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|Intro. [Recording date: April 26, 2010.] Between last visit and present conversation, it has been the "most interesting period of my life." Topic: new essay, epilogue to The Black Swan, in Europe will be a standalone book; post-mortem of sorts on events of the last two years. Crisis of 2008 was uninteresting to you--puts you in a small group. Most think it is landmark, negative. Learned more from stock market crash of 1987 than anything else. Outlier then, world more robust at the time, "it was still a much more significant event than the last crisis." We've had a lot more shocks in history, except it happens that memory is short, for reasons related to education. Professors don't have the incentive to focus on the techne; they focus on the epistome. They don't focus on the "know how"--they focus on the "know what." History is an accumulation of small stories and tricks you can't compress into an equation. This crisis taught me nothing except as a simple test case: built the argument, but we've known about fragility. The new essay is called "On Robustness and Fragility"--we've known the topic since the Babylonians. Slightly long time. Debt fragilizes systems. We've known since the Babylonians; forgotten; the Romans had to relearn it, waging wars to satisfy debt obligations. Entire package of things you don't do and have negative advice, categorical; because heuristics. Anyone who has a grandmother knows about the ills of debt--makes you fragile, makes you a slave, debt is not healthy for an economic system. You need to have the opposite, redundance, to make your life more stable. Any grandmother would have taught you that from experiences of crisis of 1929. Yet we had Modigliani-Miller, optimization in economics, post-Samuelson era. optimizing economics, take a very reduced class of things and they optimize, makes you more fragile under perturbations. Can't teach robustness because it is too complex for them; can teach you simple tricks, really fragilized. Simple tricks: have debt to optimize, seems to be optimal. In Shakespeare's Hamlet, also: Polonius's advice to Laertes: "Neither a borrower nor a lender be." Going back to Septuagint. Mediterranean religions had either an explicit or implicit ban on debt. Jewish religion did away with the ban later on. Made it easier. Under Judaism, interest to a fellow Jew was frowned on. There were ways put in place to get around that, but the prohibition initially certainly discouraged borrowing and lending. Others had the same, copied, continuation of the Jewish religion. The Arabs had the same ban on that. When you lend to someone, it had to be humiliating for the person, an acceptance of defeat by not letting him pay interest. So the person, not being able to pay interest, is forced to accept a failing somewhere. Very surprised that all these economic textbooks, all these studies and behavioral finance, and behavioral biases, nobody gave a thought to the idea that overconfidence translates 1-1 into accumulation of debt. Someone who knows the future won't necessarily borrow. What's the point? I know I'm going to make an 8% return, and if I underestimate my error rate I will know with certainty I'm going to make an 8% return, so if I borrow at 5% I can leverage up the wazoo. Plus, salary going up. Permanent income hypothesis, Milton Friedman. Same for government. Vastly more optimal than diluting your returns. French government has had deficit now for 39 years. Won't stop any time soon. No government intends to have a permanent deficit, but they keep having deficits, and also inflation. The projections are usually marred with over-confidence. They have all these economists who produce forecasts, like the IMF. Greece has at least a 13% debt to GDP; they forecast 3%. Forecasting maps one0-to-one with debt. The more you have forecasting, the more you are going to have debt. The Congressional Budget Office (CBO) projected that in 2016, Social Security revenue from the payroll tax would for the first time be less than the money going out the door to retirees. Unfortunately, that occurred this year. They were only off by 6 years. This was a surprise to them. Went to D.C. for a lecture in 2006; told them they should get another job. I want to live in a society where human error doesn't penalize the multitude. This is my mission for the rest of my life: figure out how to build a society in which people can make mistakes that are inconsequential. Want to encourage small mistakes, a discovery; an option. At the same time, large mistakes are crippling.
