Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate March 27th.
Events like the COVID-19 pandemic of 2020, the US housing crash of 2007-09, and the terrorist attack of September 11, 2001, can be called “black swans”: in each case, few people were able to predict them reliably. But they were known unknowns, not unknown unknowns. That is, in each case, knowledgeable analysts were fully aware that such a thing could happen, even that it was likely to happen eventually. They could not predict that the event would happen with high probability in any given year. But the consequences of each of these events were severe, and predictably so. Thus, policymakers should have listened to the warnings and should have taken steps in advance. They could have helped avert or mitigate disaster if they had done so.
Listen to the Cassandras
After the danger of the new coronavirus had become apparent to all, US President Donald Trump repeatedly said that such a pandemic was “an unforeseen problem” that “nobody ever thought would be a problem.” But of course epidemiology experts had warned about the danger for years, and as recently as last October.
After the attacks of September 11, 2001, President George W. Bush said, “Nobody in our government at least, and I don’t think the prior government, could envisage flying air planes into buildings.” National Security Advisor Condoleezza Rice claimed: “no-one could have predicted that they would try to use an airplane as a missile.” But in fact experts had warned about the possibility of terrorists flying planes into buildings like the Pentagon and even about the possibility of terrorists bringing down the World Trade Center. The Cassandras included the Director of the counter-terrorism unit at the President’s National Security Council, Richard Clarke, the man who in August 2001 sent Bush a memo titled “Bin Laden Determined to Strike in the United States”.
It is tempting to attribute such failures entirely to the incompetence of some of our leaders. But that is too facile an explanation. Also caught completely by surprise were the public in general and the financial markets in particular.
The stock markets were at historic highs shortly before they crashed in the global financial crisis of late 2008 and again just before the current crash that began in late February 2020. In both cases, there were plenty of candidates on the list of potential black swans. Indeed, housing prices had already been in decline for over a year in the first case and the COVID-19 virus had already surfaced in Wuhan, China, by the start of 2020.
The worst misperceptions of investors did not just lie in their optimistic baseline forecasts. The markets did not even see a risk: the VIX, which reflects investor perceptions of risk or uncertainty, was very low in advance of both 2007-09 and 2020.
Black swans versus narrow data sets
I see several systematic factors that help explain why such extreme events have come as complete surprises to our leaders, to the public, and to the financial markets. Even the technical experts can be myopic: they sometimes fail to cast the net wide enough when they analyze the data. They look only at recent data sets – which are by definition short data sets. They think that because the world is changing rapidly, events from 100 years ago are irrelevant.
Americans often add a second set of blinders to their forgetfulness of history: they focus excessively on what has happened inside the United States. They discount what happens in other countries, perhaps out of a belief in American exceptionalism (“the US is different”).
In 2006, finance whizzes who priced US mortgage-backed securities relied on the recent history of housing prices for their statistics. They effectively applied a rule that housing prices never fall in nominal terms. What they really meant was that they themselves had no experience with housing prices falling in nominal terms. In reality, it had happened in the US in the 1930s, and it had happened in Japan in the 1990s, but it had not happened in the lifetimes of US analysts in the US. If the analysis had included a longer or broader data set, the statistical estimates would have assigned a distinctly positive probability that housing prices would fall, and mortgage-backed securities would therefore crash. (Government policy got it wrong too, of course, from subsidizing housing debt to inadequate financial regulation.)
Financial analysts who limit their data to their own country and their own time period are like 19th century British philosophers who concluded that all swans were white, by induction from their personal observation. They had never been to Australia, where black swans had been discovered in a previous century, nor had they consulted an ornithologist.
Plagued by unpreparedness
Even when the experts get it right, the leaders often don’t listen to the experts. One reason may be that the political system does not respond appropriately to estimates like a 5 % chance of disaster per year, even when the consequences of failing to prepare are large in expected value (that is, the probability of the event, multiplied by consequences of the event if it occurs, is large).
In advance of 2020, the experts got the risk of a serious pandemic right. Bill Gates and many other astute observers got it right. Even a multitude of Hollywood movie producers got it right. And yet the US federal government was not prepared. The current Administration in 2018 eliminated the unit at the National Security Council that had been set up by the Obama Administration to deal with the risk of pandemics. It worked to cut sharply the budget for the Centers for Disease Control and Preparedness and other public health agencies (including the CDC office in China). That obliviousness helps explain why the US finds itself less well prepared than many other advanced countries like Singapore, lacking enough testing kits, respirators, ventilators, hospital beds, or and capacity.
Just as important, the White House didn’t have a plan ready, and did not know that it was important to develop one even during the months after the new coronavirus surfaced in Wuhan and it started to spread worldwide. (Or perhaps the plan was: if we administer few tests, then we can report few confirmed cases and so keep the stock market up for another week.
Although Trump on March 19 said “Nobody has ever seen anything like this before,” there had been plenty of precedents. The very deadly Ebola virus killed 11,000 people in 2014-16; but the victims were far away in Africa. The influenza pandemic of 1918-19 killed 675,000 Americans (among some 50 million worldwide); but that wasn’t in living memory. If you haven’t seen a black swan with your own eyes, then it must be that nobody ever has.
Apparently, in order to make an impression on our leaders, a disaster has to kill lots of fellow citizens within their own memory spans. Such a lesson is underway, worldwide, today. Let us hope that the price of the lesson, in the number of deaths, is not too high.
This post written by Jeffrey Frankel.