I have been preparing to teach my first MBA class ever at the Anderson School. Don Trump should enroll in my “Real Estate Finance” class. This class preparation has displaced some precious blogging time. But, I did manage to write this for the Christian Science Monitor. There is a mildly deep idea here. Social scientists are talking more about “fat tail” risk. Scenarios that we thought had a probability of zero of taking place may be more likely than this to actually occur and underlying trends such as climate change or financial liberalization may make such risks even more likely to take place. Such risk recognition should trigger new investments that protect us.
The ugly scenario is when we complacently believe that the probability of a bad event taking place is zero when in truth the probability is increasing. It is a cliche that a silver lining of disasters is that we update our risk assessments and may even over-respond to the new news. After the attacks of 9/11, I was afraid to fly. In terms of adaptation and self protection, such over-responses may be a good thing. The key is to recognize that in a “non-stationary” world that we “know that we do not know” the probability of ugly rare scenarios. Focusing on the climate change challenge — if we have this self recognition, then this stimulates a demand for solutions and new products, new land use and building codes and new ways of building our cities to protect ourselves. This logic bolsters my optimism in our ability to adapt to an anticipated but vague threat.
if we have this self recognition, then this stimulates a demand for solutions and new products, new land use and building codes and new ways of building our cities to protect ourselves. This logic bolsters my optimism in our ability to adapt to an anticipated but vague threat.
Your logic is not like our Earth logic.
What fascinates me is the eagerness of economists to transubstantiate conflict into black swans, absolving well-financed incompetence and downright evil, from blame.
The problem with climate change is not “tail-risk” — the known risks are not in anyone’s tail. The threat is the slow, but certain accumulation, at an uncertain rate and with uncertain timing of effect. But, the problem? The problem is conflict: the problem is that some people have a vested interest in bringing about climate change and putting the costs off on other people: brown people in third-world countries, or future generations, or the poor. The tempting path of adaptation, for some powerful actors, is to extract and use fossil fuel now, and hope they are dead, or rich in the future, when they can adapt to the effects, by further exploitation of externalities, or worse.
Pretending that risks are unknown, or, even more incredibly, claiming after the financial crash or the nuclear meltdown, that “no one imagined” using an airliner to crash into a building, or no one imagined that liar loans would go bad, or no one imagined that there was an uncontained risk at a nuclear power plant, is just a way of changing the subject. It’s a variation on a the magician’s trick of distraction, combined with a dramatic (“meaningful”) gesture. The magician does it, to convince the audience that he just pulled a rabbit out of an empty hat by saying, “abracadabra”. The incompetent and irresponsible power player does it, to absolve herself of guilt and blame.
The nuclear power plants in Japan were — this should be obvious in hindsight — almost incredibly badly designed. And, this despite being sited in a country with a traumatic history with things nuclear, and despite nearly-hysterical lobby groups highlighting the dangers of nuclear power. Still, the people assigned in society with the responsibility of designing and maintaining nuclear power plants acted with abject incompetence, unmoved by the worries of others.
It is not like there weren’t people worried about the dangers of nuclear power. But, somehow, in the peculiar political specialization, all the people genuinely worried were excluded from the actual process of designing and evaluating safety. Instead, we assigned design and management to people with an interest in cheap power generation and false re-assurance.
It’s this conflict and separation, from specialization — not the supposed remoteness of tail-risk (which isn’t all that remote or uncertain if you are going to flip the coin enough times) — which ought to concern economists.
The people, who drill for oil are not worried about ocean ecology. BP is not worried about the health of the Gulf of Mexico, only about using enough poisonous dispersant that they cannot be “scientifically” blamed, when the dolphins or the tuna die. They’re not worried about tail risk; they are worried about creating a data fog.
Ditto for Wall Street. They’re not worried about tail risk. Goldman Sachs are worried about how to create enough financial volatility, that they are able to skim their billions from the casino’s churn without being caught out without control of the Treasury Department.
They are out to get us. It’s not a conspiracy, it’s just business. And, they will adapt. Doesn’t that make you feel all optimistic?
As usual, the claim that “nobody could have foreseen” is false.
