Sunday, March 24, 2013

How Debt Ruins Systems

How Debt Ruins Systems:
Nassim Nicholas Taleb is a former trader and hedge fund manager,
a bestselling author, and a groundbreaking theorist on risk and
A finance professor at New York University and a research
scholar at Oxford, Taleb drew wide attention after the 2007
publication of The
Black Swan: The Impact of the Highly Improbable
, which
warned that our institutions and risk models are not designed to
account for rare and catastrophic events. Among other things, the
book presciently cautioned that oversized and unaccountable banks
using flawed investment models could trigger a financial crisis. He
also warned that the government-sanctioned housing finance
agencies, Fannie Mae and Freddie Mac, were sitting on a “barrel of
dynamite.” One year after The Black Swan was
published, Taleb’s predictions came to pass.
Taleb doesn’t identify as a libertarian, but he often sounds
like one. He supported Ron Paul in the 2012 presidential
election and has cited the libertarian economist Friedrich Hayek as
an influence. He has called New York Times columnist
Thomas Friedman “vile and harmful,” and he coined the phrase
“Stiglitz Syndrome” after Nobel Prize–winning economist Joseph
Stiglitz, referring to the phenomenon of public intellectuals being
held utterly unaccountable for their bad predictions. The
economists Paul Krugman and Paul Samuelson are among Taleb’s other
Nobelist bĂȘtes noire.
Taleb’s new book, Antifragile:
Things that Gain with Disorder
, argues that in order to
create robust institutions we must allow them to build resilience
through adversity. The essence of capitalism, he argues, is
encouraging failure, not rewarding success.
Reason TV Editor in Chief Nick Gillespie sat down with Taleb in
January for a wide-ranging discussion about debt, technology, the
banking system, capitalism, and why he’ll never take writing advice
from “some academic at Cambridge who sold 2,200 copies.” Video of
this interview can be seen at
reason: What is antifragility and why is it so
Nassim Nicholas Taleb: Antifragility is
something that likes volatility and likes variation, likes turmoil,
likes stress—up to a point. The opposite would be robust.
Robust is like a rock. It doesn’t care. Diamond is perfectly
robust. What is antifragile gains from disorder and may even need
disorder for fuel.
reason: You talk about it in terms of
materials, but antifragility applies more to systems or living
organisms, right?
Taleb: Exactly. What people fail to
understand—and this is what libertarians tend to pick up rather
quickly—is that even when you read Adam Smith, you have this
illusion that the economy functions like a machine. But it’s not
like a washing machine. A washing machine needs maintenance. It’s
more like a cat than a washing machine. A human body needs some
stressors. And everything organic and complex communicates with the
environment via stressors.
reason: Is it kind of a fractal system?
Taleb: Exactly. It’s fractal because you have
layers. Like the restaurant business. It’s composed of restaurants.
And for the restaurant business to be robust—or perhaps
antifragile—you need every single restaurant to be fragile. It’s
the opposite of Nietzsche’s “What doesn’t kill me makes me
stronger.” What kills me makes others stronger.
(Interview continues below video.)

reason: Because they learn?
Taleb: They learn from your mistakes. You have
evolutionary forces where the individuals sacrifice for the
collective. It works within your biological system. You’re composed
of cells. If you harm some cells, your overall health will
reason: Most people would say when you have a
system and if there’s a contagion in it, if there’s a cancer in it,
if there’s some kind of stressor that starts taking over, it’s
going to spread to the whole system. This is what we hear about the
banking system, the financial crisis. You’re arguing that a robust
or an antifragile system is capable of seeing this part of the
system being cancered and learning from it.
Taleb: To cite the great Yogi Berra, a good
antifragile system is a system in which all mistakes are good
mistakes. And the bad system is one, again to paraphrase Yogi
Berra, where you tend to make the wrong mistakes. Let’s compare the
banking system to, say, transportation. Every plane crash makes the
next plane crash less likely and our transportation safer. Now,
with the banking system, [a failure] leads to increased probability
of failure of an entire system. That’s a bad system.
reason: What’s the best way to stop that so
you’re not allowing the problem to replicate throughout the
Taleb: What fragilizes an overall system? Three
things: One, centralization. Decentralization spreads mistakes,
makes smaller mistakes. Decentralization is where we converge with
libertarians. A second one is low debt. The third is skin in the
reason: Paul Krugman, one of your great friends
or nemeses, just recently wrote that these trillion-dollar deficits
don’t matter.
Taleb: All these economists, let’s put it this
way: Risk is not their thing.
Debt leads to fragility. We’ve discovered since the Babylonians
that debt has systemic consequences whereas equity doesn’t. Let’s
say that you have two brothers. One of them borrowed and they both
had predictions about the future—forecasts. One brother borrows.
The other issues equity. The one who borrows will go bust if he
makes a mistake. The one who issues equity will fluctuate but will
be able to survive a forecast error.
reason: But is it also true that the brother
with equity can never really have that big payday?
