It is really quite simple.

  1. Entropy increases (the only way to decrease entropy is to expand the borders to include other systems with less entropy, got that?).
  2. To keep profiting in an entropic environment, complexity must increase.
  3. The current solution for increasing complexity is connectivity. (Another solution is becoming more educated, but that is incompatible with the old-think specialized training that the current system promotes).
  4. Increased connectivity makes entities non-independent.
  5. Risk models of massive systems all rely on the central limit theorem which says that uncertain is distributed as a Gaussian. Unfortunately, the central limit theorem assumes that all events are independent.
  6. Central limit theorem based models are thus failing. The unpredicted events are black swans.

Since we have a system build on institutional inertia that is “understood” and “run” by people with limited understanding, the system is going to create more and more black swans. It is essentially a “feature” of a failed design. Humans have created a system that nobody understands. Perhaps more accurately, humans have created a system in which the kinds of persons that rise to positions of leadership also lack the qualities of understanding exactly what they are leading—if you really understood exactly what you were in charge of, would you want to be in charge in the first place? Maybe self-delusion is what makes positions of power bearable?

Two solutions must be implemented:

  1. Complexity MUST NO LONGER be achieved by interconnectivity. Differentiation by outsourcing is downright crazy when the outsourcing is limited to a contract and a phone call.
    Let me repeat that. It is INSANE! If you are a business, you will someday find that your supply chains get disrupted for reasons beyond your control. You will also find that these disruptions hurt all players and that you can not simply find another supplier. You are, in short, screwed. If you are a person, who has outsourced basic living tasks *shakes head*, you will find someday that you
    have created an entity comprising you AND “your helper” that can not be separated without pain. You have become interdependent. You will be the only source of money for your assistant, who will be kept at the “technician level”. Your assistant will be the only one knowing how to run the very basics, that is, the foundations of your life. Again, you figure, you are safe because you can always find another, but you can’t; because few things are independent anymore. Never outsource “your legs”!
  2. We need a substantially better risk model than what they teach at so-called top universities. The financial crisis is partially to blame on grads from the same universities thinking the same way and failing in the same way DESPITE their fine models assuming that they come from different institutions and think in uncorrelated ways (yeah, right, they probably got each other on speed dial). First, decision makers need a refresher in the difference between precision and accuracy. Precision is useless without accuracy, in fact it is worse than useless because it instills a false sense of confidence. Second, people must learn to think. A new model must be qualitative in nature. The first thing to do after killing all the lawyers is to kill all the quantitative guys.

Obviously, this is not going to happen. Complex systems built on interconnectivity must therefore collapse. How this happens will be the subject of a future paper, although recently you could watch in real time in a limited part of the economy (finance, consumer credit, real estate, and homebuilders) 😛

Originally posted 2009-07-27 00:34:28.