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: Getty
Show Hide image

The political centre can still change the terms of Brexit – Labour's ambiguity can't last

If Labour continues to favour leaving the single market, then we are essentially for the same policy as the government.

This was on any basis an extraordinary election, unique in recent British experience and with major political consequence. The country is deeply divided: between young and old; metropolitan and outside the cities; better off and worse off.

And the country is suffering from the state of its politics. This time last year we were the fastest growing economy in the G7. We are now the slowest. The international investment community is negative on us. The savings rate is at its lowest in 50 years. Incomes are stagnating. The international reputation of Britain is rapidly losing altitude. There is a daily drip of worrying news on Brexit. The Grenfell Tower tragedy sums up for many the sorry condition of our social cohesion.

There is a slightly anarchic feel to our politics, intensified by the realisation that the government is weak and drifting. There is more followership than leadership.

We feel like a country which has lost its footing and is stumbling; but seemingly with no choice but to stagger on. This is where everything has changed and nothing has changed.

The election result should enable a fundamental re-appraisal of Brexit. Large numbers of people voted to stop a hard Brexit and rejected explicitly the mandate Theresa May was demanding. Instead, both main parties remain wedded to leaving the single market.

Now we argue over long transitional periods, and complicated methods of re-creating new regulatory mechanisms with Europe – which essentially mean we will have to keep close to European regulation – when all such things do is re-emphasise the inherent dangers of the whole venture.

I agree that if the will of the British people remains as it was last June, then Brexit will happen. But, to state what in a less surreal world would be blindingly obvious, it is possible, that, as we know more about what Brexit means, our "will" changes.

Our leaders should at least lead a proper debate about the options before us. They should become the nation’s educators, engaging us, explaining to us, laying out every alternative and what it means.

Rational consideration would sensibly include one option of negotiating for Britain to stay within a Europe itself prepared to reform and meet us half way.

Emmanuel Macron's victory in France changes the political dynamics of Europe. The members of the eurozone will integrate economic decision-making. Inevitably, therefore, Europe will comprise an inner and outer circle. Reform is now on Europe’s agenda. The European leaders, certainly from my discussions, are willing to consider changes to accommodate Britain, including around freedom of movement. Yet this option is excluded.

In the week before the election, my Institute along with Luntz Global Partners conducted a poll in France, Germany and the UK around attitudes to Europe, Brexit and politics.

The British people’s attitude to Europe is ambivalent. They do think "Brexit means Brexit" and for now there is no groundswell for a second referendum.

But, they want a strong relationship with Europe. A majority oppose hard Brexit. The opposition to free movement of people, once you break it down, is much more nuanced. The French and Germans share some of the British worries, notably around immigration, and would compromise on freedom of movement.

There is no evidence that Britain wants to pay a high economic price for Brexit. A majority would probably coalesce around a "soft Brexit".

However, the problem is that the difference between a hard and a soft Brexit has a very simple starting point: membership of the single market and customs union. If we stay within those rules of trade, where more than 50 per cent of our exports go, then the economic damage of Brexit will be limited. But, we will have to abide by the rules. 

The political difficulties of this are evident. It would lead in short order to a scratching of the British collective head and feeling of "well, in that case, what's the point of leaving?"

On the other hand, if we do leave the single market and customs union, then it is also clear that the economic damage is potentially large. No one who has seriously examined these issues believes that a third country free trade agreement (FTA) is remotely a substitute for membership of the single market. A "jobs first" Brexit outside the single market is a contradiction in terms.

So when people blithely say "we will get roughly the same terms as we do now with the single market", I literally know no one in the European system who believes this.

***

We have over-estimated, as ever, the weakness of Europe. Growth rates are recovering. Politics is stabilising. Yes many clouds remain – from Italian and Spanish banks to popular anger at cuts, low pay and immigration concerns. Europe is not out of the woods. But it thinks it sees a path out of those woods and our poll shows that French and Germans see Europe as a guide not an obstacle.

The EU27 will basically stick together in defending the rules of the single market. But we are all learning, as we proceed, the damage Brexit will do. 