Taleb: For him! But overall the system is well
distributed. There’s an accounting equality. Debt traditionally has
blown up systems and has been very good for governments to wage
war. I’m not against credit. I’m against leverage.
reason: So you give me a loan and I say I’m
going to pay you back and that gives me the ability to get
something in the short run that will help me produce more in the
long run. That’s OK?
Taleb: Banking started [like this]: You’re
going to Aleppo, Syria, and Florence and you’re going to send me
some silk. You trust me, and my correspondent in Aleppo would pay
you the minute I get my silk—that kind of transaction. That’s
called letter of credit, where you have debt conditional on some
commercial transaction being completed. And it also allows people
to finance some inventory, provided the buyer is a committed buyer.
That kind of facilitation of commerce is how it all started—the
letter of credit—and it developed very well.
Before that we had debt in society and it led to blowups in
Babylon, and then they had to have debt jubilees. Then of course
the Hebrews also had debt jubilees. And of course, they say neither
a borrower nor a lender be. The Romans didn’t like debt. The Greeks
didn’t like debt, except for a few intellectuals. Intellectuals for
some reason, like Mr. Krugman, like debt.
Later on debt came back to Europe with the Reformation and it
was mostly to finance wars. The industrial revolution was not
financed by debt. California was not financed by debt; it was
financed by equity. So debt is not necessary. You can use it for
emergencies. Catholic societies—Aquinas was against debt and his
statements were stronger than the Islamic fatwa against debt.
We have learned through history that debt in the form of
leverage can blow things up. Debt fragilizes. Now what we have had
in this economy is a growth of debt mostly financed indirectly by
governments. Because if you blow up, we’re going to be behind
reason: So this is the problem of too big to
fail, which went from being a worry to being inscribed in official
Taleb: Exactly. When you’re a banker and you
have the upside but no downside, what are you going to do? Create
the maximum number of loans that don’t blow up often, and collect
your bonuses.
You’re paying for his downside. This, to me, is not capitalism.
It is a misunderstanding of basic rules. Skin in the game started
with Hammurabi, led later on to eye-for-eye, and led to the Golden
reason: You talk about decentralization. One of
the most fascinating things in the global economy in the last 50
years—you could argue over the past 1,000 years—is that in many
ways it’s becoming more and more decentralized. Certain types of
knowledge are more decentralized than ever before. Economies
compete in a way that they didn’t before; countries can no longer
force investors to keep their money in a particular currency, in a
particular geographic location. Even as we’re facing a global
crisis, is globalization generally a good thing?
Taleb: It is if you know how to handle it—if
you let firms fail.
There is something called the island effect. In nature,
an island will have a higher number of species per square meter
than a continent; it’s actually proportional to the square of the
area. We’ve lost the island effect. Now you have Google dominating
the whole planet. It’s not a problem. The thing is that if we stop
letting these firms fail when they become ill, they can get large
enough to dominate government. Now, computer firms I’m not worried
reason: Why aren’t you worried about computer
Taleb: Because it’s a competitive environment.
Google is a product of a competitive environment.
reason: So we can see the end of Google on the
Taleb: We can see the end of Google, and it
doesn’t make a difference. It makes no difference for you and I. If
Google fails tomorrow, there will be something else, don’t worry.
The government won’t save them. And I don’t think they’ll fail, for
that reason: They know the government won’t save them. But you can
have some centralization/concentration. That’s not the
The problem we have had in almost all Western countries is that
nominally they say they are decentralizing, but effectively they’ve
[given] more and more power to the central government. You want
decisions to be spread out. Government debt is a result of
centralization, and typically the cause of more centralization.
It’s a very bad circle.
reason: I suspect one of the reasons you are as
popular as you are is that in the United States it’s rare for an
intellectual, particularly one who is good at math, to also have
any sense that history has something to teach us. You decided at an
early age you were interested in becoming a philosopher. Talk about
that and how that linked into the work you’re doing.
Taleb: I wanted to be a philosopher from the
beginning, but there was civil war in Lebanon. I left. I came back
from France and I realized I had too many books to read. And I
loved reading but I hated to be given books to read because if
you’re bored with it you lose the option. I like the optionality of
switching to finding your own path rather than being in a
straitjacket of university.
Then I realized that I had better study something more
technical. I continued two lives, one technical and one
nontechnical. The technical led to options trading. And the option
trading led to a doctorate related to probability theory applied to
options, and in some obscure stuff.
reason: What is your goal as a public
Taleb: I don’t want to be a public figure.
After Black Swan, for the first six months, nine months,
one year, I was thinking it was nice to go to Davos. And then I
didn’t like it, so I came back home and became a private
reason: Why didn’t you like it?
Taleb: Too many empty suits. And also, what’s
my profession? It’s to write books. I only write articles to
explain some of the ideas of the books. I do technical papers and
books. And everything else I do is because a publisher wants me to
write op-eds.
reason: Let me put it differently: What are you
hoping that your ideas add to the public understanding of how a
good society would work better, and what kinds of mistake to
Taleb: It has already led to beautiful results.
