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

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A multitude of rivals

Unless Donald Trump is able to master geopolitical complexity, the trouble in the Middle East will get far worse.

Well, who’d have thought it? Another popular insurgency in the series that started in Tunis in late 2010. The gift that keeps on giving. Only this time it has hit the United States, to the bemusement of those who like their liberal internationalism neat and any populist revolutions a long way from home. The same people who misread the Arab uprisings of 2011 and continue to believe magically that movements based on the word of God will embrace tolerance and inclusivity seem shocked that some Americans have decided to have an uprising of their own.

None of this will be lost on the leaders or people of the Middle East. My guess is they will be a lot less shocked than commentators in the US and Europe are. After all, the blurring of business and politics, the instrumentalisation of identity, ambiguity about where the public good ends and personal advantage begins and an often casual attitude to facts are characteristic of the politics of the region. More fundamentally, relations between states in the Middle East and North Africa are transactional; most significant trade flows are in commodities; and conflict within and between states is endemic. The region politically looks far more like the Hobbesian world of early-modern Europe than it does the Kantian dream of the European Union. Donald Trump talks like a mercantilist: Barack Obama talks like a Rawlsian idealist. Most Arab, Israeli or Iranian leaders are more comfortable with the former than the latter.

Indeed, Obama’s own eloquence has counted against him. His Cairo speech of 2009 in retrospect looks like a cruel illusion, one of Auden’s clever hopes more than the proclamation of a new ethical order, as many wanted to think at the time. It was unbacked by practical policies or even sustained attention. The moral reset never happened. What followed instead was disorder: the public disavowal of the Egyptian president Hosni Mubarak in 2011, an apparent assumption that the politics of Islamist revelation were consistent with ­liberal pluralism and – when the error was realised – grudging acquiescence in the counter-revolution and increasing exasperation with the result.

The Iran nuclear deal may or may not prove to be as great an achievement as its supporters claim. However, the self-congratulatory attempt to sell it to the Gulf states with an odd mixture of scolding and exhortation merely alienated them. It wasn’t that they didn’t understand the weight of Iran and the desirability of a negotiated settlement: they did and do. They simply didn’t want to be treated like the most disruptive students at the back of an International Relations
101 remedial class.

So the standard by which they – and Sisi’s Egypt, Erdogan’s Turkey, Khamenei’s Iran and everyone else in the Middle East – will judge the incoming administration is not the one that socially liberal and politically idealistic Americans and Europeans will use. They won’t worry so much about free trade: oil and gas will find their own markets. They’re OK with going bilateral: multilateralism only gives them headaches, which was why the Iranians liked dealing principally with the US over their nuclear programme, why Cairo is flirting with Moscow and why the choice between Algiers and Rabat is always going to be binary. They’re good at negotiating deals. If that’s how the new guys in Washington want to proceed, that’s fine by them.

The energy producers will like a renewed emphasis on industry: the Rust Belt isn’t coming back but it doesn’t hurt to pretend that it might. They will still worry about the resilience of fracking but that was going to be the case anyway. If new areas for energy production are opened up in Alaska, the Gulf of Mexico and elsewhere, then that adds to the downward pressure on prices. However, it will take a while to start producing significant quantities of oil and gas from the new fields. And at least it reflects an enthusiasm for hydrocarbons rather than waves, wind or water.

The real areas of uncertainty are elsewhere. All the states of the region want their concerns to be taken more seriously than anyone else’s. That will entail having opinions on the conflicts between them – and sometimes taking sides. That may be more straightforward with Israel than has been the case under Obama. Trump on the campaign trail suggested he will tilt much more towards Israel than Obama has done, not just on issues such as settlements and the status of Jerusalem but on hardcore security solutions to the challenges of Palestinian nationalism, Islamist extremism and the more generalised threat from Iran and its proxies.

