Nassim Taleb is a literary essayist, hedge fund manager, derivatives trader and professor of risk engineering at The Polytechnic Institute of New York University. But he is best known these days as the author of The Black Swan: The Impact of the Highly Improbable. During a recent visit to Wharton as part of The Goldstone Forum, he spoke with Wharton finance professor Richard Herring — who taught Taleb when he was a Wharton MBA student — about events in the Middle East, the oil supply, investing in options, the U.S. economy, the dollar, health care and of course, black swans.
An edited transcript of the conversation follows:
Richard Herring: It has been much too long since we have seen you here, but we certainly have been reading about you…. Your first best-seller — Fooled by Randomness — was a wonderful reminder to us all that we know a lot less than we think we do about who is competent and who is not. There could not have been any better real-life illustration of it than the crisis we have all been through in which many people we thought were enormously competent, and who took very big bonuses, turned out to have made losses, not profits, and were merely lucky and not competent at all. But you were thinking about an even earlier era and the problems in evaluating who is good at financial management.
Taleb: Yes. Fooled by Randomness was actually much more general than finance. It was about the fact that we cannot identify skills because of sampling error. I call it the easy problem of statistical knowledge because it is easy to solve. It is very curable. I had two problems, of course — the black swan, the second problem, is much more difficult to cure.
But the ‘fooled by randomness’ problem we can deal with. We can definitely exercise some skepticism in some cases. It is, of course, more general than finance — more general than management. For example, if a general won a war, was it because he was a good or lucky? Of course, you’d rather be lucky — particularly if you are at war. So the problem is much more general than finance. But it has wonderful solutions. And a lot of people have broached these solutions.
The black swan problem is much more difficult, vastly deeper and does not have a solution that does not entail a total revamping of some institutional architecture. That’s why I am having a rough time getting the message across.
Herring: On the contrary, I think you have actually had a wonderful success in getting at least the fundamental message across. I have heard people who have no relation to finance ask, ‘Are we facing a black swan here?’ which is a wonderful contribution. Because fractal theory is very, very difficult for non-specialists to comprehend.
Taleb: That’s true. But I’ve been trying to emphasize the true message of the black swan, which is that there are some environments in which rare events are simply not predictable.
Most people think that they can predict the black swan, that with quantitative sophistication they can get answers. They don’t get the idea that because we can’t predict black swans, then we need to restructure institutions and rethink strategies to be more robust in the face of uncertainty.
Herring: Yes, that is very much in line with your contribution to our recent book, The Known, the Unknown, and the Unknowable in Financial Risk Management.
Taleb: The map into this terrain is quite difficult to follow. You have to avoid having things fail too late. You have to avoid debt because debt makes the system more fragile. You have to increase redundancies in some spaces. You have to avoid optimization. That is quite critical for someone who is doing finance to understand because it goes counter to everything you learn in portfolio theory…. I have always been very skeptical of any form of optimization. In the black swan world, optimization isn’t possible. The best you can achieve is a reduction in fragility and greater robustness. You may have heuristics, but not an optimization rule. I hope the message will finally get across because I haven’t succeeded yet. People talk about black swans but they don’t talk about robustness, which is the real lesson of the black swans.
Herring: I would agree that you have raised interest in the phenomenon of black swans and certainly the emphasis on looking for them. But it is a very tough problem to know what to do…. We have to go to the next level of raising it, and really starting to identify what is vulnerable and what is not. Like we know that solar energy is not vulnerable to black swans, but nuclear — as we have just discovered — is found with the black swans. The one in a million year accident has happened…
We seem to have had over the last six weeks a number of black swans flying through our global universe. You know a lot about the Middle East. Should the “Arab Spring” of political revolutions in the Middle East and North Africa be considered a black swan?