See, e.g., http://www.fairwarning.org/2011/03/utility-engineer-warned-of-tsunami-threat-at-japanese-nuclear-plant/
To my mind, the best thing ever written on the disconnect between what engineers know and what their managers choose to believe is Richard Feynman’s report on the Challenger disaster, which begins:
“It appears that there are enormous differences of opinion as to the probability of a failure with loss of vehicle and of human life. The estimates range from roughly 1 in 100 to 1 in 100,000. The higher figures come from the working engineers, and the very low figures from management. What are the causes and consequences of this lack of agreement? Since 1 part in 100,000 would imply that one could put a Shuttle up each day for 300 years expecting to lose only one, we could properly ask “What is the cause of management’s fantastic faith in the machinery?”"
and concludes: “Nature cannot be fooled.”
http://www.ralentz.com/old/space/feynman-report.html
Prof Kahn,
My appraisal of the financial crash of 2008 is obviously different from yours. You do not seem to understand the concept of “other peoples money”. You may be right in saying that, for example, bankers and financiers didn’t the risks involved in the exotic financial instruments they created. But only because they couldn’t be bothered to understand the risks they were taking on behalf of shareholders, pension funds, and so forth. The fact that almost nobody on Wall Street was forced into personal bankruptcy during the crash of 2008 suggests to me that these people understood the risks of low probability events perfectly.
Likewise, I don’t understand why you think Donald Trump should take this class. He has consistently been very successful in obtaining financing for his real property transactions, his many defaults notwithstanding. And he consistently makes money for himself (which is his objective). He seems to consistently lose money for everybody else. Possibly the idiots who invest their money in his projects might benefit from your class but I doubt it since Trump’s failings as a steward of other people’s money have been widely publicized over the years. It does not take an MBA in finance to know that investing with Trump is a very bad idea. Someone who can’t read a newspaper won’t be helped by learning how to read a pro forma.
As for the bankers and “financiers” who keep lending Trump money, their problem is surely not ignorance of proper financing techniques. The reason they keep lending money to The Donald (and then losing it when he threatens bankruptcy,etc) is, in my opinion, because they are gambling with other peoples’ money and are therefore more concerned with the fees generated by a transaction than with whether the chump whose money they are lending will actually be paid back.
Amen to what M Guthman has to say. As an Anderson Alum, I would strongly recommend you incorporate his thesis into your thinking about your class and any discussion of “risk.” The financial crisis was the result of a cascading agency problem pure and simple. As for tail risks, yes they are totally ignored, because as Taleb has repeatedly pointed out, they do not fit into the standard models. The problem - contra the modelers - is that these are risks precisely because they cannot be measured with any confidence. The unknown unknowns to borrow from the otherwise vapid Donald Rumsfeld.
“The nuclear power plants in Japan were — this should be obvious in hindsight — almost incredibly badly designed.”
It’s always easy to criticize a design in hindsight, but let’s be realistic: The plants in question got hit with a category 9 earthquake, the aftershocks of which would be entered into the history book if not overshadowed by the original quake. They got hit by a, by some estimates, 7 meters high tsunami.
And the resulting death toll looks likely to be less than a year’s normal operation of a comparable coal plant would produce.
If this is “incredibly badly designed”, then conventional power plants, indeed pretty much every single other structure in the world, are insanely, mind bogglingly badly designed. Words lack to say how badly designed everything else is on the scale where these nuclear power plants were “almost incredibly badly designed”.
We’re using a double standard here, and you can’t even SEE the standard applied to nuclear power plants, when looking around from the vantage of the standard applied to everything else.
Now, don’t get me wrong, maybe the standard being applied to the nuclear power plants is the right one, and homes and businesses should be designed so that a category 9 earthquake doesn’t cause 20,000 casualties. But I do know this:
If, a year ago, you’d known the earthquake was coming, and had a billion dollars to spend upgrading things to save lives, you should have put it just about anywhere EXCEPT upgrading the nuke plants, if you wanted to save the most lives.
Oh, and this is how the more recent nuclear power plants in Japan handled the quake. A bit better than 40 year old plans weeks from being decommissioned, it appears.
If the reference to 40 year old plans weeks from being decommissioned is to the Fukushima plant, it appears your information is incorrect and the plant was given a 10 year extension just a month before the quake. http://www.nytimes.com/2011/03/22/world/asia/22nuclear.html
Isn’t the problem with nuclear power that there is always going to be massive incentives to keep an outdated plant in service? By the time it is 40 years old, it is going to be fully paid for and the electricity relatively cheap to generate. without regulators forcing upgrades, why would any private power company decommission a 40 year plant in favor of a new plant that will take years to build and even longer to amortize the capital costs of construction?