Former US Defense Secretary Donald Rumsfeld is surely a controversial character but no one will judge him to lack intelligence. One of his most famous quotes, while at a first glance quite obvious, is in fact rather profound: “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. These are things we do not know we don’t know.”
It is those “unknown unknowns” that science philosopher and essayist Nassim Nicholas Taleb, was referring to, when he cornered his famous concept of a “Black Swan”: An event, which cannot be grasped before it occurs because it doesn’t fit in our framework of understanding the world. The 9/11 terrorist attacks were such an event.
Once a black swan event has occurred, there will be plenty of experts delivering an ex post story, explaining it, fitting it in our cognitive frame and making it look obvious and predictable in hindsight. Taleb calls this the narrative fallacy. Interesting enough, since Taleb has published his book, the black swan concept itself has become part of narrative fallacies. Many pundits, who didn’t see the financial crisis coming, are referring it now as a black swan event. By doing this, they are delivering at the same time a rather good excuse for their forecasting failure. “If the financial crisis was really an unknown unknown, you cannot blame me for not having foreseen it”, so goes the argument.
However, this is a rather lame defense, as the financial crisis was definitively not a black swan. Economists and experts could, and indeed should, have seen it coming. An explanation of why they didn’t, stems from the missing fourth possibility in the known-unknown square: the unknown known. Radical philosopher Slavoj Žižek introduced this concept in a critique of the US administration regarding the Iraq war but it can as easily apply to the behavior of the vast majority of us, economists, before the financial crisis.
Every element of the crisis was in plain sight: from the housing price bubbles to the alchemy of securitization, from the tremendous leverage in the financial sector to the immense international macroeconomic imbalances. Yet, only a handful of bright minds were able to put the pieces of the puzzle together and warn of the disaster’s imminence.
In my view, this blindness in front of the obvious has to do with the self-perception of the vast majority of economists as being hard scientists, which we are not. Many of us rely on models for the sake of their theoretical beauty despite having been proven wrong by reality, over and over again. This attitude can be summarized in “if the world doesn’t fit my theory, then the world must be wrong”.
Not many economists had Alan Greenspan’s courage after the financial crisis to humbly admit: “I found a flaw in the model that I perceived is the critical functioning that defines how the world works.” As I am writing this article, I am pretty sure that modern portfolio theory, value at risk and the efficient market hypothesis continue to be taught in academia as if the financial crisis never happened.
So where is the next unknown known? At least since David Hume and very likely earlier, we should know that wealth cannot be built through money printing or public consumption financed by debt creation. However, many economists today not only feign to ignore it but are even encouraging governments to pursue those dangerous policies. When in a couple of years from now, a new crisis hits in form of sovereign default, high inflation and currency debasement it won’t be a black swan but just a new manifestation of the unknown known in economic science.
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