"I told you so"

Nassim Nicholas Taleb doesn't say that about himself, but nobody would argue with him if he did. And that's how Russ Roberts introduced him in this March 23 interview.

I've talked about him several times before; one was a review of his two bestsellers (see this article). Here are links to those books:

• Fooled by Randomness

• The Black Swan

Taleb has utmost respect for Hayek (as I do), but he doesn't consider Hayek an "economist" — because economists have a habit of fooling themselves with their equations. (The economy, unfortunately, is a stubborn thing that does not behave the way their equations say it should—regardless of which economists’ equations we’re talking about, and regardless how many centuries they’ve spent developing their models.) Here's an excerpt from The Black Swan:

In 1974 [Hayek] received the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, but if you read his acceptance speech you will be in for a surprise.  It was eloquently called "The Pretense of Knowledge," and he mostly railed about other economists and about the idea of the planner.  He argued against the use of the tools of hard science in the social ones, and depressingly, right before the big boom for these methods in economics.  Subsequently, the prevalent use of complicated equations made the environment for true empirical thinkers worse than it was before Hayek wrote his speech.  Every year a paper or book appears, bemoaning the fate of economics and complaining about its attempts to ape physics.

Russ Roberts's latest interview with Taleb is worth listening to. So is the interview from two years ago. Here are both links:

• Taleb interview, Mar 23, 2009.

• Taleb interview, Apr 30, 2007.

Comments

[Bob]

I do not have an hour to listen to the podcast. My limited exposure to Taleb paints a picture of a critic. So, I'd want to know what solutions or alternatives he offers to current practices.

Are there any in the podcast?

[Optimist123]

Bob:

You probably won't have time for the book, then. Too bad, I got a lot of good chuckles out of both books.

While everybody else was using their version of the investment model that says the % in bonds should equal your age (and that you should rebalance every 6 or 12 months), his strategy was a version of the 80-20 rule: 80% in cash and short-term Treasurys, 20% spread around in exotic options (one of which would be a jackpot in a black swan event).

Everybody made fun of him, saying 80% cash wasn't an "investment." But the joke's on them: cash has turned out to be one of the best investments of all.

[Gil]

I would have to disagree there S. Optimist. Doesn't having 80% in cash only amount to a sensible investment if there's going a crash? Suppose, on the other hand, if the was a raging bull market for 20 years straight - would Taleb's strategy makes sense then? This reminds of those who say you'd have been better off buy beer and recycling the cans than buying bonds, shares or real estate. Just because a certain way of 'investing' worked within a certain exceptional timeframe, does that mean it should be used for investing in ordinary times? Likewise there's another story of a fellow who said he invested in real estate at a decent time period yet complains (in retrospect) that had he invested in shares he would have made three times more money.

[Optimist123]

It's 80/20, and it's the 20 that pays off in a black swan event, whether that event is up or down.

The 20-year bull market is exactly what he talks about in the book. It's just like a baby turkey: growing, growing, growing, steadily, reliably, and predictably, for months and months... all the way up to Thanksgiving Day -- at which time the multiple regression stochastic growth prediction model fails catastrophically.

[SkylightMT]

Is he saying this current crisis is a Black Swan event? I had always thought of black swans as unpredictable. But looking back, the current situation seems very predictable.

"The more informational economic life is, the more it can deliver large deviations." I'm struggling to get this. Is it because, like the opera singers, with such global communication available via the internet, instead of there being many diverse local heros, you get a few that rise to the global top while the others are lost to oblivion; in the same way, a few choice economic activities (e.g. writing CDSs) become globally preferable - its the magnitude combined with the narrowing of choices that leads to potential catastophe (or massive gain if it goes the other way) - am I getting this right at all?

He talks about leverage and complexity not being compatible. It reminds me of Heisenberg's Uncertainty Principle - you can know one or the other to 100% certainty, but not both. We could be leveraged out the wazoo if we fully understood our lending and were limited to a few varieties; OR we could have some really complex economic activities as long as we maintained decent capital. Don't know why this should be the case, exactly, but it makes sense that it is.

He's quite a famous doom and gloomer, often brought up on the doomer sites. I'm surprised you like him, Oh Optimistic One.

He also thinks we need to bite the bullet and let things that are going to collapse to collapse. I was fervently against this at the beginning of this crisis, believing that, by history, govt intervention had much better outcomes than no intervention. Now I am beginning to think differently.

I think that (having recently given childbirth) our economy is right now, these past few short weeks, in the breathing space between contractions (re stock market, optimistic words from G20 et al). But the contractions are going to be coming more painful and fast soon. Leading to the new birth of something... wonderful, I hope, and not catastrophic. Now that's optimistism!

[Gil]

Heck, modern society could be considered a 'black swan' event. Throughout history most people were simple farmers and economies were relatively circular - each person knew they were going to inherit whatever their parents did. Such traditional systems could go centuries without much change and might therefore be considered highly predictable. Modern society, however, keeps changing and it is said a great many young people are doing jobs that didn't exist when they were born.

[SkylightMT]

Ten principles for a Black Swan-proof world

By Nassim Nicholas Taleb

Published: April 7 2009 20:02 | Last updated: April 7 2009 20:02

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

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine 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.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess. Instead, find the smart people whose hands are clean.

4. Do not 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” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

7. 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. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, 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 companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.

In other words, a place more resistant to black swans.

The writer is a veteran trader, a distinguished professor at New York University’s Polytechnic Institute and the author of The Black Swan: The Impact of the Highly Improbable

Copyright The Financial Times Limited 2009