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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The Brexit odd squad

The Brexiters are resilient and have the support of some unlikely foreign allies. Can they really topple the political establishment and lead Britain out of the European Union?

Look at the troops arrayed on the Leave and the Remain sides in the June referendum and you might think that our continued membership of the European Union is assured. On the side of staying in the EU are Britain’s four living prime ministers, the International Monetary Fund, the Treasury, most members of the Labour and Liberal Democrat parties, the Trades Union Congress, the Confederation of British Industry, the governor of the Bank of England, the head of the NHS, Britain’s three largest trade unions and the US president. Leave has Boris Johnson, Nigel Farage and the contested ghost of Margaret Thatcher.

Yet few expect the final result of Britain’s In/Out referendum to be as asymmetric as that roll-call would suggest. At the top of the pro-EU campaign Britain Stronger in Europe, there is no doubt: it could lose.

So what – and who – is responsible for the unlikely appeal of Brexit’s “odd squad”? And how do they work together when their side is so fractious and its big personalities seem so uninterested in teamwork?

The story begins on the morning of 20 February, when David Cameron summoned his cabinet to announce the results of his EU renegotiation and ask his ministers to support Britain’s continued membership of the Union. Those who did left by the front door; the six dissidents were asked to leave by the tradesman’s entrance.

Nipping out the back were the full cabinet members Iain Duncan Smith, Michael Gove, Chris Grayling, Theresa Villiers and John Whittingdale, plus the employment minister, Priti Patel, who has the right to attend cabinet meetings. They soon reconvened at Vote Leave’s headquarters, a nondescript tower block in Westminster, where they posed with a giant sign bearing the campaign’s slogan “Vote Leave, take control” – a sight more reminiscent of a group of local councillors vowing to protect a bus lane than the upper reaches of the British political class.

Then again, the cabinet Leavers are not, on the whole, an impressive bunch. Villiers and Grayling were among the casualties of the formation of the coalition government in 2010, moving from their briefs to make way for Lib Dems, and both had to be content with junior posts until the 2012 reshuffle. Since then, Villiers has been a competent if uninspiring operator in Northern Ireland. Grayling was widely held to be a failure at the Ministry of Justice and now serves as Leader of the House of Commons, historically the antechamber between full cabinet rank and the wilderness.

As for Whittingdale, he is that rare creature in Whitehall: a secretary of state for culture, media and sport who does not regard the post as a stepping stone to bigger things. As the recent white paper on the future of the BBC showed, the golden thread of his thinking is scepticism: towards the EU, the BBC and regulation of the press. He was Margaret Thatcher’s last political secretary in Downing Street and, after becoming an MP in the 1992 election, he set up meetings between the former prime minister and his fellow new boys from the 1992 intake – meetings that John Major blamed for fanning the flames of Eurosceptic rebellion in the dog days of his premiership.

Priti Patel also has impeccable Eurosceptic credentials. She cut her teeth as a press officer to the Referendum Party, set up in a doomed attempt to secure an In/Out referendum in 1997. Following William Hague’s election as Tory leader and the adoption of complete hostility towards the single currency, she joined the Conservative Party, becoming an MP in 2010.

She is best known for contributing to Britannia Unchained, a series of essays by Patel and four of her fellow 2010-ers (including Dominic Raab, widely expected to run for the Tory leadership next time). The book was intended to provide the intellectual ballast for a revivified Thatcherism, though the only part that attracted headlines was the claim that British workers were “among the worst idlers in the world”.

This dubious crew of ministerial heavyweights has grown marginally more likeable since Duncan Smith’s resignation as work and pensions secretary. Yet it is not his six-year tenure as a minister but his two-year stint as Tory leader that has left the biggest mark on the Brexit debate, with his former hires among the loudest advocates for a Leave vote – including the founding editor of ConservativeHome, Tim Montgomerie, now at Gove’s old newspaper the Times. (In the unhappiest periods of Cameron’s first term, when the Prime Minister was frequently criticised by Montgomerie in that newspaper, Cameroons would mutter about the irony that one of their sharpest critics had served as chief of staff to the least successful leader of the Conservative Party in its history.)

As for Michael Gove, though he is loved by lobby journalists, he remains a hate figure in the country at large and particularly among teachers, as a result of his belligerent tactics during his time as secretary of state for education.

***

The last of the senior Brexit-supporting Tories didn’t leave through the back door that morning because he hadn’t yet declared his position. That came the next day, in a media scrum outside his home in Islington, north London.

The former mayor of London Boris Johnson is still Britain’s most popular politician, surviving crises and scandals that would have left others dead in the water. He is also the only politician whom the Remain campaign truly fears. But Johnson is not a wholly congenial presence among Britain’s Brexiters. Although he is a far more adept planner than his dishevelled appearance – or his paper-thin record at City Hall – would suggest, he can be difficult to manage. His  weekly Telegraph column has largely been turned to cheerleading for Brexit but Vote Leave’s biggest gun doesn’t always point in the direction its chief strategists would like.

