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

Photo: STEFAN BONESS/PANOS
Show Hide image

What Britain needs to understand about the profound and ancient divisions in Germany

As Angela Merkel campaigns for re-election, the balance of power in Europe is changing.

On 24 September, Angela Merkel will be re-elected chancellor of Germany and that, we might think, will be that. With Merkel and France’s Emmanuel Macron in control of the European project, populism will surely be vanquished and the old Franco-German core of the EU restored. Yet things are changing, and if western Europe wants Germany to keep singing “Ode to Joy” as enthusiastically as “Deutschlandlied”, it will have some work to do. Our Brexit negotiators need to see how important this is to Macron, to other European leaders and, above all, to thinking Germans.

For we may all soon miss the old, self-effacing Germany. Despite having such economic power, it always seemed to have no greater wish than to exist as part of a larger whole. Konrad Adenauer, its first postwar chancellor and founding father, made Westbindung (“binding to the West”) the heart of West German politics. Adenauer came from the deeply Catholic Rhineland, “amid the vineyards” as he put it, “where Germany’s windows are open to the West”. His instinctive cultural sympathy was with France, but he knew that West Germany’s existence depended on keeping America in Europe. France he courted out of profound conviction, the US out of clear-eyed necessity, and he was worried that after him this twin course might be abandoned. His demands for reassurance during his final year in office led to John F Kennedy’s “Ich bin ein Berliner” speech of 1963. Every West German knew about that, and about the Berlin Airlift: these became locations of national memory from which West Germany triangulated its sense of self.

There were some Germans for whom this was too much. Anti-Americanism was ingrained among West Germany’s hard left, the early Green Party and the tiny hard right. But even Germans who were suspicious of America had no fear of tying themselves closer to Europe. On the contrary, that was exactly what they wanted. The standard explanation of this is guilt. West Germans, in this argument, felt so remorseful about the horrors of the Second World War that they wanted to make amends. This idea fitted with others’ belief that Germany did indeed have much to feel guilty about.

A nuanced version of this held that the western Germans thought they had somehow “got away with it”, compared with their brethren in the east, who had felt the weight of Soviet vengeance: rape, pillage, occupation. Accordingly, Germany’s willingness to subsume itself so thoroughly, even as it footed the bills for the European Economic Community and later the European Union, was accepted with little gratitude, almost as an ongoing war debt repayment.

This guilt thesis is based on a misunderstanding of German history, especially of the experience of western Germans. The most graphic illustration of this comes from Adenauer. In 1955, he privately informed the British that while he was obliged to act in public as though he wished for reunification, he intended to devote his remaining years to blocking it. In 1961, he secretly proposed to the Americans that they offer the Russians a swap: they and he should, he said, give up West Berlin in return for Thuringia (the region containing Leipzig and Weimar). He wanted, in effect, to make the River Elbe the eastern border of Germany.

Why did Adenauer dislike the eastern Germans, think Berlin was expendable and consider the River Elbe to be the natural frontier? Simple: he knew that the Elbe was Germany’s Mason-Dixon line. Beyond it lay the flat, grim Prussian heartlands, which until 1945 stretched into present-day Russia. This vast region was known to Germans as “Ostelbien” – East Elbia. Adenauer viewed the “unification” of Germany in 1871 as East Elbia’s annexation of the west. That’s why in 1919, as mayor of Cologne, and again in 1923, he tried to get Britain and France to back a breakaway western German state. Having failed, he is said to have muttered, “Here we go, Asia again,” and closed the blinds every time his train crossed east over the Elbe.

Prussia was a different country. The victorious Allies agreed. On 25 February 1947, they declared: “The Prussian state, which from early days has been a bearer of militarism and reaction in Germany… together with its central government and all its agencies are abolished.” The name Prussia was eradicated. The Prussian hegemony of 1871-1945, an anomaly in the two millennia of German history, was over.

If we understand this, we understand what West Germany really was and why it acted as it did; why the “reunification” of 1990 – or, at least, the way it was handled – was such a mistake; why we may all have to stop taking Germany quite so much for granted now that East Elbia is back; and why our Brexit negotiators are on a hiding to nothing if they believe that the Germans have no more urgent business to consider than their car exports to us. Far more important to liberal Germans is keeping safe the western soul of Germany.

***

West Germany was anything but an artificial construct. It was the historical Germany, being almost geographically identical to what was, for almost 1,200 years, the only Germany. Julius Caesar named the land, together with its people, in 58 BC; 49 years later, Drusus, the greatest commander of the infant Roman empire, is said to have been supernaturally advised that after defeating every tribe he met in Germania, he should halt at the River Elbe. By 100 AD, Roman rule was shown by a fortified border, the Limes Germanicus. You can still walk large stretches of it; it encompasses most of the richest land in modern Germany and all of the great cities except Hamburg, Berlin and the 19th-century industrial monocultures of the Ruhr. Even these last were born as trading posts or forward bases within what archaeologists call the “market region” of Germania – the lands beyond the limes where commerce with the Roman empire defined the whole culture. Southern and western Germany’s cultural roots are almost as Roman as France’s.

