SPIRE SIGN IN Register

SpirE-Journal 2011 Q1

Black Swan Events: What does 2011 hold?

Reader's Ratings:

Black Swan Events: What does 2011 hold?

To the casual observer, the world nowadays is seeing freakish events happening in freakish proportions – from destructive weather phenomena to political revolutions to dramatic terrorist attacks. In truth, history is littered with events of a radically unexpected and unpredictable nature. All create vast challenges for business leaders. Can such events be predicted and planned for, and if they could, what might 2011 hold in store?

Black Swan Events: What does 2011 hold?

The Middle East is ablaze. The dramatic events that began in January 2011 with the popular uprising in Tunisia that toppled dictator Zine el-Abidine Ben Ali have captured the imagination of the world. But they must also weigh heavily on the thoughts of business planners. President Obama famously rebuked the US Director of Intelligence for not having forseen the fall of Ben Ali and his more powerful counterpart in Egypt, former President Mubarak, both staunch US allies. But how much harder must it be for businesses to forsee and plan for such events. 

To the casual observer, it may appear that such freakish events – noted for their radical departure from the norm and their seeming “unpredictability”- are happening with increasing frequency. Rogue states threaten political conflict. Political revolutions topple authoritarian governments ensconced in power for decades. Terrorists seem poised to strike with weapons of mass destruction. What were thought to be stable financial systems come to the brink of collapse 1930s-style. Freakish weather phenomena strike world-wide, bringing droughts and earthquakes in some places and tsunamis and flash floods in others. 

To the careful student of history, however, such events have always been with us. Their impact may be magnified by today‟s saturation penetration of the 24 hour news cycle on television, radio and newspapers. But the pages of history are littered with happenings that seemed unthinkable to people alive at the time. The fall of Constantinople to the Ottoman Turks in the 1400s, the drought that precipitated the utter collapse of Maya civilization in Central America centuries ago and the Taiping rebellion which brought China to its knees in the 19th century (and sparked mass emigration) are a few examples of such events from the distant past.

Black Swans

According to Nassim Nicholas Taleb, who coined the term “The Black Swan” in his book of the same name, these events are extremely rare or, in other words, have negligible probability of occurrence. However, if they do happen, they have a disproportionately major impact. In statistical terms, these events can be considered “extreme outliers”, which are impossible to predict with existing technical know-how. The events are termed Black Swans because, in a world dominated by white swans, the black ones are a rarity. 

There are a number of events that had an enormous impact globally that could be categorized as Black Swans, from World War I, the “Spanish flu” pandemic of 1918-21 and the Great Depression to, more recently, the 9/11 attacks, the collapse of the Soviet Union and the 2008 Financial Crisis. However there are legions of events that had a smaller or a regional rather than a global impact – including, for example, the Boxing Day Tsunami of 2004 (which claimed some 200,000 lives) and the SARS epidemic that affected East Asia in 2003. 

Despite advances in forecasting technology and business planning, freakish events continue to challenge decision makers in government and business. For example, changes in sea surface temperature and the shrinking of glaciers, both of which are attributed to global warming, could have impacts that are hard to foresee. The massive floods in Pakistan and Australia in 2010 highlighted the unpredictable impact of changing weather patterns. The floods in Pakistan affected an estimated 20 million people and 20% of its land1. Similarly, the torrential rains that affected the state of Queensland in Australia impacted 30,000 properties, shut coal mines, cut rail links and damaged crops. Economists have estimated the cost of this episode of freakish weather at AU$ 20 billion (US$ 19.8 billion). 

Clearly, such freakish events only contribute to uncertainty in planning and business decision making. 

When we look more closely at most Black Swan events, it becomes evident that they reflected longer-term trends that could have pointed to some discontinuous event happening at some point, though the exact nature and timing of the event would virtually defy systematic prediction. 

Can close study of longer-term trends be a way to cope with Black Swan events?

Natural Phenomena

Clearly the very nature of weather patterns, with their complex endogenous feedback patterns, make accurate, long-range prediction very difficult. But meteorologists can and do attribute risk factors to specific events happening over the longer term. For example, it is widely predicted that a major earthquake will hit the Kanto (Tokyo-Yokohama) region of Japan in the next few decades – though the impact it will have is far less certain. 

