Beware those Black Swans

The bestselling economist Nassim Nicholas Taleb argues that we can’t make the world financial system

After completing my book The Black Swan, I spent some time meditating on the fragility of systems with the illusion of stability. This convinced me that the banking system was the mother of all accidents waiting to happen. I explained in the book that the best teachers of wisdom are the eldest, because they may have picked up invisible tricks that are absent from our epistemic routines and which help them survive in a world more complex than the one we think we understand. So being old implies a higher degree of resistance to "Black Swans" (events with the following three attributes: they lie outside the realm of regular expectations; they carry an extreme impact; and human nature makes us concoct explanations for their occurrence after the fact).

Take Mother Nature, which is clearly a complex system, with webs of interdependence, non-linearities and a robust ecology (otherwise it would have blown up a long time ago). It is a very old person with an impeccable memory. Mother Nature does not develop Alz­heimer's - and there is evidence that even humans would not easily lose brain functions with age if they took long walks, avoided sugar, bread, white rice and stock-market investments, and refrained from taking economics classes or reading the New York Times.

Let me summarise my ideas of how Mother Nature deals with the Black Swan. First, she likes redundancies. Look at the human body. We have two eyes, two lungs, two kidneys, even two brains (with the possible exception of company executives) - and each has more capacity than is needed ordinarily. So redundan­cy equals insurance, and the apparent inefficiencies are associated with the costs of maintain­ing these spare parts and the energy needed to keep them around in spite of their idleness.

The exact opposite of redundancy is naive optimisation. The reason I tell people to avoid attending an (orthodox) economics class and argue that economics will fail us is the following: economics is largely based on notions of naive optimisation, mathematised (poorly) by Paul Samuelson - and these mathematics have contributed massively to the construction of an error-prone society. An economist would find it inefficient to carry two lungs and two kidneys - consider the costs involved in transporting these heavy items across the savannah. Such optimisation would, eventually, kill you, after the first accident, the first "outlier". Also, consider that if we gave Mother Nature to economists, it would dispense with individual kidneys - since we do not need them all the time, it would be more "efficient" if we sold ours and used a central kidney on a time-share basis. You could also lend your eyes at night, since you do not need them to dream.

Almost every major idea in conventional economics fails under the modification of some assumption, or what is called "perturbation", where you change one parameter or take a parameter henceforth assumed to be fixed and stable by the theory, and make it random. Take the notion of comparative advantage, supposedly discovered by David Ricardo, and which has oiled the wheels of globalisation. The idea is that countries should focus on "what they do best". So one country should specialise in wine, another in clothes, even though one of them might be better at both. But consider what would happen to the country if the price of wine fluctuated. A simple perturbation around this assumption leads one to reach the opposite conclusion to Ricardo. Mother Nature does not like overspecialisation, as it limits evolution and weakens the animals.

This explains why I found the current ideas on globalisation (such as those promoted by the journalist Thomas Friedman) too naive, and too dangerous for society - unless one takes into account the side effects. Globalisation might give the appearance of efficiency, but the operating leverage and the degrees of interaction between parts will cause small cracks in one spot to percolate through the entire system.

The debt taboo

The same idea applies to debt: it makes you very fragile under perturbations. We currently learn in business schools to engage in borrowing, against all historical traditions (all Mediterranean cultures developed over time a dogma against debt). "Felix qui nihil debet", goes the Roman proverb: "Happy is he who owes nothing." Grandmothers who survived the Great Depression would have advised doing the exact opposite of getting into debt: have several years of income in cash before any personal risk-taking. Had the banks done the same, and kept high cash reserves while taking more aggressive risks with a smaller portion of their port­folios, there would have been no crisis.