|Explained in essay we have two things going on: the problem of forecasting has increased dramatically over the past 25 years because random variables became a lot more fat-tailed thanks to the Internet. Why? Complexification: when you have interdependence, you no longer reach the Central Limit. When I start buying a certain movie in NY in response to people buying that moving in Spain, I am no longer independent. Variables become a lot more fat-tailed--prone to extreme events. We've had that arising since the Internet. Third part of The Black Swan--we are moving into an environment, the randomness becoming freer of natural constraints. Fat tails, except for Gray Swans. We've had that complexification of the world arising continuously, while at the same time having more fragility, through either optimization or more government role, but mostly debt. The rise of debt has been monstrous. That makes forecasting difficult. Talk a little more about the reaction you get when you tell people not to forecast. Some would say, "Better to have some map than no map"; you point out that's not true at all. In Atlanta, flying to NY; announcement that pilot is flying to NY but can't find a map of NY; going to use the map of the Chicago airport. You would get off the plane and cancel your flight. Against portfolio theory, so give us something else. There is nothing else. Small probabilities are not measurable empirically. People got offended. Built four quadrants: map of where your errors are not consequential and where conventional statistics and forecasting work. If you tell people that this is where your techniques work; and this little corner where they don't work--people are going to be very friendly. You tell them how smart they are. Instead of telling people it's 30% fat, you tell them it's 70% fat-free. Reframing the problem. The fourth quadrant--cannot afford to use the wrong map because it could crash the plane. All the mistakes we've had from forecasting come from the fourth quadrant. In the fourth quadrant, you need something else: Robustness. I want to live in a more robust society; the first thing I've got to do is get rid of extra problems because they make the society more fragile. Recently in Korea, gentleman from the IMF; on a panel, sitting next to an economist who likes deficits--deficits necessary because we need to get out of the crisis. Don't know history. We're going to bail out Greece, and then we'll get bailed out by Mars. Gentleman from the IMF stood up and gave a 2-3 minute forecast for 2010-2014. Anyone in the room listening to the forecast without asking what his forecasts for 2008-2009 were in 2001-2007 needs to go up again. Want a society where a gentleman like him can be as incompetent as he wants without it harming innocent people.
|Know we have a deep belief that, okay, so I didn't do a good job in 2003 predicting 2008, but now I have more data. The whole essence of the econometric priesthood is the idea that the bigger the sample, the more reliable the forecast. Flaw: we don't have any more data because the process that created the additional data is different from before. It's an illusion that we have more data. The natural answer should be that what we have is more fat tails, because the process that generates the new data is causing more unreliability because of the fat tails. Not against forecasting; just make sure you don't have small errors that are destroying the whole thing. Glimpse of what things we can forecast: Tomorrow, looking out the window, see a cloud. Can forecast the rain. Rain forecasting is not in the complex domain. Up to a point. Up to one or two days, mechanical. See a truck rolling down a hill, know where it's going to head. Not really forecasting--it's projection, extrapolation, very simple. Climate, completely different matter because of nonlinearities. Very good at knowing June, July, and August will be warmer than November, December, and January. Almost always right. Clouds from satellites. A company can forecast its inventory in the very short term. As you go out, the error becomes monstrous. Explained in The Black Swan with billiard ball. Forecasting ten years down the road has an error rate several billion times the error rate for a five-day forecast. No company tries to project its inventory 25 years from now because they know it's a waste of time. The question is whether it's a waste of time six months from now. What's worth forecasting and what isn't; what do you need to insulate yourself from? Point in the essay, and underlying point in the book--you need some redundancy. Since you know your errors are going to grow over time, and since you know that your ability to predict the future is imperfect, you want to create some redundancy. Some sort of backstop other than the taxpayer to take care of the future. Government deficits. I have personal redundancy--I spend less than I earn; I have a big buffer, probably not enough, maybe huge in other people's eyes. Government should shoot for positive net revenues--a surplus--so they don't get too big a deficit. All this is good, but biggest mystery is that it's obvious. How can people still listen to the Number 2 man from the IMF talking about his forecast in the future when he never got anything right in the past?
|Find it strange that in the aftermath of the crisis, the demand for my services has never been higher; true of the economics profession in general. Some would argue it's better to have a map of Chicago, better than no map at all, even if you are going to fly to New York. If you want to figure out what's going on in the economy, better to ask an economist than electrician--but that's not necessarily true. People use astrologers all the time and it's not hurting anyone. Alternative medicine, lowers your anxiety. Just want to build a society in which forecasts are not taken seriously. Example: you need an option, insurance--two lungs, two kidneys. Economists: you need one central kidney and people would borrow it--that would be more efficient. Only family-owned companies really survive in the long run. Look at Mother Nature. Redundancies; no debt. Debt is the opposite of redundancy. I have $100 in capital; I hide $80, barbell strategy in The Black Swan; banker would borrow $3000 and take a huge amount of risk.