Europe knows it will be poorer and less powerful without us. We know our currency is down around 12 per cent; already jobs are going; there is not £350m a week more for the NHS; and we actually need most of the migrants who come to work in the UK. On any basis, leaving is complex and will take years.

Brexit is the biggest political decision since the Second World War. Given what is at stake, and what, daily, we are discovering about the costs of Brexit, how can it be right to deliberately take off the table the option of compromise between Britain and Europe so that Britain stays within a reformed Europe?

We are doing so because the Tories fear that if Brexit in some form does not happen, they will re-open the fissure within their party. For three decades this internal Conservative battle has wreaked havoc with the politics of the country, rather as empire tariff debates did in the late 19th and early 20th centuries.

Meanwhile, the true challenges of the country are unaddressed. The legislative programme is dominated by Brexit to the virtual exclusion of anything else. The Government may ask for "new ideas" from all sides of politics, but the reality is it has no bandwidth seriously to do anything other than Brexit.

It is not too late for the country to grip its own destiny, change the terms of the Brexit debate and turn its attention to the true challenges the nation faces.

This is where what happens to the Labour Party matters so much. The ambiguity of Labour’s position on Europe may have helped us access both Remain and Leave votes, though I am dubious.

However, it can't last. If Labour continues to be for leaving the single market, and the signs are that it will, then we are essentially for the same policy as the government.

This will become apparent to those who voted Remain. But more than that, it puts us in the same damaging position for the economy as the Tories; and in circumstances where we are also trying to end austerity through spending programmes which, to be clear, are larger than any Labour Party has ever proposed.   

I agree Labour had a remarkable result which I did not foresee. I pay tribute to Jeremy Corbyn’s temperament in the campaign, to the mobilisation of younger voters and enthusiasm this generated. His supporters shouldn't exaggerate it; but his critics including me shouldn't under-state it. He tapped into something real and powerful, as Bernie Sanders has in the US and left-wing groups have done all over Europe.

There is a genuine and widespread desire for change and for the politics of social justice. This should alter the context in which we debate politics; and help influence the policy solutions.

But it doesn't alter the judgement about the risks of an unchanged Corbyn programme, if he became prime minister and tried to implement it at the same time as Brexit.

If a right-wing populist punch in the form of Brexit was followed by a left-wing populist punch in the form of unreconstructed hard-left economics, Britain would hit the canvas, flat on our back and be out for a long count.

The conventional wisdom is that the centre ground in British politics is now marginalised. It is true that the country didn't vote for centrist politics on June 8; but neither was it on offer. The space for the centre may seem smaller; but the need for it is ever bigger.

Our poll shows that a majority in all three countries surveyed still identify most with the centre of politics; and that the policies people want are those which produce real change, but from basically a centrist position.

Both main UK parties now face a fundamental choice of direction. The Tories could go back to that of David Cameron, in the style of Scottish Conservative leader Ruth Davidson. Or they could stick with the politics of the last year, defined by Brexit and immigration.

Labour’s leadership could champion a position on Europe radically distinct from the Tories, and reach out to those in the parliamentary Labour Party with experience of government to craft a programme of credibility as well as change.

Or they could dismiss the need for compromise and double down in their efforts to make their takeover of the Labour Party complete. 

The Labour Party should be cautious in thinking "one more heave" will deliver victory next time. The Corbyn campaign was a positive factor in the election result; but the determining factor was the Tory campaign.  

In all the elections since 1979, the result at the end was more or less what I expected at the beginning. Not this time. There is no doubt in my mind that at the beginning of the campaign the public were indeed about to give the Tories a landslide. After all, we had just had a really poor local election result, a normally reliable predictor.

***

What happened is a perfect illustration of why the Greeks were right that hubris is always followed by nemesis. Their error was less in calling the election than in the conduct of it.

The winning strategy was the one they started with: Theresa May is a leader above party, asking for a strong negotiating hand to get the best Brexit deal. But instead of keeping to it, they shattered it. Brexit policy turned into hard Brexit or "no deal" Brexit, rather than the "best deal for Britain". The manifesto was not above party but absolutely of the Tory Party: austerity, typical tough Tory policy on social care and school meals, plus fox hunting.