Perhaps the biggest potential source of weather-related Black Swan events in the future is the prospect of global warming. This phenomenon has been blamed for many of the episodes of aberrant weather the world has seen in recent years, from the melting of Artic and Antartic ice to the incidences of violent typhoons and hurricanes across the Pacific. 

In recent years, global meetings have discussed ways of linking climate change to development and devising geo-engineering schemes that reduce emissions. The Copenhagen Summit (2009) failed due to political gridlock. Currently, few experts predict an early agreement between the developed and emerging countries on climate change. A positive Black Swan event might, therefore, be the development of a global political consensus among the major countries of the world on a way forward in arresting global warming, in the same way that the world agreed to ban chemicals containing CFCs3 in the 1990s. This could, for example, happen at the 2011 Climate Conference in South Africa. 

Another Black Swan event, related to global weather and energy usage, would be the invention of a cost-effective Green fuel source that has the potential to substantially reduce, if not replace, the use of natural gas, coal and oil. Obviously, such a development would require substantial investment in new technology and sufficient time for costs to be driven down to commercially viable levels, as well as for the requisite technologies to mature. However, if this does become a reality, it would change the fundamental structure of the global economy. In a best case scenario, it could make available renewable energy at low prices and limitless supply, triggering a global economic Golden Age. In such a scenario, fossil fuel based companies could collapse and new energy-exporting regions could emerge.

Owing to misunderstanding of the causal chains between policy and actions, we can easily trigger Black Swans thanks to aggressive ignorance—like a child playing with a chemistry kit. – Nassim Nicholas Taleb
Economic Events

Freakish weather conditions are just one source of massive uncertainties. The global economic downturn rattled the political and socio-economic fabric across the world. While governments focused on kick-starting their economies through stimulus spending in 2008 and 2009, the emphasis, since mid-2010, has been on reining in public spending and on monetary tightening. This could lead policy makers down a path to tough economic decisions, which could result in widespread public unrest. Europe, especially Greece, witnessed such unrest in 2010. Other countries in Europe, such as Portugal, Spain, Italy and Ireland, have also showed signs of fiscal weakness and could be in the grips of unrest this year. 

A Black Swan event across Europe could be coordinated labour union and public protests, which would further restrict the maneuverability of governments and the European Union to implement reforms. This could, in-turn, lead to a crisis in European Union institutions, as Germany resists further concessions to indebted Southern European countries. A substantially different structure of economic governance for Europe might be the result. What all this means for business might be short-term pain but long-term gain in the form of a more stable and sustainable structure for managing the EU economy and currency. 

On the flip side, positive Black Swans may appear, creating discontinuous but ultimately beneficial change to the economy. Disruptive changes in technology, consumer habits or corporate business models might be the drivers here. In recent years, such changes seem to have been mostly generated from the Information Technology sector. The explosion of IT in the workplace, mobile phone penetration, the internet and social media are good examples. However disruptive technology and processes from other fields have also had a powerful, if not revolutionary, effect that few foresaw – life-extending medical procedures such as angioplasty, the containerization of ports and the Green Revolution that enabled massive agricultural growth in Asia. 

Looking ahead, a number of nascent technologies and processes are at a stage where they might see “take-off” in the very near future, with potentially revolutionary effects. These include commercial space-flight, artificial intelligence, cybernetics and radically life-extending medical breakthroughs such as vaccines for cancer and HIV. While it does not appear that a breakthrough is round the corner on any of these fronts, the same could be said for the internet in the mid-1990s. And it should always be recalled that economic events usually generate mixed effects, creating winners and losers in society – this is very clearly the case for medical technology that extends life, with such technologies promising to fundamentally disrupt the economics of retirement and public finances.

Politics

Since late 2010, a massive wave of public anger and protests has swept through the Middle East and North Africa, profoundly affecting countries like Tunisia, Yemen, Egypt, Syria and Algeria. These protests have been primarily directed against regimes seen to be authoritarian and corrupt. The effects of this unrest are being felt across the region. However, in 2011-12, these could spiral to countries that have long had deficits in governance and transparency. 

The Economist Intelligence Unit (EIU), in its Index of State Capability 20105, categorized 91 of 163 countries as those that have had weak or very weak governance. The Global Corruption Barometer 20106, published by Transparency International, suggests that public opinion on government efforts to combat corruption in countries of Latin America, Asia Pacific, West Balkans and Sub Saharan Africa has deteriorated. 