But what about 9 AD and the destruction of three Roman legions by the German tribes under Arminius? There is a popular myth that this kept all Germany free and different. We owe this idea to Martin Luther and his supporters: Luther claimed from 1520 onwards to be a German, anti-Roman hero and identified himself with the newly rediscovered tale of Arminius. More decisively, the events of 9 AD were an obsession of later Prussian historians, who had an interest in claiming that the real Germany was one that was pure and un-Romanised. Yet the reverse is true. Under the Romans, then the Merovingians, then the Franks, the Rhine/Danube super-region of Germany remained politically and culturally a part of western Europe. After Charlemagne, a Rhineland German, “restored the Roman empire” (as his seals put it) in 800 AD, western Germany was the very centre of things. It was never a nation state, but always the key part of a greater whole, the Holy Roman empire.

Along the Elbe, things were different. Charlemagne extracted tribute from the pagan Slavs across the river, and his successors tried to build on this, but the German conquest and settlement of East Elbia only really began with the Wendish Crusade of 1147, the northern arm of the Second Crusade. Three centuries later, the entire region was still hotly disputed by Balts and Slavs, with German supremacy threatened by major defeats at Tannenberg (1410) and in the Hussite Wars (1419-34).

Long-contested frontier lands breed a special kind of society. The German incomers cowed the natives, such as the pagan Pruscie from whom they ultimately borrowed their name, through brute force. Where they couldn’t, they had to make armed deals with local elites. In this new sort-of-Germany, the Junkers, an aggressive landowning caste, lorded it over the Slavs and Balts – as well as poorer Germans, who knew that the locals would cut their throats if the Junker castles fell, so were loyal and subservient to their masters. East Prussia remained like this within living memory.

In 1525, Prussia named itself and declared itself the first Protestant state. From then on, it had absolute rulers, the Hohenzollern dynasty, backed by a quiescent Lutheran state church. The Junkers swore loyalty in return for exclusive access to all officer-level jobs in the army and the administration. By the mid-18th century, Voltaire quipped that while other states had armies, the Prussian army had a state. The overriding strategic concern of Prussia was always with the east. In his 1758-59 campaigns, Frederick the Great was shocked to find the Russians extremely hard to beat. He bequeathed to his successors a policy of keeping the tsars onside. Partitioning Poland between them was the sticking plaster that masked this Russian-Prussian rivalry, right until 1941.

This thoroughly east-facing power was, by the normal standards of European statehood – history, social structures, religion, geography – a different country from the Rhineland, Swabia or Bavaria. It defeated them all in 1866, laying the ground for the “unification” of 1871. The Prussian empire (for that is what it was) could now enlist the wealth, industry and manpower of Germany in pursuit of its ancient goal: hegemony over north-eastern Europe. By 1887, the future imperial chancellor Bernhard von Bülow was already musing on how to destroy Russia “for a generation”, cleanse Prussia of its Poles, set up a puppet Ukrainian state and take the Prussian armies to the banks of the Volga. This is the bloody Prussian – not German – thread that leads directly to the Nazi onslaught of 1941. In 1945, that centuries-long struggle was settled, in almost inconceivable violence. Half of East Elbia was ruthlessly stripped of Germans and handed over to Poles or Russians; the rump became the German Democratic Republic (GDR), a mere satrap of the Red Army.

So while it is easy and comfortable to say that the otherness of eastern Germany today is the result of that 40-year Soviet occupation, history says otherwise. East Elbia has always been different. Take the voting patterns: from 1871 to 1933, East Elbia outside Berlin (always a left-liberal political island) was the main electoral reservoir for the authoritarian right. The Prussian Conservative Party under the empire, the Deutschnationale Volkspartei until 1928 and the Nazis from 1930 depended on rural and small-town East Elbian voters. It was they who (just) swung things in 1933, by going 50-60 per cent for the “Hitler coalition”. Had all Germany voted like the Rhineland or Bavaria, Hitler and his Junker allies would have got nowhere close to a majority. Small wonder that Adenauer didn’t want East Elbia back and was secretly delighted to have it safely fenced off behind the Iron Curtain.