Taleb: The events in the Middle East are not black swans. They were predictable to those who know the region well. At most, they were gray swans or perhaps white swans. One of the lessons of “Wild vs. Mild Randomness,” my chapter with Benoit Mandelbrot in your book, is what happens before you go into a period of wild randomness. You will find a long quiet period that is punctuated with absolute total turmoil…. In The Black Swan, I discussed Saudi Arabia as a prime case of the calm before the storm and the Great Moderation [the perceived end of economic volatility due to the creation of 20th century banking laws] in the same breath. I was comparing Italy with Saudi Arabia. Italy is an example of mild randomness in comparison with Saudi Arabia and Syria, which are examples of wild randomness. Italy has had 60 changes in regime in the post-war era, but they are inconsequential…. It is a prime example of noise. It’s very Italian and so it’s elegant noise, but it’s noise nonetheless. In contrast, Saudi Arabia and Syria have had the same regime in place for 40 some years. You may think it is stability, but it’s not. Once you remove the lid, the thing explodes.
The same kind of thing happens in finance. Take the portfolio of banks. The environment seemed very placid — the Great Moderation — and then the thing explodes.
Herring: I would agree that people knew the Middle East was very vulnerable to turmoil because of the demographics, a very young population, and widespread unemployment, the dissatisfaction with the distribution of income and with regimes that were getting geriatric. But knowing how it would unfold and knowing that somebody immolating themselves in a market in Tunisia would lead to this widespread discontent — and we still don’t know how it will end — is a really remarkable occurrence that I think would be very difficult to predict in any way.
Taleb: Definitely, and it actually taught us to try not to predict the catalyst, which is the most foolish thing in the world, but to try to identify areas of vulnerability. [It’s] like saying a bridge is fragile. I can’t predict which truck is going to break it, so I have to look at it more in a structural form — what physicists call the percolation approach. You study the terrain. You don’t study the components. You see in finance, we study the random walk. Physicists study percolation. They study the terrain — not a drunk person walking around — but the evolution of the terrain itself. Everything is dynamic. That is percolation.
And then you learn not to try to predict which truck is going to break that bridge. But you just look at bridges and say, “Oh, this bridge doesn’t have a great foundation. This other one does. And this one needs to be reinforced.” We can do a lot with the notion of robustness.
Herring: Going back to the Middle East, how would you suggest that people deal with that?
Taleb: I would rather have a little bit of turmoil — physical turmoil — because that noise rises to the surface. It was a very bad idea to suppress the Islamic Fundamentalists. [We have been] living in this environment now for 14 centuries. We all understand that you shouldn’t stifle dissident voices. You let them rise … because you are actually strengthening the system. It is a hydra-affect. Call it anti-fragility. You should let everyone partake of the political process and make it messy. Just like people go to the health club — it is a painful experience. I mean, for me at least, it is not a very pleasant experience. But it makes you stronger. You see? You should let that noise rise because if you stifle the noise for a long time, the thing can erupt.
The second myth that I would like to debunk is about revolutions. I recently read a few books on the French Revolution. I realized that the places that are vulnerable are not places where you have a starving lower class. You simply give them a little bit of bread and they are comfortable. The real danger is a rising middle class with thwarted expectations, like the upper middle class in Saudi Arabia. They are deprived of power and extremely resentful of the royal family because they encounter them daily, while the lower classes do not. The same is true of Bahrain. It does not have economic problems. It has an upper middle class that feels stifled by the regime. When you have resentment, it comes usually from the educated, upper middle class like the French Revolution.
Herring: They feel they are being blocked.
Taleb: They feel they are being blocked. Exactly. And they feel resentful. They feel their jealousy. This is what will eventually threaten Saudi Arabia. People are saying that there are between 7,000 and 15,000 extended relatives of the King and members of the royal family who own the place. So technically they own the place. Their private purse is the public purse. If you are part of the upper middle class, you will become increasingly resentful. These are the spots that are the most fragile.
Herring: Given your view on the fragility of Saudi Arabia, how should we think about making direct investments in Saudi Arabia, the supply of oil or military alliances?
Taleb: I think that an oil shock would be very good because we need to be trained to finally give up on these stupid cars. We have so many alternative sources, and people are too lazy. We need to enhance anti-fragility in this area. You can move from wild randomness into mild randomness by creating some. It is like hormesis: You give someone a little bit of poison and they get stronger. Economic life gets stronger not with bailouts, but with bankruptcies.