Saudi Arabia, meanwhile, will be closely watching what position the new administration takes on the recently passed Justice Against Sponsors of Terrorism Act, which will allow families and victims of the 9/11 attacks to pursue a civil lawsuit against Riyadh. The kingdom will also monitor how belligerent campaign statements about Islamic State and its ideological cousins might play out in power, and how compliant the US approach will continue to be on the Iran nuclear agreement. A unilateral abandonment of US commitments is unlikely: the deal is a Security Council matter, many other states have equity, and they are only too eager to do business, as we have seen for some time with China and now more recent activity by France’s Total and German and British business delegations to Tehran.

It is also not clear that being justifiably suspicious of Iran automatically makes you a friend of Riyadh. Trump has done business with the kingdom in the past but has also criticised Saudi over-reliance on the US for its defence. And hardliners in Tehran would probably be undisturbed if Washington walked away. A resumption of enrichment would hardly look like a victory for the new US administration, especially if European energy firms were the wider beneficiaries.

Trump has displayed a startlingly nativist and isolationist side during the presidential campaign. The test of this will include Iraq, where the US has a highly effective strategy at the moment that involves significant political and military commitments; Syria, where it does not; and Yemen, where it had one but mislaid it. And even in Iraq, the real test will be sustaining an effective political strategy after the fall of Mosul. This will happen on Trump’s watch, not Obama’s.

In the end, the Trump administration will come up against a fundamental and enduring feature of Middle Eastern politics: everything is connected. In business, if one golf-course project is a bust, you can always find another that isn’t. In the international diplomacy of the Middle East, that won’t work. It may be unfair, but US presidents are supposed to do something when 400,000 people die in a civil war somewhere and Iranian-backed militias colonise zombified states. If you recognise Jerusalem as the undivided capital of Israel, you alienate not just Palestinians, but most other Arabs and Muslims and many Europeans. But you need them if you want a proper contain, distrust and verify policy on Iran. You also give movements such as al-Qaeda, Islamic State and Hezbollah – one of the biggest criminal enterprises on the planet – a perfect alibi. If you think the answer on Syria is to let Bashar al-Assad reassert control with the help of the Russians and the Iranians, you need to be able to persuade those Arabs and Turks who back the largely Sunni opposition to stop doing so. You can’t do that if they think you don’t respect them or their interests. And you might want to ask yourself if making nice with Putin over Aleppo could lead him to think you wouldn’t mind if he helped himself to Tallinn, Riga and Vilnius while he was at it.

Full disclosure: I’m a signed-up member of the international relations blob. So I would say this, wouldn’t I? But here goes anyway. The trick is managing political complexity. That isn’t something for which the president-elect is famous, and wasn’t a notable feature of the campaign debates. It may be that his choices of secretary of state, national security adviser, CIA director, and indeed energy and treasury secretaries, will reflect an understanding of the importance in a complicated and uncertain world of competent, experienced figures, and of the central role of the US president in supporting the liberal international order created after the Second World War that underpinned the US rise to dominance. I hope so. If this order collapses it won’t be just because US voters elected Donald Trump. It will be because of demographic, economic and sociological shifts across the globe.

As far as the Middle East and North Africa go, the dilemma is not so much Thucydidean (rising powers challenging established rivals) as Machiavellian: a multitude of rivals with shifting allegiances challenging each other for primacy. We have lacked a common understanding and collective purpose for at least a decade. Determined and smart US political engagement across the region is essential to rebuilding both. Without that we won’t see a new and stable order created by the regional states: we will see more entropy. US partners in the region will feel both abandoned and licensed. US enemies will feel liberated. In both cases, the costs of hedging with other external powers – Turkey, Russia, China, India – will decrease dramatically. Good luck with the aftermath of all that. However bad the region may look today, “the worst is not. So long as we can say: ‘This is the worst.’”

John Jenkins is a former British ambassador to Saudi Arabia, Libya, Iraq, Syria and Burma. He also served as a senior diplomat in Jerusalem, Abu Dhabi, Kuwait and Malaysia, and as director for the Middle East and North Africa at the Foreign Office in London. He is now the executive director (Middle East) of the International Institute for Strategic Studies, and is based in Bahrain

This article first appeared in the 17 November 2016 issue of the New Statesman, Trump world