|Appeal of the debt issue. You talk about the role of leverage, debt--seductive but leaves you vulnerable to collapse. That's the Kahneman view; but Vernon Smith, co-winner of the Nobel Prize that year has an alternative view. He accepts everything in the behavioral economics world, or much of it; people make mistakes, they misestimates, but markets punish people for making those mistakes. We've stopped punishing people; stopped the feedback loops that would encourage people to learn from the dangers of debt. Is it just human nature or is it also some public policy errors? Don't think that human biases are harmful in the natural environment. They exist. Governments provide a non-natural environment. Not many do-overs in nature. Evolution doesn't give people a second chance. Survived this crisis, have higher tax bill; those who lost money in this crisis have a bigger tax break. Obama, Cash for Clunkers program, give $3000 to those who buy a car; those who don't buy a car pay for it. Large corporation eventually dictate to the states what they way. "I have 300,000 employees!" The last thing I want to hear is someone trying to hijack the state because they hire so many people. That's an argument against giving you money--you've misused the resources that you were entrusted with. Now it's time to let someone else hire those 300,000 people, who could use them more effectively. Big guy enters into collusion with the state automatically, at least in America. The worst thing we've had here is that moral hazard--people started attacking my point that small probabilities, people take a lot of risk by small probabilities, by saying the market knows how to price them. But the market does not know how to price them and there is a huge amount of moral hazard. A company making $200 million blows up and the hair dresser pays for it subsequently. The model showed no risk. The state has been tampering with the functioning of the system. If the state wasn't there, large companies would self-destroy. The ones that would survive would be the small, robust units. Or the large ones would be more cautious because they've learned something. Disproportionately more fragile to unseen shocks. Example: French company, Société Générale, rogue trader with $50 million dollars hidden in the drawer; had to liquidate that one right away. Costs a lot more per unit to liquidate $50 million dollars than $500 dollars. When you concentrate companies, squeezes are more costly to the company. Dinosaurs had to go first--more efficient to be large but unseen shocks are going to hit you harder. Large companies, large states are disproportionately more fragile. Want the nation to destroy the car companies early on so that I don't have to pay for more bonuses; same with banks. Should have been destroyed in 1982-1983, survived with help of the government. We don't live in a natural environment where these biases are harmless; the biases get compounded under the state. Société Générale: they were the Number 1 creditor of AIG. When the government bailed out AIG in September of 2008--the Number 2 creditor was Goldman Sachs; they were owed $14 billion by AIG;--Société Générale was owed more than $14 billion. But we insured! They insured with an insurer not capable of carrying out its obligations--rated Triple-A--but the government kept their promises anyway.
|The banking system; regulation is what got us here. Regulators encouraged banks to take hidden risks, less visible risk. Banks have a vested interest in growing and in going bankrupt. Vested interest to create debt instruments. If you just let the banks destroy themselves--why should your grandchildren pay the price through deficits when one adult lent to another adult--then things will get definancialized automatically. The role of financial institutions will be reduced organically, not through some measures that are going to make lawyers rich. Lawyers' business comes from regulation. A year and a half after the crisis started, we are worse off because all the ills are compounded. Larger financial institutions; larger state roles; more deficits; more susceptibility to forecasting; more dependence on economists who never got anything right in the past. Fear hyperinflation. All these people think they understand monetary policy. Quote from paper: "I tried to explain the problems... Government should not be given toys they do not understand." Fear that we are going to have a deflation and the remedy is going to be worse.