***

West Germany (1949-90) – Germany shorn of Prussia – was, then, no historical fluke, and nor was the supra­national way it acted. This was the real Germany. But the hasty reunification of 1990 (there was no referendum or election on the issue) changed things. Why should the inhabitants of the former GDR, rather than Poles and Czechs, get immediate access to the wealth and benefits of the West? Because they were Germans. With that, the chancellor Helmut Kohl embraced the notion that being German overrode all considerations of social, economic or historical difference. He also subliminally revived the idea, common to the Second Empire and the Third Reich, that East Elbia was special and needed subsidising by the rich west of Germany. The director of the Bundesbank, Germany’s central bank, resigned in 1991 over this abandoning of economic sanity for political nationalism.

Since 1990, the former East Germany has received more than €2trn from the old West Germany, for a fast-ageing, shrinking and disproportionately male population of only 16 million, including Berlin. That’s the equivalent of a Greek bailout every year since 1990, and as a straight gift, not a loan. This represents a huge shift in financial priorities, overshadowing Germany’s annual net EU budget contribution (currently €15.5bn). In 1990, Kohl promised that western German aid would soon turn the new states into “blooming” areas, but they have become, instead, proof that age-old differences resist even the most gigantic subsidies.

Between 30 and 40 per cent of voters in East Elbia have declared over the past two years that at the general election, they intend to support either Alternative für Deutschland (Germany’s Ukip), Die Linke (heirs to the old East German Communist Party) or the all but openly neo-Nazi National Democratic Party (the NPD, currently represented in the Mecklenburg-Vorpommern state parliament). Though theoretical enemies, these three parties are united by cultural affinities: all despise economic liberalism, oppose Nato and the EU and want closer relations with Russia.

East Elbia no longer has the population to swing the entire German electorate of more than 61 million but many liberal western Germans are nervous. They recoil at the sight of anti-asylum-seeker attacks, which are proportionally far more common in East Elbia than in the west, or when they see Merkel heckled by right-wingers. They call East Elbia Dunkeldeutschland (“Dark Germany”) and joke bitterly that if Britain can have a Brexit, why can’t the old East Germans, whom they lump together under the name of Saxons, have a “Säxit”? But it’s no laughing matter. They know there are those only too aware of any anti-western drift in Germany and eager to give succour to it.

Alexander Saldostanov, the rabid leader of Russia’s “Night Wolves” bikers and a public friend of Vladimir Putin, recently told Germany’s bestselling daily, Bild, that he dreams of a grand union between Germany and Russia: “We have so much in common. You simply have to free yourself at last from America, that scourge of humanity. Together, we can, should and must take power.”

There’s no danger of that, but there is a sense in which eastern Europe is, to Germans, no longer “the other”. It’s the place whence natural gas flows from Russia, where labour is cheap but skilled and where the people are keen to work with Germany on setting up new sites of joint national memory. From Kaliningrad to Prague, museums and projects are springing up in which the horrors of the past are neither denied nor used as ammunition in today’s negotiations. In eastern Europe, perhaps because Russia is so close, the Germans are rarely made to feel guilty for their grandfathers’ sins. Meanwhile in the west, from Greece to Britain, people can’t resist mentioning the war whenever the Germans don’t act as desired.

***

Germany’s resources are not infinite. Nor is the patience of the 40 per cent of Germans who “have net worths of essentially zero”, as Die Welt reported last year – largely because German home ownership rates are the lowest in the EU. They are disproportionately concentrated in the old east, the region that never had supranational, western European connections. From them come ever-louder voices saying that Germany’s EU contribution is too high. And with Britain out, the maths will look even worse to such voters. If south-western Germany’s taxes have to keep bailing out the country’s east, while also helping out the old and new EU lands, what is left for, say, the post-industrial Ruhr, which has financial and social problems of its own? There are tough choices ahead, and it’s not hard to imagine a day when Germany decides to aim its subsidies and investments where they seem most welcome. The old idea of Mitteleuropa – a multi-ethnic, German-centred Middle Europe, neither of the West nor of the East – no longer seems so antiquarian. Nothing would gladden Putin’s heart more.

So, yes, Merkel will win the election and will have a chance to revive the EU’s Franco-­German core. Yet the relative strengths of France and Germany are different now. As for their leaders, while Adenauer was a devoted Catholic Rhinelander, Merkel is a Lutheran vicar’s daughter from the east. Bonn was physically close to Paris, Brussels, The Hague, even London; Berlin is closer to Prague and Warsaw.

With Donald Trump’s wavering on Nato and his noisy anti-German protectionism, along with Brexit, the West may no longer seem vital to Germany’s future. During Merkel’s election debate with her main challenger, Martin Schulz, on 3 September, Brexit was not even mentioned. The old EU core will have to work to keep Germany anchored, resisting any new call from the east. Macron and German liberals know that; that’s why there will be no Franco-German split over Brexit just to sell us a few more Audis. The sooner David Davis and Liam Fox realise that the Germans have far bigger issues to deal with, the better.

James Hawes is the author of “The Shortest History of Germany” (Old Street Publishing)

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