Documents dating back to the Babylonians show the ills of debt, and Near Eastern religions banned it. This tells me that one of the purposes of religious traditions has been to enforce prohibitions to protect people against their own epistemic arrogance. Why? Debt implies a strong statement about the future, and a high degree of reliance on forecasts. If you borrow $100 and invest in a project, you still owe $100 even if you fail in the project (but you do a lot better in case you succeed). So debt is dangerous if you are overconfident about the future and are Black Swan-blind - which we all tend to be. And forecasting is harmful since people (especially governments) borrow in response to a forecast (or use the forecast as a cognitive excuse to borrow). My "Scandal of Prediction" (bogus predictions that seem to be there to satisfy psychological needs) is compounded by the "Scandal of Debt": borrowing makes you more vulnerable to forecast error.

Just as Mother Nature likes redundancies, so she abhors anything that is too big. The largest land animal is the elephant, and there is a reason for that. If I went on a rampage and shot an elephant, I might be put in jail and get yelled at by my mother, but I would hardly disturb the ecology of Mother Nature. On the other hand, my point about banks in my book - that if you shot a large bank, I would "shiver at the consequences" and that "if one falls, they all fall" - was subsequently illustrated by events: one bank failure, Lehman Brothers, in September 2008, brought down the entire edifice.

The crisis of 2008 provides an illustration of the need for robustness. Over the past 2,500 years of recorded ideas, only fools and Platonists have believed in engineered utopias. We shouldn't think that we can correct mistakes and eliminate randomness from social and economic life. The challenge, rather, is to ensure that human mistakes and miscalculations remain confined, and to avoid them spreading through the system - just the way Mother Nature does it. Reducing randomness increases exposure to Black Swans.

My dream is to have a true "epistemocracy"; that is, a society robust against expert errors, forecasting errors and hubris, one that can be resistant to the incompetence of politicians, regulators, economists, central bankers, bank­ers, policy wonks and epidemiologists.Here are ten principles for a Black Swan-robust society.

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

No socialisation of losses and privatisation of gains: Whatever may need to be bailed out should be nationalised; whatever does not need a bailout should be free, small and risk-bearing. We got ourselves into 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.

People who drove a school bus blindfolded (and crashed it) should never be given a new bus: The economics establishment lost its legitimacy with the failure of the system in 2008. Find the smart people whose hands are clean to get us out of this mess.

Don't 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" from these savings while claiming to be "conservative". Bonuses don't accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives.

Time to definancialise

Compensate complexity with simplicity: Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. Complex systems survive thanks to slack and redundancy, not debt and optimisation.

Do not give children sticks of dynamite, even if they come with a warning label: Complex financial products need to be banned because nobody understands them, and few are rational enough to know it. We need to protect citizens from themselves, from bankers selling them "hedging" products, and from gullible regulators who listen to economic theorists.

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. We just need to be able to shrug off rumours, to be robust to them. Do not give an addict more drugs if he has withdrawal pains: Using leverage to cure the problems of too much leverage is not homoeopathy, it's denial. The debt crisis is not a temporary problem, it's a structural one. We need rehab.

Citizens should not depend on financial assets as a repository of value and rely on fallible "expert" advice for their retirement: Economic life should be definancialised. We should learn not to use markets as warehouses of value.

Make an omelette with the broken eggs: The crisis of 2008 was not a problem to fix with makeshift repairs. We will have to remake the system before it does so itself. Let us move voluntarily into a robust economy by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, 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 firms and no leverage - a world in which entrepreneurs, not bankers, take the risks, and in which companies are born and die every day without making the news.

Extracted from the postscript to "The Black Swan: the Impact of the Highly Improbable" by Nassim Nicholas Taleb (Penguin, £9.99)
© Nassim Nicholas Taleb 2008 penguin.co.uk

This article first appeared in the 05 July 2010 issue of the New Statesman, The cult of the generals

Picture: SÉBASTIEN THIBAULT
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Jeremy Corbyn, Emmanuel Macron and the age of volatility

The rise of populism in Britain and France is the result of a restless “crowd electorate”. Both countries' future stability depends on their changing relationship with the EU.