During Barack Obama’s visit to the UK in April, Johnson became embroiled in a war of words in which he suggested that the president had an ancestral dislike of Britain because of his “part-Kenyan” heritage. Having made this racially charged argument in the Sun, he extended the story needlessly by giving a similarly robust interview to the Daily Mail, much to the frustration of staffers at Vote Leave.

So there you have it. An unpopular firebrand, an unsuccessful former Tory leader, four relative nonentities and a blond bombshell who is considered clever but uncontrollable. It is less a huddle of Big Beasts than a grotesque menagerie – and these are among the sensible, mainstream voices on the Leave side. The other politicians who can get on to the Sunday shows to talk Brexit include Nigel Farage, who is adored by the four million people in Britain who voted Ukip in last year’s general election – and hated by the remaining 42 million. Yet he is a national treasure compared to George Galloway, formerly of Labour, who secured just 37,000 votes in the mayoral election. An unkind observer might say that none of the Brexit-backing politicians can stop traffic: half of them because they are unknown and the other half because most people would quite like to run them over.

There are also few compelling figures from business, sport, entertainment and science backing Brexit. Ian Botham is a rare celebrity Outer. “Cricket is a game where you achieve the greatest success when you are confident in your own ability to go out and stand proud,” he wrote in the Sunday Times. “Britain has that spirit.” In April, a slew of acts withdrew from a gig in Birmingham after finding out that it was organised by Leave.EU. Only Phats & Small, whose last hit was in 1999, refused to pull out.

Then there’s the infighting. To give just one example of the ongoing civil war, Vote Leave – the officially recognised campaign group for Brexit – believes Farage is so toxic to its cause that it regards his invitation to appear in a TV discussion alongside Cameron as an establishment stitch-up. “ITV has effectively joined the official In campaign,” said a Vote Leave statement to journalists on 11 May, written by Dominic Cummings, the campaign’s director. “There will be consequences for its future – the people in No 10 won’t be there for long.”

***

In the light of all this, why are the pro-Europeans so worried? Many feel that the current campaign is beginning to remind them of a nightmare year: 2011, when Britain voted decisively to reject electoral reform by moving from first-past-the-post to the Alternative Vote (AV). Around the time of the 2010 general election, polls had shown that Britain was in favour of the change by a 27-point margin. But on 5 May 2011, more than two-thirds of voters said No to AV, which ended up more than 35 points ahead.

What undid the Alternative Vote was a ruthlessly effective campaign against it – one that was almost completely fact-free. No2AV focused relentlessly on the cost of a new voting system; poster after poster made reference to its illusory price tag of £250m. “He needs bulletproof vests,” intoned one illustrated with a picture of a soldier, “NOT an alternative voting system.” Another came with a picture of a baby: “She needs a new cardiac facility, NOT an alternative voting system.”

As one veteran of the pro-AV campaign recalled recently: “It was impossible to fight. How do you repudiate it without repeating it? We never found a way.”

That appeal to economic interests was so powerful that Vote Leave has come up with a similarly memorable figure: the £350m weekly cost of Britain’s EU membership. This has been debunked by fact-checkers such as Full Fact, which estimates that the UK pays roughly £9.8bn a year once money back is taken into account. Regardless, Vote Leave keeps quoting the figure – and no wonder, because the chief executive of Vote Leave is also the architect of No2AV’s crushing victory: a 38-year-old LSE graduate called Matthew Elliott.

Despite Vote Leave’s anti-politics flavour, Elliott is a Westminster insider and well connected in the wonk world. He is the founder of the Taxpayers’ Alliance, the most high-profile of a close network of think tanks that are a proving ground for a rising generation of right-wingers. The Taxpayers’ Alliance, the Institute of Economic Affairs and the Adam Smith Institute together form what one alumnus jokingly calls a “Sorbonne for neoliberals”.

Much of Vote Leave’s staff is drawn from another Elliott creation: Business for Britain. The group was set up ostensibly to lobby for David Cameron to renegotiate Britain’s membership of the EU but was in reality designed as a Leave campaign in utero. Accordingly, many of its early recruits have ended up moving across.

Elliott is regarded as having a keen eye for talent and for being generous with his time. At each organisation where he has worked, he has taken care to bring on promising protégés. Alumni of the Elliott school include Susie Squire, who spent two years at the heart of Cameron’s administration as press secretary; Nick Pickles, head of UK public policy at Twitter; and Dylan Sharpe, the combative head of public relations at the Sun. Most of his favourite employees have three things in common: libertarian politics, a cut-throat instinct and loyalty to him personally. Those who have worked for Elliott largely speak highly of him.

The same cannot be said for the second leading player in Vote Leave who has the Remain side worried: Gove’s former henchman Dominic Cummings. David Laws – who, as a junior minister, worked closely with Cummings when he was at Gove’s Department for Education – describes him as a “grade-A political Rottweiler”. “As well as being bright,” Laws writes in his memoirs, “Dom Cummings was also blunt, rude, impatient and tactless.” According to friends of both, without Cummings’s encouragement, Gove would have been a mostly silent presence in the Leave campaign because of his close friendship with Cameron.

