The world is going through one disaster after another. But are these all Black Swan events or known unknowns? And are these events occuring more frequently, or are they just being better reported? What's a risk manager to do?
Even Nouriel Roubini, Dr Doom who predicted the global financial crisis, can't keep up with global catastrophes, troubles and crisis. He tweeted last week: "rising rate of Black Swan/Tail Risk/Unknown Unknowns events: repeated natural disasters, Japan nuclear meltdown risk, Middle East turmoil."
If it isn't the great financial depression, then it is the Eurozone, Dubai World debt shock, PIIG debt crisis, earthquakes in Haiti, Pakistan, China and Japan and the current slate of regime-topping changes in the Middle East and greater unrest in the Arabian Gulf, the world is lurching from one disaster to another and seems to be suffering from 'Black Swan' fatigue.
The U.S. economist Ilan Noy cautions that we may not necessarily be in a phase of high-frequency disasters, just better reported calamities.
"...It is useful to note that while the most widely used dataset on disasters shows that their incidence has been growing over time, this increase is probably driven by improved reporting of milder events; truly large events do not show a similar trend," notes Noy.
The chart below from Inter-American Development Bank (IDB) shows that the number of large-scale events haven't gone up.
Apart from the tragic loss of life, there is also not much evidence of economic decline due to these disasters.
"The evidence on the short-run growth effects of disasters appears fairly clear by now... Countries with higher per capita incomes, higher literacy rate, and better institutions are not only less vulnerable to the initial impact of the disaster, but their macro-economy is less affected as well...," Noy says.
"In particular, there is no evidence from recent data that even large natural disasters have any measurable adverse impact on the national economy of rich developed countries like Japan. In contrast, poorer less-developed countries do face significant short-run costs of disasters, and these can translate into significant income losses."
Pity that the charts do not cover political and economic disasters such as those that we have seen in the United States, Europe and now the Middle East.
BLACK SWANS
There is also a danger that the term 'Black Swan', popularised by economic philosopher Nassim Nicholas Taleb, is in danger of being used to describe every economic and political disaster.
His description of Black Swan is: "... random events that underlie our lives, from bestsellers to world disasters. Their impact is huge; they're nearly impossible to predict; yet after they happen we always try to rationalise them."
On Japan's earthquake, Taleb has the following to say:
"The Japanese Nuclear Commission had the following goals set in 2003: " The mean value of acute fatality risk by radiation exposure resultant from an accident of a nuclear installation to individuals of the public, who live in the vicinity of the site boundary of the nuclear installation, should not exceed the probability of about 1x10^6 per year (that is , at least 1 per million years)".
"That policy was designed only 8 years ago. Their one in a million-year accident occurred about 8 year later. We are clearly in the Fourth Quadrant there."
The Fourth Quadrant, according to Taleb is:
"Complex decisions in Extremistan: Welcome to the Black Swan domain. Here is where your limits are. Do not base your decisions on statistically based claims. Or, alternatively, try to move your exposure type to make it third-quadrant style ('clipping tails')."
But was the crisis in the Middle East and the ouster of Egypt's Hosni Mubarak also Black Swan event, especially when every decent economic report on Egypt talked about Mubarak's lack of a succession planning? Wasn't Moamer Gaddahfi always so unpredictably brutal and malicious, that he was actually predictably brutal and malicious? Was it the first time Bahrain Shi'ites protested against the Sunni dynasty that ruled it? Is it news that the Saudi citizens - Sunnis as well as Shi'ites - are deprived of basic freedoms? And is it the first time that the Saudi royalty has bought its way out of trouble?
Then there are the 'Unknown Knowns' popularised by the malevolent former U.S. Secretary of Defence Donald Rumsfeld, that are keeping risk managers awake at night.
The description of the term is worth repeating here as it may serve as an interesting point to ponder for all risk managers:
"[T]here are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know." - Donald Rumsfeld, February 12, 2002
While the Black Swan may explain some of the market volatility, it is true that many events that can be tagged as 'known unknowns' and 'unknown unknowns' have also risen. It may also be true that investment managers and risk managers have been lazy to explain away certain events in that way simply because they had not adequately factored in the risks. The media often make many incidents greater than they are especially to rope in readers, viewers and website 'clickers', but risk managers must not fall into the same trap.
AlifArabia 2011
