Tag Archives: Taleb

Quote of the Day

“I have only one project, one big idea: uncertainty. It crosses many different disciplines — math, political science, psychology, risk management — and I swing in between those, but it is always on what we call the epistemological question. There are two parts to this question: math and computation, and psychology. The second causes us to think we know more than we do. It is an endless topi. Bernanke has six problems: One, his education is in tools that aren’t helpful — and he doesn’t know it. Two, he studied the Great Depression, and he thinks he knows too much — this is nothing like the Great Depression. You can’t compare this and the Depression. Three, 99% of risk is tied to the debt/leverage and the explosion of connectivity. It’s like he did not see a truck coming right at him. Four, he has no notion of nonlinearities, and how monetary policies can be responsive in nonlinear ways. Five, he doesn’t understand fat tails. Six, he doesn’t realize that the biggest risk of failure is signified by the Federal Reserve: He thinks we need more regulation; we actually need smaller institutions. And not one person in Congress had the presence of mind to ask him these questions.”

— Nassim Nicholas Taleb, AI5000, Jan/Feb 2010

Black swans? Or black crows?

Nassim Taleb is moving along just fine with an elegant critique of banking’s misaligned incentives . . .

In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich. Furthermore, it is that incentive scheme that got us in the current mess.

Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses.

. . . But then, after showing how easy it is for bank management to capture short-term gains without worrying about long-term risks, Taleb concludes that 

This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.

It’s a big leap from misaligned incentives to only the government can run banks. Doesn’t the expert theoretician of the highly improbable Black Swan understand that highly centralized governments are most often the cause of devastating Black Swan events? The only difference being: we shouldn’t really even call them Black Swans in the case of government failure. These events are not uncommon or unpredictable. The inherent difficulty and high-frequency failure of highly centralized bureaucracies managing dynamic systems is so common and predictable, in fact, that we might call them Black Crows. 

We can do much better than nationalizing the banks. Boards should obviously reform compensation practices. Today’s shareholders have been mostly wiped out. The shareholders of the “next banks” won’t soon forget. But most crucially we should amend the wildly incoherent monetary policy regime that does more than any other private or government action to misalign incentives. During credit bubbles, dollars are easily vacuumed up by the financial industry. In a very real sense, they would be irresponsible not to exploit the Fed’s explicit free-lunch program of accommodation “for a considerable period.” Remember, Chairman Greenspan virtually ordered Wall Street to lever up.

A stable currency is the ultimate disciplinarian, the incentive aligner par excellence.

Update: See Taleb and Nobel psychologist/behavioral economist Daniel Kahneman discuss these topics at length here.