossible, Europeans had always thought, because they'd never seen one.

NASSIM NICHOLAS TALEB: We saw a lot of white swans. Every white swan was confirming that, you know, hey, all swans were white.

PAUL SOLMAN: Taleb's book, published in April 2007, was called "The Black Swan" because, in 1697, Dutch explorers discovered Australia and black swans.

NASSIM NICHOLAS TALEB: And, sure enough, they saw that black version and said, "Hey, one single observation, OK, can destroy thousands of years of confirmation." So, likewise in the markets, all you need is one single bad month to destroy years of track record.

PAUL SOLMAN: In the book, Taleb wrote, "The increased concentration among banks seems to have the effect of making financial crises less likely. But when they happen, they are more global in scale and hit us very hard. True, we now have fewer failures, but, when they occur, I shiver at the thought."

NASSIM NICHOLAS TALEB: The banking system, the way we have it, is a monstrous giant built on feet of clay. And if that topples, we're gone.

Never in the history of the world have we faced so much complexity combined with so much incompetence and understanding of its properties.

PAUL SOLMAN: But there's been complexity before. There has been overextension of credit before. We've had crashes in American history many times before. We're a resilient system. Won't we pull out of it?

NASSIM NICHOLAS TALEB: Let me tell you why it's not like before. Look at what's happening. The world is getting so fragile that a small shortage of oil -- small -- can lead to the price going from $25 to $150.

PAUL SOLMAN: A barrel.

NASSIM NICHOLAS TALEB: A barrel. A small excess demand in an agricultural product can lead to an explosion in price.

We live in a world that is way too complicated for our traditional economic structure. It's not as resilient as it used to be. We don't have slack. It's over-optimized.

PAUL SOLMAN: What do you mean by "over-optimized"?

NASSIM NICHOLAS TALEB: Let me tell you what is happening in the ecology of the banking system. They're swelling to large banks, OK, because it's vastly more optimal to have one large bank than 10 small banks. It's more efficient.

PAUL SOLMAN: Well, we've certainly seen the consolidation of the industry.

NASSIM NICHOLAS TALEB: Exactly. And that consolidation is what's putting us at risk, because we are -- when one bank, large bank makes a mistake, OK, it's 10 times worse than a small bank making a mistake.

PAUL SOLMAN: And I guess I'm realizing that that's where your famous work comes in. It's always been characterized by the work that you're central to as the butterfly somewhere disturbs a little bit of air and, halfway across the world, a tornado hits or something, right? Is that what we're talking about here?

BENOIT MANDELBROT: Certainly very similar. The word "turbulence" is one which actually is common to physics and to social scientists, to economics. Everything which involves turbulence is enormously more complicated, not just a little bit more complicated, not just one year more schooling, just enormously more complicated.

PAUL SOLMAN: Turbulence is why, because it's badly understood, weather forecasters can't necessarily get it right.

BENOIT MANDELBROT: Precisely. In fact, the basic -- the basis of weather forecasting is looking from a satellite and seeing a storm coming, but not predicting that the storm will form. The behavior of economic phenomena is far more complicated than the behavior of liquids or gases.

Impacts from sudden changes

PAUL SOLMAN: So, getting back to your fundamental work and insight, this is a system that can become turbulent or is inherently turbulent, that doesn't have enough of a buffer, and that's the danger?

BENOIT MANDELBROT: That is not well-understood. In fact, that is misunderstood for which tools have been developed which assume that changes are always very small.

If one of them comes, nothing bad happens. If several of them come together, very bad things have happened. And the theory does not take account of that, and the theory doesn't take account of very large and sudden changes in anything.

The theory thinks that things move slowly, gradually, and can be corrected as they change, whereas, in fact, they may change extremely brutally.

NASSIM NICHOLAS TALEB: Now you understand why I'm worried. I hope I'm wrong. I wake up every morning -- actually, I don't wake up every morning now. I start to wake up at night the last couple of weeks hoping that I'm wrong, begging to be wrong.

I think that we may be experiencing something that is vastly worse than we think it is.

PAUL SOLMAN: And we think it's pretty bad.

NASSIM NICHOLAS TALEB: It's worse. Of all the books you read on globalization, they talk about efficiency, all that stuff. They don't get the point. The network effect of that globalization, OK, means that a shock in the system can have much larger consequences.

Hedge funds' looming impact

PAUL SOLMAN: What is the doomsday scenario? I mean, what actually happens tomorrow, next week?

NASSIM NICHOLAS TALEB: I mean, I am convinced -- there's been a package recently of $700 billion. It's pocket money, because you don't understand -- they don't understand the ripple effect that hedge funds have, OK, that the banks not lending to hedge funds will force hedge funds to liquidate positions.

PAUL SOLMAN: Sell off?

NASSIM NICHOLAS TALEB: Sell off positions. These positions, sold off by hedge funds, will impact other entities.

PAUL SOLMAN: Driving down the price.

NASSIM NICHOLAS TALEB: Driving down the price. Driving down some prices. That a supermarket, OK, needing funding, will not be able to find a bank solvent enough to lend them money against inventory to make payroll, OK?

You may have chain reactions we've never imagined before. And these come from the intricate relationships in the system we don't understand.

PAUL SOLMAN: You've been around a lot longer than we have. That's possible. Is it likely?

BENOIT MANDELBROT: Well, we don't know the probability. We don't have enough knowledge. We don't have enough information. We don't have enough reliable information on data which are not published. I mean, I sleep better, perhaps, than Nassim, but I don't sleep very well.

Challenges to prediction

PAUL SOLMAN: Is it possible that what's also unimaginable, which is that this will simply right itself, is that a possibility?

BENOIT MANDELBROT: Everything is a possibility. I mean, again, it is not -- I try my best to answer questions which are scientific, and which I can respond to and which have scientific evidence and not personal opinion.

Everything is imaginable. What's the joke, that prediction is very easy when you predict the past or something?

PAUL SOLMAN: Well, predictions are -- predictions are difficult, particularly about the future.

BENOIT MANDELBROT: That's what I wanted to remember.

PAUL SOLMAN: Benoit Mandelbrot, Nassim Nicholas Taleb, thank you very much.

NASSIM NICHOLAS TALEB: Thank you.

BENOIT MANDELBROT: Thank you.

RAY SUAREZ: On our Web site, you can watch all of Paul Solman's reporting on the financial crisis and ask him questions on the economy. Visit us at PBS.org. Just scroll down to NewsHour Reports.