|One of simple but deep ideas in the essay is that true/false is not what matters. What we care about is the expected outcome. It's easy to say we are going to get inflation. A little is not so bad--not good, but not so bad. A hyperinflation can destroy society. Too many of our models are about the probability of x or y, but it's the consequences of x or y that matter. Did four things: tried to channel ideas into four disciplines. Econometrics, statistics, fourth-quadrant approach; second, distinction between know what and know how, Polanyi, Hayek, people we don't hear about, from Wittgenstein to Burke to Oakshott; third, robustness; fourth, epistemology. True-false doesn't count in your daily life except in maybe the first quadrant. No decisions are based on true/false. People say "Do you have evidence of that?" Do you have evidence that the gentleman is a terrorist? No. So why are you searching him? Small probability, but the consequences of his being a terrorist are humongous. Like looking at the world in 2 dimensions, 2-D, when the world has 3 dimensions. A lot of logic that has been studied in both mathematics and philosophy is so incomplete as to be unusable. Russ: Where I'm sympathetic to behavior economics, behavioral finance--we don't seem to be very good at that 3-dimensional thing. Our brains really struggle to deal with the third dimension and the consequences. Taleb: We're not that bad. Dread risk: we are wired for some classes of risk avoidance; overestimate the odds because you see something on television. We have a mechanism to take account, but we don't live in the right habitat for that. Goes haywire, makes us overestimate some events at the expense of others. People are afraid of sharks in San Diego. Dread risk has served us well. Paranoia has a survival advantage. Is that why we find economists so appealing--someone has a model, someone has a theory? When you are sick you like to use a doctor. For a long time, seeing a doctor was not a good thing--increased your chance of death. Hospitalization was very bad for you, quadrupled the chance of death. Next book, Tinkering, studying that problem. In medicine, always better to do something rather than do nothing. We have had that bias for acts of commission, not acts of omission. Very hard for people to say we don't know what works so we'll just do nothing. Unless you frame it by saying this is how Mother Nature does things automatically. Broke nose recently, running on rocks; ice it. Mother Nature doesn't ice things, wants nose to swell for a reason. Looked at it and there is absolutely no evidence that icing is good for you. Good for the ice makers. Statisticians: well, you have n of 1. The n of nature is the largest n you can get. Need to live close to the natural state. That's the thinking of Burke, Polanyi; Hayek to a lesser extent. Not a conservative--a conservationist. Want to follow Mother Nature in the fourth quadrant, want a state that doesn't blow up.
|Medicine. Human body is a complex system, akin to an economy; prone to unintended consequences when we intervene and meddle; complementarities and nonlinearities--yet we've gotten better in healing the human body. It's better now to go to a hospital than to not go. Not suggesting we should let Mother Nature take its course if you get cancer or rip open an artery--Mother Nature is going to let you die. We don't live in a natural habitat. What Mother Nature is good at correcting is helping us live in spite of civilization. Technology makes us live longer but punishes us by making us sicker. We've been eating things very unnatural to us. Aristotle. We've never understood the human body; but we have had some breakthroughs in making people live longer through drop in the crime rate. Russ: Better nutrition in childhood. Taleb: Nutrition was actually better before agriculture. Penicillin. Harm done by the healer, like bleeding--bad track record of medicine. People tell you to eat three meals a day; no animal eats to work out. You hunt to eat. Empirically people are healthier when they go through periods of starvation. Chapter in The Black Swan about distributions in nature--just like the economies that let companies go bust, which robustifies the others; should not never eliminate stressors. We have had a reduction in stressors; very risky. We are weaker than our ancestors. Antibiotics. Look at the distribution of energy to expenditure for a hunter-gatherer. Starve; active while starving. Get their food in a feast or famine way; not steady, not a bell curve. You kill a large animal, big inflow of protein; then nothing at all for a while. Spent three to four years reading on states of nature for health or other things. Humans use their own rationalism to make laws. For example, that you get healthier jogging--but you don't get healthier jogging because it is on smooth surfaces. Art De Vany podcast was greeted with a lot of skepticism by the listening audience. You've been trying to implement some of these ideas for yourself. How's it going? Between the first conversation and this one, about 25 pounds of adipose tissue. Smaller excess weight. More fitness. Brain works better. Started walking about 20 hours a week. Strolling, not power walk. Needs to be effortless. Wrote in 2-3 weeks 100 pages. Stressing self now and then. Sprint once in a while, but no jogging. Run on rocks--black swan, can break your nose. Makes you aware. Try to avoid smooth surfaces, gyms. Art De Vany uses a gym. Unnatural to lift weights unless you have an emotional drive to do so. Lift heavy weights; keep them over my head; seen some literature on it; don't use machines. Wife's version: You should sprint with a dead deer on your shoulders, or at least carry it home. Don't have the emotional trigger when you go to a gym. Lack that. Olympic weightlifting. Seen significant difference. Hope it's not confirmation bias. Back to Mother Nature. Footnote: using an n that's monstrous. Human knowledge is too limited. Know what, know how: Mother Nature know how; humans try to know what. Doesn't work very well in nonlinear domains. We've exhausted the linear domains. Of course government can put a man on the moon; but we know nothing about volcanoes. They do what they can, not what they need to.
