The Reverse Black Swan, Part II

In the Reverse Black Swan Part I, I drew three conclusions from Taleb’s work.

1) Unexpected technological breakthroughs are possible. That’s good

2) The timing and nature of the breakthroughs cannot be controlled. That’s bad

3) Unexpected large bad events are possible as well. That’s bad. In fact, we can get bad events which have as big an impact, in the negative direction, as the technological innovations. These principles help frame a very important policy question: How can we design our economy and financial system to decrease the odds of the negative Black Swans wiping us out, while doing the most to maximize the positive Black Swans of technological change? Or to put it another way, what kind of regulation do we need?

Reading and thinking about Taleb leads me a different answer than I would have given 6 months ago. Yes, we need more regulation—but it should be ‘regulation by simplification’ rather than ‘regulation by supervision’.

Why? As a technological optimist, I believe in innovation as the major force for growth over the long run. So one important part of policy is setting up the conditions under which technological innovation can occur. That means supporting R&D and education, encouraging venture capital and entrepreneurship, and making sure that government regulation does not get in the way of 'good' innovation.

But here's the kicker: Innovation is fundamentally unpredictable, both in timing and scale. That means no matter how much we spend on R&D and education, we cannot guarantee big economy-moving innovations--the reverse Black Swans--will arrive on any timetable. The best example: For all the money lavished on biotech and healthcare science over the past decade, turning scientific advances into economically viable and clinically useful products has been very difficult. Eventually it will come--but eventually could be tomorrow or it could be ten years from now.

That means innovation policy needs a second focus: While we are working hard on finding "The Next Big Thing," we also need to avoid or minimize the odds of negative Black Swans wiping us out in the mean time. The right way: 'Regulation by simplification', which means forcefully simplifying enough of the financial system and economy so that we actually understand what's going on, and can see problems occurring before they get too big.

This is the way that Taleb put it in a recent Financial Times piece:

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.

What does this mean in practice? In his book, The Black Swan, Taleb lays out the idea of a "barbell" strategy:

taking maximum exposure to the positive Black Swans while remaining paranoid about the negative ones.

For an investor, Taleb explains the barbell strategy this way:

you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills...the remaining 10 to 15 percent you can put into extremely speculative bets.

The implication, as Taleb says, is that "you are 'clipping your incomputable risk, the one that is harmful to you." At the same time, you are maintaining your exposure to the upside, and putting yourself in situations "where favorable consequences are much larger than unfavorable ones." Some examples of businesses with big upside include:

some segments of publishing, scientific research, and venture capital. In these businesses, you lose small to make big.

The principle of the barbell strategy extends from the investor level to the economy level. That is, we should put ourselves in a position to enjoy the benefits of reverse Black Swans, while reducing the odds of out-of-control crises sneaking up on us.

The first step: Simplify big portions of the financial system so that we actually understand what is going on. Why is that important? It's becoming clear in retrospect that no one--literally no one--understood all the interactions between the new financial instruments, the massive flows of money sloshing around the globe, the huge trade deficits and the world housing boom, not to mention fifteen other factors. When the regulators let Lehman go bust, they had no idea it was going to lead to a run on European banks.

In other words, the global financial markets made up a complex system, defined as a system that produces results outside the bounds of what anybody could reasonably foresee. That's not a good thing. To the degree possible, we need to turn the financial markets into a simpler system, which is easier to understand.

That may mean partitioning the financial system and going back to something like a Glass Steagall world. There would be one part which consists of simple banks that only take deposits and make simple loans, and which are heavily insured by the government. The other part would do the more complicated and harder to understand financial deals, with explicitly no guarantee from the government and measures put in to restrict leverage.

Taleb is not alone here. Paul Krugman recently wrote a NYT piece called "Making Banking Boring," which was heading in the same direction.

Reducing leverage and debt is an essential part of the simplification process. The reason? Excess use of leverage can turn almost any system 'complex', in the sense of making it hard to predict. If I take on a lot of debt, I've become vulnerable to relatively small negative events. If my trading partners have taken on lots of debt as well, we've set up a situation where there's the potential for chain reactions.

In the broadest sense, taking on big debt forces you to make an assumption about future growth--but as we saw before, growth depends on technological innovation, which is itself unpredictable. In other words, too much debt amplifies the fundamental unpredictability of innovation. Indeed, Taleb would like to go the other way and delink most of the economy from the financial system, arguing that "economic life should be definancialised."

Now, that goes against prevailing wisdom. The Free Exchange blog at the Economist magazine objected to Taleb's FT article, saying:

While limits on leverage are necessary and tax policy which encourages firms to issue debt rather than equity is misguided, the villain here is not complexity. Perhaps Mr Taleb and lawyers hired as regulators do not understand complex derivatives, but many people do. Should we outlaw innovation for the benefit of people who lack quantitative skills? These products do indeed provide a means to hedge risk. The crisis may have been much worse without some of the financial products that did pay off.

Further, the crisis was not caused by complex products. It was the result of a terrible assumption—that housing prices would continue to rise....Wishing away complexity does not change that or prevent future incompetence.

But Taleb is making a different point. He would argue that as complexity rises, you have to make more and more assumptions, with less and less understanding of the underlying system. As a result, the chance of making a 'terrible assumption' rises. This time it was the future path of housing prices. Next time it will be something different. As Taleb writes in his book. "Remember that infinite vigilance is just not possible."

Whew...sorry this took so long. The next piece in the reverse Black Swan series will look at innovation at the corporate level.

Before it's here, it's on the Bloomberg Terminal.