Peter Neuwirth wrote a blog post titled Fragility, Antifragility, and Financial Forest Fires in two parts (part 1, Part 2). Peter Neuwirth is the author of What’s Your Future Worth? which describes the basic principles behind the actuarial perspective.
Part 1
« There is a fundamental complexity and opacity that our financial system now embodies. There are too many “moving parts” in the investment markets, and too many of them are interdependent in ways that very few people are aware of and even fewer completely understand. Even those that understand how the interactions work today will never be able to predict the evolution of the system and how those interactions might change in the future. Most importantly, nobody understands the system as a whole. It wasn’t designed by anyone and it is not managed by anyone. And yet it is a system we all must live in. »
« Nassim Taleb is, in my opinion, one of the world’s foremost experts on complex systems and their potential for collapse. In his book Antifragile he describes 3 different categories of systems; fragile, resilient and, antifragile. Specifically, a system is fragile when it responds negatively to volatility in its environment (or the ”macro-system” in which it is embedded) while a resilient system is one that is impervious to volatility, remaining stable regardless of the stressors given by the environment/macro-system. Antifragile systems, on the other hand, get stronger under volatility. One straightforward example of an antifragile system is that of the human body, which, (within certain ranges) gets stronger/healthier when subject to environmental stress. For example, a child’s immune system gets stronger after exposure to certain diseases and our muscles grow when we are forced to exercise. With this framework in place, Taleb explores and explains many phenomena that we observe, but consistently misunderstand. Taleb then describes how these misunderstandings can lead to spectacularly bad decisions. »
Part 2
« All complex systems are, by their nature, prone to unanticipated combinations of circumstances (some extremely unlikely) that can conspire to bring the system down. Engineers have known this for decades and will use many techniques to protect against these completely unpredictable (by humans) events. »
« Taleb… has also looked at the problem of complexity from a deep theoretical perspective and one of his key insights is that when your system’s survival or livelihood is dependent on a “macro-system” of this nature, your focus should not be on understanding (or trying to understand) the macro-system, but rather on understanding your relationship to the macro-system and in particular how you respond to the stresses, unpredictability and inherent volatility that is inherent in such a macro-system in which you or your system is embedded. »
« In other words, your goal is to make sure you are antifragile and not fragile. »
« But what if the macro-system itself is fragile? Which brings us to the 100 trillion dollar question. Exactly what kind of system is our system of money? Is it like the Paris Metro or our power grid; a complicated transportation/transmission system designed by people? Or is it a naturally evolved and impossibly complex one like the Amazon rainforest? Is it fragile like the Space Shuttle where the only hope for the short term survival of its human passengers is redundancy and extreme vigilance while at the same time we have to accept that eventually there will be a total and complete system failure destroying all the systems (human and otherwise) within it? Or is it antifragile like the human body where stresses (within certain ranges) make the system stronger? »
« I think the answer is that our Global Financial System is an evolved and impossibly complex system… In short it’s a hybrid and in many ways has the worst features of both types of systems – just like a naturally evolving system it is too complex, dynamic and opaque for us to understand and predict, but on the other hand it is like a human designed system that does not operate at a natural sustainable equilibrium, has an uncomfortable degree of fragility and appears to need constant human “management” to keep its potential collapse from destroying all the important systems (e.g. companies and communities) that are embedded in it.»
« In many ways the world of Money seems similar to our physical modern world where we have tampered with the naturally evolving earth and upset its sustainable equilibrium. I live in a part of California where I don’t believe nature ever intended so many humans to reside… In Taleb’s terms, we have taken an antifragile system and with our tinkering, have made it fragile and prone to collapse. »
« I do think that the Financial Crisis of 2008-9 bears an uncanny resemblance to a raging wildfire, and that only with the extraordinary efforts of the Federal Reserve and Central Banks around the world was our monetary system saved. Like the Tanker Air Carriers used to fight forest fires out west, the US Federal Reserve alone poured over a trillion dollars of liquid cash into the global banks around the world to prevent the crisis from shutting down all commerce. And now 10 years later, the underbrush has returned, and one of these days lightening will strike again. Whether there is enough water left in their storage tanks around the world to put out the next conflagration is anybody’s guess. »
« And yet we need to live in this uncertain, complex and possibly fragile environment »
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