The public recoiled. The 16m who voted Remain realised they had to vote to defeat the Brexit mandate she was seeking. Anyone who cared about the public realm, and wished for an end to or an amelioration of austerity, understood this was their only opportunity to register that wish. Not foreseeable; but on reflection completely explicable.

The Labour electoral performance was unexpected. But that is exactly why we have to be careful in interpreting it. Victories in Kensington and Canterbury were amazing. But losses in Middlesbrough and Stoke were equally alarming. 

The Corbyn enthusiasm, especially among the young, is real, but I would hesitate before saying that all those who voted Labour voted to make him prime minister; or that they supported the body of the programme rather than its tone.

I think they thought that the likelihood was that the Tories would be the government, but were determined to neuter the mandate. This is why you could have – another unique dimension to the election – candidates standing for Labour overtly distancing from Jeremy Corbyn and yet still being elected, some with big majorities.

The common refrain among some Labour MPs is that the policies were popular, and if we retain them and unite, we will win next time. We should beware our own form of hubris. The Tories are not going to run another campaign like that one.

Next time, Labour’s economic programme will come under vastly greater scrutiny. No one is going to believe that there is not a real possibility of Jeremy Corbyn as prime minister. The campaign mishaps which happened every time the spending figures were put under the spotlight won't pass so easily. 

Understandably, some Labour MPs who, only weeks ago, thought their best hope of salvation rested on disassociation from the leader, now feel disoriented. But policies which were wrong in May didn't suddenly become right in June.

Many in this election voted with profound reluctance. There were an unusual number of voters making up their mind very late. Ultimately, neither party won a majority.

It is true that politics has changed dramatically from ten years ago. Our poll shows people want change and by large numbers, in all three countries. Years of austerity and an acute sense of an elite separated from the rest has led to a belief that the promise of generational progress has ended. This generation believes it has done better than the last. But it does not believe the next generation will do better than them. That is the market of anxiety in which the populists peddle quack solutions. 

But the poll also shows that support for the centre stays strong. People will default to populism when a radical centre is not on offer; where it is, they will vote it in, as Macron has shown.

I am not advocating a new party. Quite apart from the desirability of such a thing, our political system puts formidable barriers in its path. In any event, as a member of the Labour Party of more than 40 years standing, I want Labour to capture this ground.

But there are millions of politically homeless in Britain. They are not going to wander the byways of politics, bedding down uncomfortably, forever, not with their country in the dire shape it is in.

The challenge for the centre is to be the place of changing the status quo, not managing it. If it does, it still beats everything else.

What the progressive centre lacks is a radical policy agenda. This is the most immediate task and the one to which my new Institute is devoted.

One of the most dispiriting aspects of the election campaign was the absence of serious debate about the real challenges Britain faces. AI, automation and Big Data will usher in a new workplace revolution. The NHS, our school and skills system, "early years" education, welfare and retirement need to be redesigned fundamentally to take account of technology, scientific development, and changing demographics and lifestyle.

Communities and people left behind by globalisation need to be helped by specific measures which connect them to the mainstream economy. The infrastructure of Britain has to be built anew to link up the regions of the country and take advantage of our assets – geography, history, language and a culture which, despite everything, the world still admires. We need an ambitious affordable housing programme. Austerity should end; but its ending should place an even greater responsibility on government to seek solutions which change systems and not just pump money into them.

Britain has to escape the cul de sac of backward-looking pessimism with a programme of national renaissance, drawing on the best and most creative minds, to produce the new thinking which can shape our future; and can re-kindle optimism. This is why Brexit matters so much. It is not merely damaging in itself; it is a massive distraction. While other countries are moving down the fast lane of progress, we are stuck on the hard shoulder of nostalgia.

In this time of accelerating change, we are offered two different types of conservatism, one of the right and one of the left. The election was fought like one from the 1980s, but with two competing visions of the 1960s. Neither answers the call of the future.

Politics today is volatile and unpredictable. In these times, best hold to what you believe. The centre may appear marginalised; but in the hearts and minds of many, it simply needs to be renewed. Brexit makes this renewal urgent.

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