Nassim Taleb on Avoiding Black Swans

By Jeff Harding        

Nassim Nicholas Taleb wrote this piece in the Financial Times about Ten principles for a Black Swan-proof world (Hat tip to Bill D.):

JH: I love Taleb’s philosophical approach to economics and investing and I am an advocate of his theories about risk and “Black Swans.” Sometimes I agree with him for the same reasons and sometimes for different reasons. He is rather ubiquitous these days which is fine because he wants to spread his ideas. Sometimes he infuriates me with his bombe mots he tosses out on many topic unrelated to economics and investing, so maybe he takes himself too seriously, but he’s a very rare person: someone who can think.

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

JH: This is just Part I of his outrage at the derivatives industry. I agree with this: no one should be propping up Citi and AIG. Years of easy money created and inflated a fake investment boom in housing which filtered into everything else in the economy. It’s better to let it fail sooner, take the hit, and rebuild sooner. Delays only make it worse. See, Japan.

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

JH: This is the problem today. Why are we bailing out the likes of AIG and Citi? It only rewards them for bad acts. This is called “moral hazard” in economic jargon. He argues we should nationalize them and shut them down, probably by FDIC action. Why should taxpayers pay for their incompetence? No one is too big to fail. We here at The Daily Capitalist don’t like the word “nationalization,” but we do like the word “bankruptcy” for these institutions. We’ll recover just fine without them.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

JH: This blog has driven this theme home over and over (sorry if you’re tired of hearing it). Why do we let the same people who led us into this mess be given the responsibility to lead us out? Taleb rails against what I call the “Wall Street-Washington complex.” These people obviously don’t know what they are talking about and are driving the bus off the cliff.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

JH: I agree that the bonus system was a big part of taking the credit bubble to its heights. But it wasn’t the bonus system that got us here; it was the credit–debt bubble that started the bonfire. There is nothing wrong with a bonus system, but what he is talking about is the asymmetry of it. If these traders had skin in the game maybe they wouldn’t be cutting corners. Also, if they had proper risk models, these bonuses wouldn’t have been the problem. But we would still have had boom-bust because of the credit bubble. He and Roubini have started a campaign to have traders who received bonuses in companies that blew up give them back.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

JH: Well, this is kind of a truism. Of course there was too much debt and leverage. Of course leverage magnifies the bubble. It’s one of the characteristics of many bubbles. But who’s at fault for that? Again, it has to start somewhere and it started with the Fed flooding the economy with credit. What the world didn’t see was the leverage created by derivatives, which by some estimates, was far greater than bank created credit. I don’t know if he’s advocating a risk czar to prevent this. He obviously knows that it’s impossible for the government to regulate risk out of the financial system because new products will be invented to get around the regulators.

6. Do not give children sticks of dynamite, even if they come with a warning. Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

This is, in my opinion, a gross overreaction to the problem. Yes they are complex but so what? So are municipal bonds, warrants, options, and other securities. People do understand them. What they didn’t understand was not the instruments’ complexities, but the risk. These derivatives will be used in the future because they add liquidity to the market and spread risk out in small chunks to a large group. If we bundle up good mortgages and sell them to investors there is nothing wrong with that as long as they are properly underwritten. The problem with our crisis is that, contrary to popular belief, investors did understand them, what they didn’t understand or didn’t want to understand is that the underwriting standards were bad. And they knew it too, but just kept on going because of the big fees. See, “Understanding the Subprime Mortgage Crisis,” by Yuliya Demyanyk and Otto Hemert, published by the St. Louis Fed.

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

JH: I don’t understand what he’s saying here. There is no confidence in the economy right now. There is no confidence by investors that some of these big money center banks will survive. It’s all about confidence right now. I agree that the government shouldn’t be doing what it’s doing. But it wasn’t rumors that took the economy down: it was bad investments and too much debt (thank you, Fed). People will have confidence again when they reduce debt and increase savings, and when the government stops experimenting on us.

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

JH: I think I agree with this if he is saying that re-inflating the economy is a bad thing. He is absolutely correct that malinvestment along with its attendant debt is the problem.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

JH: This is a pitch for his Black Swan theory. His point is that the financial world regularly faces large, world-changing events that no one sees coming. And the investment advisers are naive, if not foolish, in their reliance on standard risk models. They regularly get killed by these events and you shouldn’t listen to people who don’t really know what they are doing. He also believes that most successful investors are probably more lucky than right. His advice? Invest mostly in low risk things like T-bills and risk only a small amount on something that might make you a lot of money. He did it himself and won big this cycle.

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

JH: I agree wholeheartedly with most of what he says here. I will interpret this as being a mostly Austrian School solution to the crisis: the quickest way out of our crisis is to let businesses fail, trying to prop them up will only delay recovery, let capital find a new home in productive businesses, ignore the fools of the Wall Street-Washington complex who lead us today, let people start saving again to rebuild our capital base, and stop making the same mistakes over and over. He sees banks as being, well, banks not hedge funds. They should be more like banking utilities and shouldn’t take the risks that hedge funds do. That way there will be less systemic risk in the world. Good luck on the bonus claw back; that’ll never happen.

Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.

In other words, a place more resistant to black swans.

JH: Get rid of the Fed, get back to a gold standard, get rid of central planning of the economy so that economic decisions are spread out over millions of players rather than just the few, and then the world will be safer.