Britain seems to have joined the rest of the democratic world in the volatility of its politics. Electorates are no longer armies, but crowds. Identities shaped by religion, class, region, ideology and tradition weaken. Conventional parties are hollowed out, and disoriented and angry voters turn to single-issue campaigns or insurgent populism. In every country this takes diverse forms shaped by political institutions and political cultures – Donald Trump and Bernie Sanders in America, Marine Le Pen and Emmanuel Macron in France, Beppe Grillo and the Five Star Movement in Italy, Nigel Farage’s Ukip and now Jeremy Corbyn’s Labour Party.

The trend, noticeable from the 1990s, was analysed in a now classic work by Peter Mair, Ruling the Void: the Hollowing of Western Democracy, which was published in 2013, two years after the author’s death. Elected governments had conceded powers to non-elected agencies such as the IMF, the World Bank, the World Trade Organisation (WTO), and above all the EU. Politicians had become professionals, largely detached from civil society and operating increasingly within these international institutions, “safe from the demands of voters”. Citizens were decreasingly willing to join professionalised political parties financed by large donors or public funds, or to identify strongly with them.

Membership fell across Europe and beyond, and among the sharpest falls were those in France and Britain, where levels of political participation had previously been high. Electoral turnout fell too.

As Mair saw it, “hand in hand with indifference goes inconsistency”, as low levels of participation were paralleled by rising levels of volatility. People who did vote for mainstream parties often changed allegiances at random, and made up their minds at the last minute in response to short-term factors. Others flooded into new movements, or even old ones that reinvented themselves as enemies of the system.

The political effects of the 2007-08 banking crisis are still being felt everywhere and subsequent policy failures have aggravated the discrediting of elites. Naturally, the most volatile element has been the young. Youthful radicalism is hardly new. In my youth, inspiration came from Mao, Che Guevara and even the Khmer Rouge. Now it comes from elderly white males such as Bernie Sanders, Jeremy Corbyn and Jean-Luc Mélenchon, who seem able to present old remedies as new revelations to those inevitably lacking political memory. Historians are perhaps tempted to seek precedents. My own choice is the 18th-century radical John Wilkes. His brilliantly provocative tactics made fools of successive governments and appealed to a largely London-based electorate.

Wilkes’s secret – apart from barefaced cheek – was that he was not seeking office. It has been liberating for Sanders, Corbyn and Mélenchon that they were not expected, and did not expect, to win, and hence were free to run election campaigns that were not programmes of government but protest movements aimed at generating maximum support and momentum. Brexit seems to have further liberated the British left. Only the hardest of Brexits would give free rein to a radical programme of nationalisation and support to industry, which would contravene EU legislation on equal competition and restrictions on state aids.

This kind of populism is a new phenomenon in modern British politics, because never has a major party entered a campaign with such an absolute conviction that it would lose. And never has the Labour Party been so dominated by the ideas and campaigning style of the hard Left: the ubiquitous rent-a-crowd, the conspiracy theories, the violence of language (especially online), the ruthless and immediate politicisation of national tragedies. This old recipe has been given unprecedented dynamism by social media. It is populism in its purest form: a movement purporting to represent “the many” against a corrupt and remote system.

Populism is unlikely to come to power in normal circumstances because of its evident risks. However, volatility is now “normal” and accidents happen.

The two most successful populists are Donald Trump and Emmanuel Macron. Both won only with the help of a chapter of accidents. The divisions in the Democratic Party, the peculiarities of the American voting system and the accusations directed at Hilary Clinton’s email system were crucial for Trump. The collapse of François Hollande’s Socialist presidency and the meltdown of the Parti Socialiste following Mélenchon’s populist challenge from the left, along with the “Penelopegate” scandal enveloping the conservative presidential favourite, François Fillon, have delivered both the presidency and a huge parliamentary majority to Macron. What might have resulted in Britain had the Grenfell Tower tragedy happened a few days before the poll?

***

Macron’s extraordinary victory in France, which some hail as a defeat of populism, is its most brilliant success. Macron came from outside politics, set up a new movement, and pledged to “renew” and “moralise” politics by recruiting half his party candidates from civil society and half from women, and excluding all with criminal records. His La République En Marche! has crushed the other parties. Unlike Trump, he has moved smoothly into power as if born to it.

