Listening to Swans

The term “Black Swan” became popular in the finance world in 2007, when Nassim Nicholas Taleb published the book, “Black Swan.” However, this term has roots back to the 2nd Century when the Roman poet Juvenal used it to describe something impossible. This metaphor took on new meaning in 1697, when Dutch explorer Willem de Vlamingh encountered black swans in Western Australia, proving that black swans did exist. This showed that something presumed to be impossible could in reality occur. When describing the US economy, there have been many cyclical trends, such as a pattern of growth, peak, recession, and recovery which evoke the phrase “history always repeats itself.” Despite this, many seemingly unpredictable events, termed “black swan” events, have dramatically transformed history and our future. Given the large impact and subsequent negative effects of each of these “black swan” events in history, the Federal Reserve (Fed) should make decisions based on these “black swan” events rather than historical trends.

When the idea of making decisions from these black swan events is proposed to economists and policymakers, many are skeptical — highlighting why would the Fed want to make decisions based on events that are, by definition, exceedingly rare. However, when looking at the last five major black swan events that have greatly impacted the United States economy, only one occurred in the 20th century, with the last four occurring in the 21st century. This sudden and dramatic increase demonstrates a new era where black swan events are not as seemingly sporadic. Instead, we have seen a sector meltdown, terrorist attack, recession, and global pandemic in the last twenty-five years, emphasizing the importance of preparing for these events and ultimately learning from them.

While there is a lot for the Fed to learn from black swan events, the Fed has continued to use past cyclical events and trends to make decisions that have resulted in massive growth and sustained expansion for the US economy. For example, during the 2008 Great Recession, the Fed made similar decisions to past recessions by responding with aggressive monetary policy actions by lowering the federal funds rate to nearly zero. This stabilized financial markets and mitigated the impact on the broader economy (DiLallo). Moreover, throughout 2023, the Fed continued to raise interest rates to combat inflation similar to the late 1970s and early 1980s when the Fed, under Chair Paul Volcker, increased rates significantly to achieve the same goal (Reynolds). Conversely, during the Dot-Com Bubble Burst, the Fed decided to lower interest rates to help stimulate economic recovery, showcasing the Fed’s efforts to support the economy (CFI). While the result of these responses from the Fed was sustained economic growth as evidenced by the 7.8% annualized return for the ten years after The Great Recession, the events and subsequent decisions of the Fed have had a lasting impact on the citizens of the United States. This can be seen as it took five years for the stock market to bottom out and begin to recover after the 2008 recession. Furthermore, it took over six years for the markets to recover and the economy to get back on track after this bottoming out (Weinberg). For consumers looking to retire during this period or families that recently had children, these inopportune events have pushed many to work many extra years as well as sacrifice the health of many newborns. As seen above, given the severe implications of these decisions made by the Federal Reserve, this further underscores the importance of reexamining the Federal Reserve’s actions to take a different approach as more of these black swan events begin to occur.

Beginning with this new approach, the basis of the Federal Reserve’s reexamination of its decision-making should stem the “Dotcom” Crash which killed many jobs, businesses, and investments in the technology sector. When looking at the period between March 2000 and October 2002, the tech-heavy NASDAQ fell by 75%, destroying most of the gains since the bubble started building. Furthermore, investor losses were estimated to be around $5 trillion during this period, further compounding the devastating effects of this black swan event. Outside of financial markets, many companies, such as Pets.com, Webvan, Worldcom, and Global Crossing were forced to shut down with over two million working-class Americans being laid off in 2001 alone (Hayes). With such lasting implications from the crash, it gave way to a fundamental transformation of the economy; specifically, a change in the operational mentality of executives and investors. Afterwards, executives began to value sustainability and sound business models emphasizing the careful examination of overvaluation, lack of profitability, high levels of debt, and market saturation (FasterCapital). Each of these business principles is now in use today which has allowed the economy to prevent massive unemployment and financial loss in specific sectors. Considering the lessons learned after the crash and how we still use these lessons today, we realize the integral learning experience that came from this unpredictable event. Since this was the first major black swan event for the US economy, it was not expected that the Federal Reserve would base its decision on these events; however, 20-plus years later, after several black swans in rapid succession, ignoring them is becoming far less justifiable.