Evolution works not with bailouts — there are no bailouts in nature — but with competition and natural selection. So you need to have some stressors and to use stressors to strengthen the system. We have not been stressed enough about the oil crisis, and it has led to a horrible situation in which the U.S. government is playing a hypocritical role driven by humanitarian forces in Libya, but at the same time supporting the Saudi royal family, essentially one tribe running a place — even giving its name to it. It is the most unstable place and the most backward of regimes in the world — all in the name of oil security.
So you realize that you have some schizophrenia as far as how a lot of Western governments are behaving. So we need a little bit of oil shock….
Herring: It requires more than a shock, doesn’t it? Because we have had those before…. In fact, the price of oil in real terms was even lower than just after the OPEC increase. So the motives for making substitutions just were not there.
Taleb: I see. But do you think that we will eventually wean ourselves from that nasty dark product from the ground?
Herring: One hopes. But it is hard to see how given the reality of the way we have built our society, with remote suburbs and interstate highways linking everything. We cannot make a very quick substitution out of the petroleum-based economy. But you are absolutely right. It has got to be faced.
Taleb: This is the fragility of having dependence on one source — one product — rather than more than one…. It is optimal to use oil visibly. But it is more dangerous. In my new book, I focus on optimization; almost 99 cases out of 100 optimizations make you vulnerable and fragile.
Herring: Yes. That’s the darker side of Adam Smith’s pin factory. You become more efficient by becoming more specialized, but you also become more vulnerable to some kinds of shocks.
Taleb: [When a company becomes] more specialized with things, and it works better, the numbers look better. But your hidden risks rise and rise. And then when you are faced with a problem, you don’t know what to do about it, whereas in other cases you have more variations all the time. You have more fluctuations and, of course, you are a lot more robust.
Herring: So you would advocate investing in options because you don’t know which one you are going to need?
Taleb: Exactly. My anti-fragility is a long option…. I started my career as an options trader. I retired several times as an options trader trying to generalize the concept…. I view the world as neutral options, long options and short options. When you long an option, you love disorder. That was the thing that hit me then — this product likes disorder — it likes volatility.
Herring: There is nothing worse than having a calm steady market if you are a volatility trader.
Taleb: Exactly. If you are a volatility trader or if you long an option. The first thing that determines the value of an option is not the spot price — the underlying price. It is the volatility — particularly when the option is remote. Uncertainty benefits an option. It is hard to explain to people that there are systems that love uncertainty. Evolution loves uncertainty. Economic life loves uncertainty, but we don’t know it.
Herring: If there is one thing that politicians seem to be riveted on right now it is the uncertainty of employment, for example. We seem to have jobless recoveries, and there are arguments over whether we have actually had an improvement in unemployment just now or whether we simply have more discouraged workers.
Taleb: We did not have a recovery. What we had is massive reliance on the printing press for more money. Did your tax base improve? No. Otherwise you wouldn’t have $1.3 trillion in expenses. So we are fooling ourselves with numbers….
You are eventually going to pay back this fake growth — [which is] sort of like Madoff style growth. Is it growth? Well, it looked like growth but it’s not really growth if you discount it by the probability that you have to pay it back.
Herring: And the trajectory for several major countries — not least the United States — is more and more debt.
Taleb: Yes, but the thing is that we are the worst here because before us we had Greece and Ireland. They are being yelled at and they are doing something about it. Here, we now have people in Congress bickering over $60 billion? The way they account for the deficit — some of it is deficit and some of it is investment. But we still have to come up with $1.5 trillion.
Herring: It may be even more than that because there is an awful lot of funny accounting that goes behind the numbers — not least of which is the health care plan.
Taleb: Of course. You have hidden liabilities. You have hidden contingent liabilities. As options traders, we know that when you sell an option you have a liability, particularly if it’s in the money. Even if in accounting ways it doesn’t show up. So we are worse off than Europe because Europe has about half the deficit that we have — as a whole. People forget that Europe has at the center Germany. The Euro Zone has Germany.