|Next book, Tinkering: what about tinkering are you thinking about? Looking at convexity; part of the robustness. All the same idea. Confessed before starting the conversation--rare confession from a public intellectual--said you had only one idea. Shouldn't say that, even privately! Takes maybe 30, 40, 50 years to get even one idea. Mandelbrot was in his 60s or 70s when he figured out what his idea was, reverse smoothness. Write about the same thing, but each time it is a different application. The black swan is not the central idea. The central idea is convexity. Convexity is when you lose a penny to make a dollar; when being wrong doesn't cost you as much as being right. Jensen's inequality: an average of expectations is not the expectation of the average. In lay terms: convexity is knowing where the lack of knowledge is going to lead you. In other words, an option is a convex instrument. Russ: Teasing you about having only one idea. Part of economics I love dearly is how simple ideas can be very deep. Think you understand something, ten years pass; realize you didn't really understand it. Takes a lifetime. Taleb: First book was on dynamic hedging; technical; for a long time nobody could understand it. Financial model, want to know if you are missing a variable, what impact that has on the forecast. If Black-Scholes option formula misses a stochastic variable, what will it do? Some options, small probabilities, gain in price. Came from convexity. Now looking at the application of convexity. Relationship to Ed Leamer's work: "Let's Take the Con Out of Econometrics." Essential idea: When we see a published paper and there are 27 variables on the left and one on the right-hand side, we don't know how many permutations the author went through to get that final specification. There could be variables missing; could be variables in there that don't belong; could be variables on which we don't have data, which is a whole separate problem. What Leamer recommends is looking at the range and sensitivity of the coefficients when we look at all the variations. Looking at second-order effects; know something's got to be missing. When I buy an option--did that for 20 years of my life--discovering now how to formulate it. Reasoning: if I'm wrong on the model, the cost is close to zero. If I'm right, I have a second-order effect. I have an option on being wrong on the models. Someone tells you an event has zero probability. If he's not certain, you already have a paradox. If it has a zero probability, or if he's estimating zero probability, it means he is estimating around zero. Necessarily, all kind of uncertainty he has would raise it from zero, because the probability cannot be negative. That's convexity. Close to zero, practically zero. Generalize: whenever some people estimate something--sales of a company for 25 years--if you stochasticize that number you are going to see the value of the company may rise dramatically. Second-order effect: higher than zero in expectations. Reasoning about 25 years ago; center of book 20 years ago. Know the model is not perfect; when a pilot is flying a plane, you know what it is going to do to you--not going to be good. Concave, reverse of convex. Errors in pricing an option usually help you.
|Where will it take you next? Black swan model. Hyperinflation trader. Know there is some error, but will pick up monstrously, in a disproportionate way, if there is hyperinflation. Evolution works because it's a free option; it's convex. Mother Nature knows it cannot produce a perfect baby; goes through a lot of trial and error. Often the mother doesn't if know, if there was a spontaneous abortion. Growth of knowledge. Libertarians. Government funding of research has led nowhere; we had the data. Book, trying to find places where government funding of knowledge has helped. Do the opposite. It's not science-technology-business; it's business-technology-science. How much do we spend on the war on cancer for how much we gain, versus how much we spend versus the gains from the outside. Pretty black and white? Confirmatory thing: universities are much better at public relations. Not saying business-technology-science is 100%. Myth is that basic research won't be done by individuals; have to have government sponsorship. Silly argument. Industrial revolution by businessmen. Medicine is obvious; heuristic science, not top down. During industrial revolution, Germany was top down and was copying England. Always have to read the opposite; attacks of black swan idea. Same concept as Fooled by Randomness--people underestimate the amount of luck--people overestimate the amount of skills. Convex luck: trial and error, costs very little; exploiting the option of nature. We are a lot better at doing outside the box than thinking outside the box. The appeal and the seductiveness of experts is also the appeal of design rather than trial and error. Politically there is a deep appeal to plans and top-down design rather than trial and error. We are humans; if you want to have a shaman, just have to make sure it is not increasing black swan risks, not in a position to be fragilized from it. Backwards, to American Medical Association; look at the food pyramid today and listen to my talk ten years from now. We know from De Vany and from the data--they want you to eat carbs and they don't want you to eat saturated fat; but a lot of the diseases that they say come from fats come from carbs. Making us sicker and charging us for their services. Multicollinearity--some things go together and make it hard to figure out which one is responsible; can make a mistake and think it's the wrong one. Controlled experiments.
|Fame and fortune that have come your way: talk in essay about being threatened to be surrounded by phonies. Became allergic to politicians. Have not been corrupted so far; remind me if you see it. Makes me feel that I have a mission and I should continue saying things the way they are. Walked out on people. Delegation to the White House; looked around and walked out because of other people there. Trying to not be corrupted. Nothing is permanent--except what you think is temporary.