The former special adviser’s commitment to anti-Europeanism is a long-held one – his first job in politics was at Britain for Sterling, which lobbied against Britain joining the European single currency in the 1990s. Thereafter, he worked for Iain Duncan Smith during his brief and unhappy leadership. A former staffer from that time remembers him as an “abrasive presence”.

After Duncan Smith’s removal as Tory leader, Cummings retreated to his native Durham, where he helped to engineer victory for the No side in the referendum on whether to give the north-east its own devolved assembly. It was the tactics used in that referendum – an endless focus on costs, coupled with personal attacks on the credentials of the Yes side – which were taken on and extended by Elliott during the AV contest. Those tactics are once again on display in this referendum.

That partly explains why, on the Remain side, Cummings is respected and feared in equal measure. Yet his confrontational approach often proves his undoing: for instance, he understood the importance of giving a cross-party sheen to Vote Leave (not least to secure the official campaign designation), yet his conduct led to the departure of the Eurosceptic Labour MP Kate Hoey. “We live in a world where people get things by being nice to each other,” reflects a former colleague of Cummings, “and Dom doesn’t really work like that.”

Hoey’s walkout set the ball rolling on another, less dramatic exit: John Mills, Labour’s largest private individual donor and a Brexiter of many years’ standing. He feared the Vote Leave brand had become irrevocably Conservative. (Unlike Hoey, Mills remains on speaking terms with Vote Leave.)

Friends say that, for Elliott, who has been “planning this [campaign] for some time”, Cummings’s disposition is a price worth paying for his tactical nous. It was Cummings who was the architect of Vote Leave’s two-pronged strategy: claiming that the money we now pay to the EU could go towards the NHS, and suggesting that Brexit will allow us to cut immigration by “regaining control of our borders”.

The perceived cut-through of the latter message with older Labour voters was behind Vote Leave’s big tactical gamble. On 8 May, an official statement by the campaign declared that leaving the EU would also entail leaving the single market.

That decision is unlikely to find favour with big businesses that rely on international trade but it does allow Vote Leave to make strong and unambiguous claims about cutting immigration. If we are outside the European Union but inside the single market (as Norway is), we would have to accept free movement of labour. If we leave the single market, however, we could introduce a points-based entry system, or even finally achieve Cameron’s otherwise impossible cap on net migration.

Upset business but win over small-C conservative voters: it’s a big risk for the Brexiters to take. It represents a throw of the dice by Cummings, who sidelined Nigel Farage precisely in order to minimise the campaign’s focus on immigration. But with the vote scheduled to take place on 23 June and a repeat of last year’s refugee crisis in the Mediterranean looming, security and borders are likely to be at the forefront of voters’ minds. For all that those on the Brexit side have denounced Cameron for running a repeat of “Project Fear”, they know that they have to make change less terrifying than maintaining the status quo.

***

In their quest to take Britain out of the EU, the Brexiters have a simple, if high-stakes, strategy. They want to appear to be the underdogs (hence their repeated complaints about the government’s £9m pro-EU leaflet) and as a scrappier, grass-roots campaign taking on the might of the establishment. Naturally, this image doesn’t reflect an unvarnished truth: the press has been largely onside and senior editors and columnists are very willing to take Vote Leave’s calls.

There is also no concern about keeping the lights on. Arron Banks, the insurance magnate who bankrolled Ukip at the 2015 general election, might have refused to fund Vote Leave after it triumphed over his favoured vehicle, Leave.EU – he has called Matthew Elliott “Lord Elliott of Loserville” and threatened to sue the Electoral Commission for naming Vote Leave the official voice of Brexit – but insiders say that the campaign’s financial position is nothing to worry about.

If Vote Leave wins, it will have scored an extraordinary victory – and, it should be noted, defied the hopes of most of our allies in the rest of the world. The politicians backing Britain’s continued membership of the EU include not just Barack Obama but his likely successor, Hillary Clinton, as well as the prime ministers of Canada, New Zealand and Australia.

There is a vanishingly small number of international politicians who back Brexit. Like the inner core of Vote Leave, they are overwhelmingly drawn from the right-wing fringe – US Republicans such as Ted Cruz and Donald Trump and the French National Front leader, Marine Le Pen, who, unhappily for the Brexiters, is expected to visit Britain to support their case.

The only foreign leader who seriously supports a British Leave vote in June is a man praised by Nigel Farage and whose country Dominic Cummings spent several years working in: Vladimir Putin, who, as far as British voters are concerned, is even more toxic than Farage, Galloway or Gove.

When Britain’s odd squad looks abroad for allies, its options are few – but this ragtag collective is far from beaten. 

Stephen Bush is special correspondent at the New Statesman. He usually writes about politics. 

This article first appeared in the 26 May 2016 issue of the New Statesman, The Brexit odd squad