In this context, a Black Swan event in 2011 could be a “Development Revolution,‟ which would bring a new wave of societal transformation, as did the Industrial and Internet Revolutions. Such an event, if it happens, would disrupt business activities across several low governance countries in the short term. However, it would reduce transactional costs of business over the medium to long term. It might also pump petrol prices to US$ 150/ barrel, above the 2008 peak price of US$ 143. This would drive-up inflation, thereby leading to further credit tightening. 

Furthermore, from events in 2010, it is not hard to foresee that Afghanistan, Iraq, Pakistan and North Korea could contribute to massive geopolitical uncertainties in their respective regions and indeed the world. These countries have been ranked 6th, 7th, 10th and 19th respectively on the Failed State Index 20107. The risk from these “failed states” (one of which is a declared nuclear-weapon state) is real, as their political, social and economic institutions have declined in capacity over time. 2011 could throw-up Black Swan events such as the Taliban re-gaining control of large parts of Afghanistan, military rule returning to Pakistan and North Korea threatening nuclear war with the South and driving down business and consumer confidence in North-east Asia. These events would impact risk assessment and, hence, business operations in South Asia, Middle East and the Korean Peninsula. Their effects on business investment and consumer confidence could be dire. 

A useful theme when discussing political Black swans is the world-wide trend towards more open and accountable government. The impulse of the middle-class and the broader population towards such politics, and their success or failure in achieving it, has been a key determinant of Black Swan events in the recent past. This looks set to continue in the near future. 

However it should be recalled that the movement towards political liberalization is not the only source of political Black Swans – these could come from traditional inter-state conflict, perhaps manifested not militarily but in terms of economic war or cyber-warfare, as has been seen between Russia and some of the independent states it borders in the past few years. And of course terrorism remains a threat, as the Mumbai attacks of November 2008 remind us. 

Public Health

While discussing freakish events and their probability, public health issues cannot be neglected. One of the biggest but least well-known Black Swan events of all time was the Spanish Flu pandemic that circled the world after the First World War, killing an estimated 20 million people. Many liken HIV-AIDS to a modern Spanish flu, as it remains incurable and threatens to spiral out of control not only in Sub-Saharan African countries with high HIV infection rates but also in Russia, China and India which all have large HIV-positive populations in absolute terms. 

This could well change in the future, if one of the many medical teams working on HIV-AIDS succeeds in finding a workable vaccine or cure. 

However new threats to public health from contaminants in water and air might emerge. The oil spills in the Gulf of Mexico and China and Icelandic Volcanic Ash, which were environmental Black Swan events in 2010, might have already damaged the ecosystem in unknown ways. The impact might emerge in the form of new health or sustainability concerns for humans, animal and marine life in 2011-12. We could term this as a “Double Black Swan Event”, whose probability of occurrence is either equal to or smaller than that of a single event [Prob. of A x Prob. of B ≤ Prob. of A]. 

In addition, new health ailments could arise from increasingly scarce natural resources, especially fresh water. In case these Black Swan events happen in 2011, it would take years of massive investment (with long gestation horizons) to repair.

Conclusion – bringing Black Swans out of the Black Box

In a globalized world, businesses are not only linked to each other but also dependent on the external environment. After a Black Swan event, in hindsight, business owners might develop strategies to avoid impact from similar events in the future. But, the question remains – how can business predict events that have a major impact but are fundamentally dissimilar to anything that has happened before – what former US Defence Secretary Donald Rumsfeld famously termed “unknown unknowns?” 

To cope with such possibilities, companies would do well to heed Taleb’s advice. He advocates the use of counterfactual reasoning or, in plain language, “what-if” analysis. This method, he believes, is more effective in dealing with Black Swans than the risk management and forecasting models that are currently used on Wall Street. 

For example, companies should ask questions along the lines of “What would have happened if such and such an event took place in 2010? How would the company have reacted? Where would we be now?” Events that have been speculated about by some experts and would have left the company devastated probably warrant more contingency planning and investment. 

Despite Taleb’s argument on the usefulness of What-If analysis, Black Swan events continue to be a Black Box for most companies and most of humankind. What 2011 has in store, only the following months will show.

Back to Top

Back to Home
BTBTBTBTBTBT