Herring: As long as they are willing to write checks, it all works.
Taleb: Well, yes, but they are at the center. So if you have to dilute the GDP by that — that goes down immensely to about 7% or 6%. It depends on whom you talk to. So the numbers are about half of what we have. So I am not that worried about Europe. Asia, the BRICs — all these people — not only are they doing well, they are more robust.
Herring: How about Japan?
Taleb: It is a disaster that has been creeping up for a long time — fiscally — visibly.
Herring: And demographically as well.
Taleb: And now that they have that shock, we don’t know what can happen. But the Japanese had the luxury of selling us cars. They had a big government deficit, which is a huge source of fragility. But at the same time they were getting cash and they had a high saving rate that absorbed it. So that was okay…. But here we don’t have anything. We don’t have the same situation here as Japan, because not only do you have a high government deficit, but it is coupled with a big current account deficit and meager private savings….
Herring: Some people would say that part of the reason we have a very different pattern than Germany and Japan is that Germany and Japan used export-led growth until they became so large that it was very hard for the rest of the world to accept their exports. We became sort of the buyer of last resort. This is not a plausible excuse for our lack of budgetary control, but it does account for a basic structural difference.
Taleb: Maybe. It can let you off the hook for a while, but at some point, no.
Herring: The same problem arises with China, which also has pursued an export-led strategy and needs at some point to have balanced internal growth to stabilize.
Taleb: That is true. But I’m looking at … what would be the worst thing that can happen to us. The U.S. has to raise $1.5 trillion for next year, okay? We’re going to have to find buyers. We have some domestic savings — a few people willing to spend. Okay? The rest of the world may buy some. And then we have no buyers. So they have to call Bernanke to come and do his quantitative easing again.
Herring: And we have a set of rules developing for banks that will require them to buy bonds, which is a bit worrisome the world over.
Taleb: Yes, instead of lending…. This is what I call the situation of failed options or not being able to find buyers and then having to fudge things so they can play that game. The rest of the world would see it and I would say, “Okay, I’m not touching that currency.”
Herring: That’s surely going to be a hard landing.
Taleb: Definitely. That would be a rude awakening. In my new book Anti-Fragility I look at a few things…. You keep postponing the blow up, but the longer you wait, the worse it gets. But we have solutions. One of the solutions is to cut right away. Clean out the cancer right away.
Herring: Do we have the political will to do that?
Taleb: No. Plus, we have moral hazards — creeping moral hazards at the level of the bankers who are still more powerful than they were before. And the politicians want to be like this. So we have this moral hazard spread throughout the whole system. The problem came from an agency problem. And the agency problem is more acute today — paying bonuses for bankers, bigger and bigger — so visibly there is something that has not been fixed in the system and [there is] no political will. And people don’t want to cut. I have — with a collaborator of mine — looked at medical expenditures in something called iatrogenics…. A solution may come in the form of people realizing finally that if you cut medical expenditures by half, people may actually live longer. Start comparing public health and then looking at what we call conditionally iatrogenics because the elective surgeons and all this is where the money goes.
Herring: Also, a lot of it is spent in the last three months of life and with no particular gain to society or the patient.
Taleb: Well, no. It’s just punishing the person into living longer. We have a high medical expenditure mostly on things that actually make us sicker — like statin drugs, for example. If you are healthy and you take statin drugs, visibly you are going to get health benefits, but you have a lot of downsides — like shorting an option. The side effects are like shorting an option. The value of that short option is not visible; it takes awhile to show. You can compute it with cancer treatments. We know from mammogram studies that if someone has a lot of cancers …. just leave the cancer alone. It doesn’t reduce the life as much as the treatment does. So it has this breakeven point. Cancer treatment is a bit of a touchy subject. But in a lot of situations in which elective surgeries are canceled because of hospital strikes, the person never comes back. They are healed on their own. Mother nature does a better job and with fewer side effects. So there may be some hope in cutting there and cutting into the military expenditures without repercussions.
Herring: But it does require looking at entitlements. There is just not enough in the discretionary part of the budget to deal with it.