The Fifth Republic is a “republican monarchy” and Macron seems to be pushing the system as far as it will go. His inauguration ceremonies equalled or exceeded the regal style of his loftiest predecessors, Charles de Gaulle, Valéry Giscard d’Estaing and François Mitterrand. He has been dubbed “Jupiter in the Elysée”, above the public fray, refusing to speak to journalists except in circumstances of his own choosing, and tightly muzzling his aides and ministers. Macron has ensconced himself in his palace with a tiny number of trusted young advisers – perhaps, as with Trump, a direct consequence of a populism that rejects established political elites. He has also begun an intensive centralisation and politicisation of the civil service, assuming the power to decide the reappointment or replacement of several hundred top officials.

However, Jupiter has an Achilles heel. The solidity of his support in the country is uncertain, and hence much depends on his cunning and charisma. This may seem paradoxical for the leader of a populist movement, but perhaps it is a fundamental feature of a politics that bypasses intermediaries and relies on the volatile support of the crowd-electorate: Trump, Macron, Corbyn, Farage, Mélenchon, Grillo – all one-man bands.


Emmanuel Macron’s success represents a populist eruption from the centre. Photo: Getty

In France’s recent legislative elections only 43 per cent of the electorate voted –probably the lowest turnout in a national election in its democratic history – due to uncertainty or suspicion. One survey puts the level of Macron’s positive support at only 11 per cent. His left-wing opponents have announced their intention of shifting the contest from the ballot box to the street, and Mélenchon has called for a “civic general strike”. Macron’s slick middle-class populism might have to confront the tough populism of the old left. I wouldn’t care to bet on the outcome.

How French and British politics develop in this time of volatility depends on the countries’ changing relationship with the European Union. France has chronic youth unemployment and its economic performance has long been sluggish. Some of its wounds are self-inflicted, but underlying them is the problem of the eurozone and the disparity of economic behaviour between France (and southern Europe) and Germany.

As long as the eurozone is managed as at present, this problem is insoluble. Germany is permanently in surplus and presses austerity on the laggards. France, while a less extreme case than Italy, needs Germany to agree to expand state borrowing by setting up eurobonds backed by the EU (that is, by Germany) and with an EU finance minister to control national budgets – hence, removing another core function of democratic governments. France’s future rests on Macron’s success. If his bold attempt to change France and the EU fails, it is hard to see where the country can go next.

Brexit may prove an easier prospect than that facing Macron, but its successful management – not least because of its centrality in the national debate – is equally crucial to our political stability. A crisis here could mean the wreckage of the Conservative Party, Jeremy Corbyn in Downing Street, turmoil in Northern Ireland and the breakaway of Scotland. Readers may regard some or all of these outcomes with favour.

***

Theresa May’s failure to secure a majority has revived doubts about how resolved the British really are. Labour’s side-stepping of the issue – accepting Brexit but not the Prime Minister’s version of it – was electorally clever but adds to the uncertainty. Adopting David Cameron’s approach to negotiation, Corbyn declares that “there is no such thing as ‘no deal’”. This inevitably encourages those in the EU who wish Brexit to be damaging enough to deter others: there have already been provocative statements from Jean-Claude Juncker and Guy Verhofstadt. Macron recently declared that “the door is always open” to Britain dropping Brexit; reversing national electoral choices is something the EU has past form on.

Quasi-Remainers of all parties are trying to strip the issue of everything except “jobs and the economy”, blithely denying the importance of democratic legitimacy, national sovereignty, immigration, strategic security and the future of the EU itself. Imagine the divisive effects on British politics and British society if a future government were forced to apologise for the referendum and asked to be readmitted to the EU: bitter recrimination, national humiliation, evaporation of international influence – all far beyond anything we are experiencing today

It would deliver a death blow to any attempt to reassert democratic choice over bureaucratic and financial power within Europe, and would mark the effective eclipse of national sovereignty for the foreseeable future. Nor would it make sense in the long run: the eurozone, if it is to survive, must create greater central control, which hardly anyone in Britain accepts; so we would in any case find ourselves on the outside.

