Ten principles for a Black Swan-proof world
Here’s a reprint from an article that appeared in the Financial Times today by one of my favorite author’s Nassim Nicholas Taleb. I first mentioned Taleb in the post Its Official: Hell Freezes Over. If you are unfamiliar with his work, definitely check out Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets
Ten principles for a Black Swan-proof world
By Nassim Nicholas Taleb
Published: April 7 2009 20:02
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.
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.
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.
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.
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.
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.
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.
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.
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).
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.
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.
The writer is a veteran trader, a distinguished professor at New York University’s Polytechnic Institute and the author of The Black Swan: The Impact of the Highly Improbable
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April 8th, 2009 at 10:54 pm
These are great… I think I might need to read this book someday
#2 exactly!!
#6 – do we trust most people to be bright?
April 9th, 2009 at 5:42 am
Those who have their dirty hands on the levers of our economy will not willingly let go. “To reign in hell..”, etc.
Unless this economy gets much worse and the average citizen gets much more angry, these things will not change this time around.
April 9th, 2009 at 6:07 am
“Should” this, “Should” that. Since when does America operate on “Should” ?
My Grandmother in Iran could’ve come up with that.
April 9th, 2009 at 7:07 am
Nirav, Taleb has made some great arguments about probability and risk. But the best probability and risk book on the market in my opinion and others is: “Against the Gods” by Bernstein. Taleb is covering well trod territory and hasn’t come up with anything new. Even his reference to “black swans” is an old mathemetician’s probability reference that may have come from Darwin’s evolutionary research (the reference is old, but I haven’t found its root). But Taleb’s timing was good, and he is smart enough to exploit that with books and TV appearances.
Here are my comments to his top 10:
T. What is fragile should break early while it is still small.
Me: Okay, I agree with this point. Somehow, we must keep the Citi’s and the AIGs of the world from getting “too big to fail”, but that is a hazardous road as it involves government intervention and therefore “unintended consequences”.
T: No socialisation of losses and privatisation of gains.
Me: I think this point is overdone by the Taleb camp. Once the “too big to fail” do fail, there is nothing to be done but to save them to save the world economy. Hindsight is 20/20
T. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.
Me: Another great sound bite that doesn’t make real world sense. Who knows how to fix complex securities and resultant damage to the global economy and banking system if not bankers and economists. Janitors?
T. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.
Me: Okay, but this is going to require lots of regulation. And the “free marketers” are not going to like that. Isn’t Taleb a free marketer? Doesn’t he think the markets know better than the government? He is contradicting himself.
T. Counter-balance complexity with simplicity.
Me: More regulation. Eliminating debt from the economy sounds good, but will lock us into lower growth and limit improvements in lifestyle, not just here, but especially in the developing world. Low leverage means higher cost of capital. It is a straight forward (linear) relationship. Higher cost of capital (interest rates) means less of everything for everyone. A harsh prescription
T. Do not give children sticks of dynamite, even if they come with a warning.
ME: who decides what is a complex derivative? If we limit financial products we limit growth and prosperity. Maybe better to regulate ALL financial products and purveyors and require them to be traded in an open market in order to provide visibility (I don’t know why we don’t have “toxic assets” trading in open markets yet. That is the best way to clear them at a fair price).
T. Only Ponzi schemes should depend on confidence.
ME: Dumb metaphor and conclusion. Economics is all about human behavior which is about psychology. Of course it is governments’ role to maintain the confidence of its people. That is one of its principle responsibilities encoded in our American “Declaration of Independence”: “the pursuit of happiness”. Government is responsible to create a stable and safe environment so the individual can do just that. That is why we agree to pay taxes.
T. Do not give an addict more drugs if he has withdrawal pains.
Me: Wrong, Dr. Taleb. A more reasonable physician might use methadone or a nicotine patch to help the patient rid his addiction. Going “cold turkey” is only for masochists (maybe like Taleb)
T. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
ME: Agreed, they should read my blog and yours and become knowledgable about finance and economics so they can make intelligent decisions of their own.
T. Make an omelette with the broken eggs.
Me: I think it is perfectly acceptable to make an omelette with a broken egg, so bad metaphor (he really needs to work on him allegory / metaphor skills). I don’t think there is anything patchwork about the radical actions taken to fix the economy. There are resources being applied that were only academic theory two years ago. This is the biggest economic experiment in history, and Taleb calls it patchwork? But his conclusion is fine, and really is the strength of our national economy: small business and entrepreurs building from the ashes of the fallen. There has already been lots of creative destruction and plenty of businesses are failing as they should in a capitalist economy, providing fertilizer for new growth.
T: “In other words, a place more resistant to black swans.”
Me: In saying this, he misses the whole point of his own argument. Black swans are just that, tail ends of a probability curve. There will always be tails. They aren’t going away, unless Taleb knows how to reinvent probability. This sounds like the same argument from Greenspan of managing the economy to “eliminate the business cycle”. It can’t be done! Human nature does not change. Greed and fear will always exist and will just promulgate in a different way in the future that has not yet been imagined. How do you regulate the unknown?
April 18th, 2009 at 2:57 am
The fact is a Black Swan-free world is impossible – surely that’s the main thrust of Taleb’s argument, or has he forgotten it himself?
e.g. Perhaps a distributed, hyper-localized system of business would be vulnerable to localized manias? Or perhaps a a hyper-cautious small scale world would not be able to find the drug researchers required to combat sudden avian bird flu?
Okay, not great examples but I’m thinking on my feet.
The point I took away from Black Swan is to expect the unexpected, and to try and make sure you have lifeboats, rather than thinking you can prevent them altogether.
April 18th, 2009 at 3:40 am
[...] off Dividends has reprinted Taleb’s 10 principles for a Black Swan-free world. Worth reading, though surely a contradiction in [...]
April 18th, 2009 at 5:26 am
“expect the unexpected, and to try and make sure you have lifeboats”
Always good advice for any investor
April 21st, 2009 at 11:48 am
[...] Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are [...]