Taleb: Definitely. You have to go everywhere.
Herring: Do you have any sense of how long we have before the hard landing is going to happen?
Taleb: No. Before that failed auction or that panic?
Taleb: I don’t know. But it may actually be healthy to have a good panic because then people realize that you can’t borrow for free as we are borrowing today because some people won’t buy your bonds unless there is a huge premium. That is the logical consequence of quantitative easing.
Herring: Although it is interesting that even now you see people [turning to] the U.S. dollar, I guess because reserve currencies have two attributes. We are good at one and not the other. One is liquidity, which we are unparalleled at producing in the Treasury bond market. But price stability is truly a risk at this point.
Taleb: The currencies people have been using are the metals, namely, silver and gold — more silver than gold.
Herring: And the Swiss franc.
Taleb: And the Swiss franc, and the Nordic currencies and the Canadian. The dollar comes last.
Herring: But there are still a remarkable number of flows — even when the uncertainty arises in the United States.
Taleb: Yes, but people have a habit of allocating X dollars — X to this, X to that. So there are automatic flows. Plus the Arabs have to buy Treasury bonds here. Otherwise, they wouldn’t be playing the game. You see?
Herring: And if you are moving around that large a sum of money, there are very few options.
Taleb: Exactly. There are very few options to park your money. But still, the dollar is weaker than the other currencies, including Europe. The euro now as we are talking is 1.42. That’s a lot stronger than it was a few months ago.
Herring: Although that, too, is probably fragile.
Taleb: Definitely fragile. The only things that are more robust are currencies without government. Although I don’t know which one is optimal. I don’t know if gold is the best. Gold is more fragile than a good collection of what I call repositories of value.
Herring: Yes, I think that’s quite right. Because at least they have a good industrial use that then puts a floor on their price.
Taleb: And those of us who are old enough to remember what happened — it was right before I came to Wharton — gold burned so many people in the Middle East. Up until then it was considered the optimal repository of value…. So we have to be careful about repository of value.
Herring: So, again, your advice is to have lots of options and diversity.
Taleb: Exactly — a lot of optionality. For example, I don’t like to buy gold. I buy options on gold either in the form of things that have gold underground — because [with oil], the cost of digging or the cost of extracting are outweighed by the profits from the revenues.
Herring: That is a fascinating concept that I think will surely have as wide an appeal as the whole idea of a black swan. Because it has left everybody thinking — once they think seriously about a black swan — “What in the world do I do with it?”
Taleb: Yes. I rephrase everything. The black swan was initially a short option. You see? This is your short option. This is your long option. And now I realize I could express it in terms of optionality. I just had to find the right English words for it to explain optionality to non-option traders.
Herring: Well, that is something that you have been really brilliant at.
Taleb: I hope it works this time.
Herring: It is amazing the extent to which black swan has entered the common vernacular [including among] people who probably have not even read the book. But it is one of the few concepts coming out of a serious economic book that has gained widespread currency the world over. It’s hard to pick up a newspaper without seeing some reference to it in one way or another. So I hope you are as successful with the solutions.
Taleb: I hope I am successful in conveying the need to avoid some problems. The best thing you can do to live long is avoid smoking. So the solution may be subtractive, not additive — like advice [about] what not to do.
Herring: We need a lot less complacency about how much we think we know. Your whole work has been leading us in that direction. It is probably your philosophical bent that what we know in fact is a lot less than we all believe we do — in almost every sphere of life.
Taleb: I know, but it’s not harmful in most domains.
Herring: Well, it isn’t if you know it.
Taleb: There are some domains in which you can be as over confident as you want without harming you.
Herring: That seems to be a deep seated trait that behavioral psychologists pick up in virtually every sphere — that we are much more confident about things we don’t know much about than the evidence warrants. When it gets to financial markets, it can be dangerous. Again, thank you very much for coming back to campus. We are delighted to have you here and really eager to hear your message about how to make a more stable, more robust world to deal with the black swans flying all around us.
Taleb: Thank you very much. I am so honored to come back after — I won’t say how many years.