The effort to restrict debate to “jobs and the economy” is based on reiteration of the dogma that Brexit threatens economic disaster. This revives the narrative created during the referendum campaign, whose most influential element was the official report produced by George Osborne’s Treasury. The IMF and the Organisation for Economic Co-operation and Development naturally followed Whitehall’s lead: that is how such bodies operate. The Treasury predicted that a “no deal” Brexit would cost around 7.5 per cent of GDP by 2030, an average loss of £6,600 per family. Even some Remainers were alarmed at what seemed a politicisation of the civil service. The former governor of the Bank of England Mervyn King has since described the report as “not an objective presentation of the facts”.

Nevertheless, the report had a huge impact on the referendum (most Remain voters said they were motivated mainly by economic fears) and its pessimism continues to overshadow the Brexit negotiations and provide grist to the mill of anti-Brexit groups in the UK and beyond: “we didn’t vote to become poorer”.

Significantly, the Treasury refuses to discuss with academics how it arrived at its forecast. However, a group of economists based in Cambridge, led by Graham Gudgin and Ken Coutts, has for the first time applied the standard scientific method of verification by trying to reproduce the Treasury’s results using the same economic models. Their findings, now accessible through Policy Exchange (“A Critique of Estimates of the Economic Impact of Brexit”), are startling.

Astonishingly (or perhaps not) the Treasury did not produce an estimate of the effects on UK trade of leaving the EU. Instead, it worked out the average importance of EU trade for all 28 member states, including the new eastern European states that do most of their trade within the EU. It also adopted a long time-scale, rather than focusing on the years since the creation of the euro – which have seen a slowing of intra-EU trade generally, and for the UK particularly.

This approach greatly magnifies the importance of EU trade for Britain, which is less than for any other EU country, and which has been declining in importance for years. Finally, the Treasury made the extraordinary assumption that if Britain did less trade with the EU, it would not be able to compensate significantly by embarking on more trade outside the EU – even though its non-EU trade has been growing and shows a favourable balance. In consequence of these methods, the Treasury prediction of the results of a “hard Brexit” was a considerable exaggeration.

Using the same methods as the Treasury, but applying data relating specifically to the UK rather than to the EU as a whole, the Cambridge researchers reach a very different conclusion. Even if it proved impossible to reach a free trade agreement and the UK reverted to trading under WTO rules (“falling off a cliff”, as some express it) there would be “only a minor loss” in overall GDP by 2030, as tariffs in 90 per cent of products have already been more than compensated for by the fall in a previously over-valued sterling. As for per capita GDP – that is, average living standards – they predict that this could actually rise if the rate of immigration were reduced.

So no deal is clearly better than a bad deal, including the “soft Brexit” advocated by Corbyn and others: to leave the single market but stay in the customs union. This would mean being unable to trade freely either inside or outside the EU or to influence EU policies from within.

In short, we have no reason to be frightened by the Brexit negotiations. Being inside or outside the EU has made no difference to our economic fortunes: our national wealth has increased at exactly the same rate as that of the US for the period since 1945. We are not facing economic disaster. It is not the case, as Nick Clegg recently asserted, that we face a choice between “painful concessions” and “economic disruption”.

Moreover, Britain is a major power independently of its ties with the EU. The international relations specialist and New Statesman contributing writer Brendan Simms estimates that it is the third power in the world after the US and China because of its wealth, size, “soft power”, military potency, and its relative internal cohesion and long-term political stability. A good relationship with Britain is important for the security, stability and prosperity of the whole European continent. Unless we play our hand extraordinarily badly in these negotiations, the outcome should reduce the potential of that volatile populism of which we are presently feeling the shock: volatility, after all, is a two-way process.

Peter Mair feared the democratic world was losing control of its political institutions, and thought it “not at all clear how that control might be regained”. Brexit should, as many of us hope, provide the beginning of an answer.

Robert Tombs is the author of “The English and their History” (Penguin) 

This article first appeared in the 05 July 2010 issue of the New Statesman, The cult of the generals