With [U.K. Prime Minister] David Cameron, when I was contacted by
him and his administration, to go before, to help—I told him,
“Listen, I’m not a public intellectual, but we can talk about my
ideas through my books. I’m not going to write articles, and we’re
going to have a conversation.” It led to being demonized by
sections of the British public—who cares?—and as well as here. But
it had an effect.
I say people can pick up these ideas very quickly. My point is
to have a systematic approach to making decisions under incomplete
information and under incomplete understanding of things, and build
a society that doesn’t blow up if someone makes a mistake, which is
the same thing. Society seems to think I have unique attributes.
I’m not the first person to think of these matters. It’s just that
I’ve devoted my life to furthering the cause
reason: When you think about the future are you
optimistic? Are you pessimistic? Or is that the wrong way to
approach it?
Taleb: It’s the wrong way to view it. My view
of the future is you don’t have to be right, you have to have a
dominant strategy to act as if you were pessimistic. I don’t want
the pilot of the plane to be optimistic. But I want the flight
attendants to be extremely optimistic. So it’s functional. I don’t
believe in beliefs.
reason: You talk about how pilots who are too
comfortable with their knowledge—they’re bad pilots, the ones who
make the errors.
Taleb: Exactly. You have to have paranoid
pilots, stressed all the time. So technology, it weakens; the
[Federal Aviation Administration] figured out it makes flights less
But again I take a stance against knowledge. Knowledge isn’t
what runs society. Knowledge is largely a narrative that comes
after we do facts. There is so much we narrate and so much that we
do without the complete theory of things. This is my central
reason: Talk a bit more about capitalism. A lot
of people think that what’s great about capitalism is that it
creates incentives that lead to success. Actually capitalism in
your view is about decentralization, about creating disincentives
and failing early.
Taleb: Since Hammurabi we’ve had civilized
society, people living together. We’re only able to do that when
people are accountable for their mistakes.
reason: Where are the signal incidents of
decentralization that’s leading to better outcomes, broadly
speaking? Where do you see that either in the United States or in
the West or in particular pockets and subcultures?
Taleb: Take Switzerland as a culture, where
nobody can name the president easily but they can name the
president of France. This is a good society because you have a lot
of volatility—but at the local level, the lower level, micro level,
translating to macro level stability. So Switzerland is a
well-decentralized system.
The problem is size. As size gets larger you have some gains of
economies of scale, whatever it is. But you have some losses in
governance, in a lot of other things.
reason: The more homogenous you become the
easier it is to be wiped out.
Taleb: To make big mistakes and to be wiped
out; this is the island effect at work. What we have had in this
country is the progressive rise of central government.
Particularly, deficits are the work of central government.
[Scottish philosopher David] Hume figured it out. He said: Small
states and city-states, they love commerce. And large governments
love war. And that’s what justifies large government—war. There is
no justification for large government other than war. And they’re
not good at it.
reason: You say that you’re not a libertarian,
but a lot of this overlaps with what’s considered libertarianism.
So why aren’t you a libertarian?
Taleb: I’m a risk-based person. My
libertarianism would be not demotic libertarianism—the
philosophical libertarianism that freedom comes as a first good—so
much as I want errors to be multiplied.
reason: So it’s a kind of John Stuart Mill. You
like the idea of experiments in living.
Taleb: Exactly. Errors need to be multiplied.
That’s it. I’m more of a left-wing conservative, if you
reason: Ayn Rand called libertarians right-wing
Taleb: There you go. So left-wing
conservatives—that would map exactly. In a way, I’m
conservationist. I want to not break things that have been around
for a long time, things that have their own logic. [Successes] come
from tinkering, not from some radical transformation of things.
reason: It’s curious that you are so popular in
the business market, because business books will end each chapter
with bullets points about what this chapter was about.
Taleb: The minute I’m bored writing I stop.
Particularly with The Black Swan, [the idea was to] make
sure that no content of any section can be discovered without
surprising the reader somewhere. Textbooks bore you. Critics hate
it because they want to skim books. People who read will not hate
it. I’m an empiricist. If I sell 3 million copies of a book writing
in some way, I’m not going to be lectured about style. Of course
the critics come in and they tell you it’s a mess. The Black
sold more probably in a day than they sold in a
reason: But you’re not going to say that the
market is always right, and that 50 million Elvis fans can’t be
Taleb: No. My point is that someone who just
arrived in a limo does not take lectures on finance from someone
who just took the subway. That’s the idea. You can take ideas,
maybe, but you don’t take instructions about how to write a book.
So if you want to write a book, either take instructions from the
Harry Potter lady or take instructions from Seneca, who
survived 2,000 years. But definitely not from some academic at
Cambridge who sold 2,200 copies.
My idea of living is taking risks for causes. The more I do, the
more I feel good about myself.