It is also far less justifiable to ignore events that have impacted both specific sectors and the overall economy as the 2008 Global Financial Crisis caused one of the greatest shifts in unemployment and bankruptcy for the US citizen. Overall, the 2008 Global Financial Crisis had a much larger and broader impact on the US economy as 8.7 million workers lost their jobs and the unemployment rate reached 10 percent. On top of that, there was a total of 3.8 million home foreclosures between 2007 and 2010 with American households losing a total of $19 trillion of net worth due to the stock market crash (Boyle). Lasting, this crisis impacted global markets with several countries, including Spain, Greece, Ireland, Italy, and Portugal, suffering sovereign debt crises that required intervention to help recover their economy (DiLallo). With such lasting effects on the US and the global economy, the Federal Reserve made major reforms in its banking and financial regulation. After the crisis, it became clear that there was a need for enhanced oversight and regulatory measures to address these systemic risks that came to light during this event. For example, it was during this period when there was a lack of accountability for banks and insurance companies that gave way to the Dodd-Frank Act that governs our banks and insurance companies today (CFTC). Today, the Dodd-Frank Act has allowed the US economy to grow and support other countries. As such, we can see how the lessons learned from this event have dramatically changed how the Federal Reserve closely monitored the regulation of loans and mortgages today, further contributing to the idea that the Fed should be making decisions based on what they have gleaned from these black swan events.

Looking outside the Fed and their close monitoring of debt instruments, black swan events, such as the 9/11 Attacks resulted in not only closed and chaotic financial markets but a total realignment of the American vision. After the initial attacks, there was chaos in the financial system, resulting in banks struggling to redistribute balances and causing unexpected shortfalls in liquidity. It was during this time that the Federal Reserve provided significant injections of liquidity through open market operations, allowing banks to maintain their payments and provide liquidity to the financial markets (McAndrews). Outside of financial issues, the attacks led to a realignment of the American vision regarding topics, such as public opinion, foreign policy, and national security. For starters, there was a sense of public unity and a surge in patriotic sentiment throughout the US during this time as well as a shift in the United States’ approach to international diplomacy as the US sought to build coalitions for safety and prosperity. These included treaty alliances with countries such as South Korea, Japan, Thailand, and Australia as well as partnerships with less developed countries like Egypt, Israel, and Jordan (Council on Foreign Relations). The realignment of the American vision towards a safer and stronger economy and country as well as various liquidity theories from this black swan event, has allowed the US to develop a robust economy that can work and learn from other countries. This sustained success from the United States’s interconnectedness with foreign countries further highlights the importance of not only the Federal Reserve to learn from these types of past events but for policymakers to also study and use these past events to maintain the growth and safety of the United States.

While the safety of US citizens has since increased from the 9/11 attacks, there has also been an increase in black swan events throughout the 21st century. Given the important lessons learned from each of these events that appear to be happening more frequently, how can the Fed today prepare and make decisions based on these black swan events? For starters, with the rise in technology, we have seen the emergence of Advanced Economic Modeling and Big Data Analytics. Today, many models incorporate complex systems theory and agent-based modeling which helps to better analyze economic factors and help anticipate potential black swan events. Subsequently, with the meteoric rise of big data analytics and artificial intelligence, the Fed can easily analyze vast amounts of real-time and historical data improving our ability to see early warning signs of emerging risks (Haider). However, a concern with utilizing electronic modeling is the subsequent rise in cybersecurity-related attacks. In response to this, the Fed has taken steps to ensure its safety by investing in advanced cyber intelligence capabilities to monitor cyber threats targeting the financial sector and economy. With central banks, financial institutions, and cybersecurity organizations becoming increasingly interconnected, this has allowed the Fed to prepare and mitigate emerging threats as well as any potential black swan event related to cybersecurity (Eisenbach).

With the Federal Reserve establishing regular channels for information between other central banks, the US government, and the US consumer, this allows not only the Fed to stay informed about global economic and financial developments but also every citizen in the US with a phone and access to the internet (Eisenbach). It is this level of interconnected communication that has allowed some experts to predict the recent black swan events, such as COVID-19 and the 2008 Great Recession. Given our investment into technology and communication across all ages, we are entering a period in which the Fed does not have to be the sole decision maker but rather, listen. Listen to what the different forums, communities, and industries are discussing because as we have seen before, at least a special few will help mitigate the impact of Black Swan events.

Citations

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