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Continued: Business forum: How do we foster trust in age of fraud?

  • Article by: ISAAC CHEIFETZ
  • Last update: January 6, 2013 - 3:19 PM

Why are major financial emergencies now erupting several times a decade, rather than once in a generation, as in the previous century?

My October column, "The Lessons of LIBOR" (www.startribune.com/business/176062311.html), discussed the long-term crisis in the global financial industry and the massive potential for fraud inherent in knowledge-based economies, where fraudulent assets can be created at little cost.

A healthy society ultimately is built on trust. And trust derives from transparency and predictability, which are hard to build and easy to destroy. How can we adjust the structure of our financial markets so that harmful bubbles become rare, rather than the norm?

The solution, in short, is to steer clear of black swans. I am not referring to Natalie Portman's Oscar-winning performance as a psychotic ballerina, but rather "The Black Swan: The Impact of the Highly Improbable," a 2007 book by investor and "philosopher of randomness" Nassim Taleb.

The Black Swan is a centuries-old logic puzzle about the limits of personal knowledge. If no one has ever seen a swan that is not white, what are the odds of encountering a black swan? Statistically, the odds of encountering the first black swan are very small, but not zero.

There is nothing in nature that indicates against their existence, unlike, say, a human with wings, or a pig who can sing the Beatles' White Album.

Taleb demonstrates that there is no reliable quantitative method to assess the unknown, or even the highly improbable -- statistics are most useful when measuring how likely one event or another is when both are experienced often enough to be calibrated.

He summarizes his ideas on his Web page (www.fooledbyrandomness.com): "We don't understand the world as well as we think we do and tend to be fooled by false patterns, mistake luck for skills, overestimate knowledge about rare events ... something that has been getting worse with the increase in complexity."

What if encountering a Black Swan is life-threatening to the Golden Goose, that is the health and sustainability of the global economy?

Taleb outlined his "Ten Principles for a Black Swan-proof World" in a 2007 Financial Times column. The three most important points?

• "No socialization of losses and privatization of gains. ...We have managed to combine the worst of capitalism and socialism."

• "People who were driving a school bus blindfolded (and crashed it) should never be given a new bus."

• "No incentives without disincentives: capitalism is about rewards and punishments, not just rewards."

But Taleb's most incisive point questions the value of financial engineering in the 21st century: "Complexity from globalization and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error."

Taleb's rules are powerful, but I would suggest they overstate the effects of complexity over that of old fashioned honesty. A Black Swan is the result of taking misunderstood statistical risks, not using complexity to mask fraud.

So a classic Black Swan example would be Toyota seeking supply-chain efficiencies so obsessively that many of its component manufacturers were clustered near a nuclear reactor sitting in a tsunami zone.

In the financial industry, the Long-Term Capital Management (LTCM) crisis of 1998 was a true Black Swan. A hedge fund led by Nobel Prize-winning economists made investments based on elegant algorithms, built on top of real world statistical fallacies. Underestimating the odds of multiple sectors of the market falling simultaneously, they overleveraged themselves and had to be rescued by a consortium of banks that feared LTCM's massive bets would topple the entire market.

But unfortunately, the overwhelming majority of financial crises of the past 30 years had outright fraud at their foundation. Consider the 1980s savings and loan crisis, Enron and WorldCom in 2000-2001, the mid-decade subprime mortgage bubble that led to the financial crisis of 2008-2009 and, most recently, the LIBOR scandal. All had lies at their core.

Managing free-form complexity will be society's biggest challenge of this century, and will continue to manifest itself in surprising ways. Taleb's latest book, "Antifragile," is a (somewhat eccentric) attempt to codify the rules of making complex systems more resilient.

But complex human civilizations are at least 3,000 years old. All rely on legal and ethical frameworks that encourage trust and curtail individual destructive behavior. We don't let convicted counterfeiters work as bank tellers, pedophiles work as day-care workers or pyromaniacs work as forest rangers.

Inevitably, society will apply principles like those of Taleb, with the goal of lessening, if not eliminating, these exhausting financial crises that are driven by short-term greed.

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  • ABOUT THE AUTHOR

    Isaac Cheifetz is president of Open Technologies, a Minneapolis-based executive search and business consultancy. Reach him at isaac @opentechnologies.com or on Twitter at @isaaccheifetz.

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