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The Causes of the Financial Crisis

By Nassim Nicholas Taleb | Public Affairs | December 2, 2010

CREDIT: Marie l'Amuse (CC).

EDITOR'S NOTE: On December 2, 2010, Nassim Taleb gave a talk at the Carnegie Council about his latest book, The Bed of Procrustes, and about the global financial crisis. He asked for the talk to be off the record. However, he kindly wrote this summary for us.

1. Hidden Risks and Agency Problems: The main cause behind the recent crisis was the accumulation of hidden risks in the system, compounded by the agency problem. The agency problem is when the manager (the agent) serves his own interest at the expense of the person he is supposed to represent.

This can be made obvious with the following fact: Collectively the managers of companies made hundred of billions over the past decade while, in the aggregate, their investors and retirees ended up poorer. The same with banks, and taxpayers are paying for it. This brand of capitalism suffers from a fragilizing lack of symmetry—managers of banks and corporations have the upside but not the downside, society has the downside but not the upside.

2. The Mechanism of Diffusion of Responsibility: We suffer in society from the use of social science tools that just don't work. These are:

  • The tools to measure small probabilities don't work, yet they look scientific and help hide a certain class of risks.

  • The methods of forecasting in place don't work and cause increased risk-taking. We have a degradation of forecastability compounded by increased reliance on forecasts.

The ethical problem is as follows: Forecasters should know that they cause people to take risks with their wrong maps. Each one of them individually would normally accept the absurdity of these tools, but, collectively, they don't. They are just "doing their jobs" or "doing what others do."

3. Complexity: In a complex environment the difference between the ethical and the legal increases—so we should avoid the complexity of regulations that makes it good business for arbitrageurs, firms with resources, and lawyers. In a pre-complex environment people had biological checks on them (shame, ethics, pride in the contribution). This is the argument I gave in favor of an artisan-style world.

4. Middle Class Values Are Not the Golden Middle: Contrary to the utopian belief in the middle class, the center is more prone to spin a story to justify a given action rather than the opposite. We often hear expressions such as: "everyone needs to make a living," "he has a mortgage." People on minimum wage don't have such ethical dilemmas.

Consider the mechanism of diffusion of responsibility by which people are ready to contribute individually to harm—in return for personal benefits—provided they do not feel directly responsible for it, and provided what they are doing appears to be socially acceptable. In other words, they are more likely to fit their beliefs to actions rather than fit their actions to their beliefs.

Note that the Greeks saw the world in three professions: artisanship, the craft of war, and farming. Only the last two were worthy of a gentleman—mainly on account that they were not self-serving and were free of conflicts of interest. In a problem that has been debated from Seneca to Montaigne, a vendor of funereal goods could not be trusted to wish for the good health of his fellow citizens. He could be trusted to make good coffins, but not in his opinions about public matters.

And the lack of accountability under such diffusion of responsibility compounds the problem.

What Should We Do? I presented the ethical dimension to the recent problem. An adage that summarizes—and simplifies—all action: captain goes down with the ship, all captains, and all ships. We need the legal system to allow for liabilities to bring symmetry and control the agency problem.

Read More: Business, Debt, Ethics, Finance, Europe, United States, Global

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