Ben Bernanke vs. The Black Swan

Congratulations to Ben Bernanke, the Chairman of the Federal Reserve Bank of the United States, for being named Time’s Person of the Year!

2009 was most certainly a difficult year for the nation in general, and for regulators of the financial markets in particular. Because we began the year on the precipice of what Nobel Prize winning economist Paul Krugman called the Second Great Depression, but then ended it on the threshold of an economic recovery, we heartily agree that this honor is well deserved.

It is somewhat disconcerting, though, that Chairman Bernanke continues to acknowledge that he didn’t anticipate the collapse of our financial and economic systems. That being the case, one cannot help but wonder whether he is responsibly planning for the emergence of the next black swan.

They’re Not All White

Huh? A black swan? Aren’t all swans white?

In reality, black swans do exist, and they played a prominent role in Nassim Nicholas Taleb’s 2007 best selling book The Black Swan: The Impact of the Highly Improbable. That’s because, for many economists and financial strategists, black swans are quintessential examples of faulty presumptions of impossibility.

Okay … so what do we mean by faulty presumptions of impossibility? Well, for centuries, Europeans assumed that all swans are white because the only swans they ever saw were white. But some free thinkers warned that, although highly improbable, it might nevertheless be possible for black swans to exist in some remote corner of the world. And lo and behold, one famous day in 1697, Dutch explorer Willem de Vlamingh discovered a pair of black swans in the New Holland region of coastal Australia.

Ever since then, the black swan has assumed an important meaning in the minds of financial market strategists. Namely, they represent events that have never previously happened, and thus are often falsely assumed to be incapable of happening … until they actually do happen. The simultaneous collapse of all global markets and economies last year, for instance, represented one such black swan event.

Some Say Black, Some Say White

Or was it truly a black swan occurrence? Bernanke would have us believe so; he has repeatedly described the great bank bailout of 2008 as an extraordinarily rare event, one not required since the bank failures that followed the great Wall Street stock market crash of 1929.

One problem with Bernanke’s assertion, though, is that such collapses actually tend to occur distressingly often. After all, the Dow Jones Industrial Average did decline by over 45% between 1973 and 1974; it later declined by over 22% on a single “Black Monday” day in October 1987. It subsequently declined by approximately 27% between 2001 and 2002; considering the frequency of these declines, one might expect such crashes to come along once every decade or so!

In fact, in his 1954 classic The Great Crash of 1929, Harvard University economist John Kenneth Galbraith noted that “the memory of the financial mind lasts about ten years.” Galbraith explained that, in his opinion, it takes ten years for the painful memories of each market crash to fade away in the minds of investors; thus, every decade or so, they can be expected to become irrationally exuberant and to begin to assume reckless levels of risk. In other words, Galbraith believed that we are doomed to experience crashes relatively frequently because human nature leads us to forget our hard-learned lessons during such time spans.

Furthermore, recent developments in the financial markets, in technology, and in society have facilitated the rapid spread of global market panics. The emergence of our 24/7 internet based news media, for instance, has made it possible for terrifying rumors and distressing news to spread across the globe in the blink of an eye.

And the use of computerized trading systems has made it possible for hundreds of billions of dollars to be yanked out of entire industries, nations, and global regions in a matter of minutes. According to Galbraith, then, global market collapses should not necessarily be interpreted as once-in-a-lifetime black swan events; instead, they should be expected to occur as regularly as the American decennial census.

He Still Deserves It!

So do we believe that Chairman Bernanke doesn’t deserve the Person of the Year award? We certainly wouldn’t go that far; in fact, even if one believes that Chairman Bernanke should have been better prepared to anticipate and respond to the collapse of our financial markets, one cannot help but admire the manner in which he ignored our political maelstrom and plowed ahead with his plan to flood our economy with liquidity.

Nevertheless, true economic prosperity will only arrive when investors regain confidence that Bernanke is prepared to manage any unanticipated problems that may occur in the future. Whether these problems are truly black swans, or whether they are foreseeable and are thus amenable to principles of enterprise risk management, our Person of the Year must nevertheless be prepared to manage another challenging year in 2010.