Federal regulators need to help insure the economy against catastrophes, not just the optimize it to do well under ordinary conditions.

Nassim Taleb, a risk engineering professor at the New York University Polytechnic Institute, made that argument today at a hearing organized by the oversight and investigations subcommittee at the House Financial Services Committee.

The panel organized at the hearing to look at the progress of the Office of Financial Research (OFR) and the Financial Stability Oversight Council (FSOC), two agencies created by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The Dodd-Frank Act calls for the OFR to help the FSOC get the data the FSOC needs to identify and track potential threats to the U.S. financial system.

Taleb, a former derivatives trader, is known for promoting “tail risk hedging,” or the need to protect against potentially catastrophic “Black Swan” events.

The OFR section of the Dodd-Frank Act “aims at the creation of an omniscient Soviet-style central risk manager,” Taleb said, according to a written version of his testimony provided by the subcommittee. “It makes us fall into the naive illusion of risk management that got us here –the same illusion has led in the past to the blind accumulation of Black Swan risks.”

Society can prepare for Black Swan events, but it cannot predict them,Taleb said.

“There have been tens of thousands of scientific papers on prediction that have not been been replicated outside the papers,” Taleb said. “Had the last crisis been predictable within these quantitative methods, then central banks with access to all manner of information, and thousands of PhDs on their staff, would have been able to see it. They failed. So please ask yourselves why you believe that the next attempt will succeed.”

Taleb suggested that policymakers should take a “less is more” approach to managing financial system risk.

Policymakers should ensure that bank managers and staffers face potential losses when they make bad decisions as well as potential rewards when they make good decisions, Taleb said.

Policymakers also should promote “reliance on simple, ‘hard,’ non-probabilistic risk measures, based on time-tested heuristics,” Taleb said. “The more complicated the rule is, the more likely it is to fail.”

Taleb also gave lawmakers a copy of a paper in which he contends that the best insurance against economic catastrophe is to create redundancy and, in effect, keep some idle capital under several different mattresses.

Traditionally, economists and others have promoted the idea of maximizing use of capital and other resources, to maximize gains, but, in extremely bad situations, having idle capital under a mattress may increase the probability that the saver will get through the crisis, Taleb said.

“Biological systems — those that have survived millions of years — include a large share of redundancies,” Taleb said. “Just consider the number of double organs (lungs, kidneys, ears)…. Once certainly pays for it, but it may be necessary for survival.”

Minimizing redundancy is, in effect, a way of skimping on catastrophe insurance premium payments, Taleb said.

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