Too Big To Fail

Nassim Taleb and Charles Tapiero has penned down a new technical article "Too Big to Fail, Too Big to Bear". I am reproducing the article here:

Electronic copy available at: http://ssrn.com/abstract=1497973
Center for Risk Engineering, New York University Polytechnic Institute Page 1
Too Big to Fail, Too Big to Bear,
and Risk Externalities
Nassim N. Taleb*
Charles S. Tapiero*
Abstract
This paper examines the risk externalities stemming from the size of institutions. The problem of
excessive risk taking and their potential external consequences are taken as a case example. Assuming
(conservatively) that a firm risk exposure is limited to its capital while its external (and random) losses
are unbounded we establish a condition for a firm to be too big to fail. In particular, expected risk
externalities’ losses conditions for positive first and second derivatives with respect to the firm capital are
derived. Examples and analytical results are obtained based on firms’ random effects on their external
losses (their risk externalities) and policy implications are drawn that assess both the effects of “too big to
fail firms” and their regulation.
Key words: Risk, Externalities, Economies of Scale
• Department of Finance and Risk Engineering, New York University Polytechnic Institute, The
Research Center for Risk Engineering, New York and Brooklyn.

Electronic copy available at: http://ssrn.com/abstract=1497973
Center for Risk Engineering, New York University Polytechnic Institute Page 2
1. Introduction
“Too Big to Fail” is a dilemma that has plagued economists, policy makers and the public at large. The
lure for “size” embedded in “economies of scale” and Adam Smith factories have important risk
consequences that have not always been assessed or properly defined. Economies of scales underlie the
growth of industrial and financial firms ([6]) to sizes that may be both too large to manage and losses too
large to bear. This is the case for industrial giants such as GM that have grown into a complex and
diversified global enterprise with extremely large failure risk externalities. This is also the case for large
banks that bear risks with systemic consequences that are often ignored and too big to bear. Banks, unlike
industrial firms, draw their legal rights from a common trust, to manage the supply and the management
of money for their own and the common good. Their failure, overflowing into the “Commons”, may thus
far outstrip their internal and direct losses. The losses borne by the “Commons” can be an appreciable
risk externality that banks do not assume. Further, when banks are perceived too big to fail, they may
have a propensity to assume excessive risks to profit in the short term; they may seek to exercise unduly
their market power; rule the “Commons” and price their services unrelated to their costs or quality.
Size may lead such firms to assume leverage risks that are unsustainable. This is the case when banks’
bonuses are indexed to short term performance, at the expense of sustainable performance hard to
quantify risk externalities. Externality is then an expression of market failure. For banks that are too big
to fail, these risk externalities are acute. For example, Frank Rich (The New York Times, Goldman Can
Spare You a Dime, October 18, 2009) has called attention to the fact that “Wall Street, not Main Street,
still rules Washington”. Similarly, Rolfe Winkler (Reuters) pointed out that “Main Street still owns much
of the risk while Wall Street gets all the profits”. Further, a recent study by the National Academy of
Sciences has pointed out to extremely large hidden costs to the energy industry—costs that are not
accounted for by the energy industry, but assumed by the public at large.
Banks and Central Banks rather than Governments, are entrusted to manage responsibly the monetary
policy—not to be used for their own and selfish needs, not to rule the “Commons”, but to the betterment
of society and the supply of the credit needed for a proper functioning of financial markets. A violation
of this trust has contributed to a financial meltdown and to the large consequences borne by the public at
large. In this case, “too big to fail banks” have contributed to an immense negative externality—costs
experienced by the public at large. In this sense, markets with appreciable negative externalities are no
longer efficient, even if we have perfect competition (i.e. complete financial markets). If a firm’s
negative externalities are not compensated by their positive externalities or appropriately regulated, then
their social risks can be substantial. In a recent New York Times article (Sunday Business, section,
October 4, 2009), Gretchen Morgension, referring to a research paper of Dean Baker and Travis
McArthur, indicated the effects of selective failures, letting selected banks grow larger and “subsidized”
at a cost of over 34 Billion dollars yearly over an appreciable amount of time.
Size is no cure to the failure of firms. For example, Fujiara [4], using an exhaustive list of Japanese
bankruptcy data in 1997 (see [2],[3],[5],[8],[10]) has pointed out to firms failure regardless of their size.
Further, since the growth of firms has been fed by debt, the risk borne by large firms seems to have
increased significantly—threatening both the creditor and the borrower. In fact, the growth of size
through a growth of indebtedness combined with “too big to fail” risk attitudes has ushered, has
contributed to a moral hazard risk, with firms assuming non-sustainable growth strategies on the one hand

Center for Risk Engineering, New York University Polytechnic Institute Page 3
and important risk externalities on the other. Furthermore, when size is based on intensely networked
firm (such as large “supply chains”) supply chain risks (see also [15], [16] and [7]) may contribute as well
to the costs of maintaining such industrial and financial organizations. Saito [11] for example, while
examining inter-firm networks noted that larger firms tend to have more inter-firms relationships than
smaller ones and are therefore more dependent, augmenting their risks. In particular, they point out that
Toyota purchases intermediate products and raw materials from a large number of firms; maintaining
close relationships with numerous commercial and investment banks; with a concurrent organization
based on a large number of affiliated firms. Such networks have augmented both dependence and supply
chains risks. Such dependence is particularly acute when one supplier may control a critical part needed
for the proper function of the whole firm. For example, a small plant in Normandie (France) with no
more than a hundred employees could strike out the whole Renault complex. By the same token, a small
number of traders at AIG could bring such a “too big to fail” firm to a bankrupt state. This networking
growth is thus both a result and a condition for the growth to sizeable firms of scale free characteristic
(see also [3],[5]). Simulation experiments to that effect were conducted by Alexsiejuk and Holyst [1]
while constructing a simple model of bank bankruptcies using percolation theory on a network of
cooperating banks (see also [12] on percolation theory). Their simulation have shown that sudden
withdrawals from a bank can have dramatic effects on the bank stability and may force a bank into
bankruptcy in a short time if it does not receive assistance from other banks.
More importantly however, the bankruptcy of a simple bank can start a contagious failure of banks
concluded by a systemic financial failure. As a result, too big to fail and its many associated moral
hazard and risk externalities is a presumption that while driving current financial policy and protecting
some financial and industrial conglomerates (with other entities facing the test of the market on their own
and subsidizing such a policy), can be extremely risky for the public at large.
Size for such large entities thus matters as it provides a safety net and a guarantee by public authorities
that whatever their policy, their survivability is assured at the expense of public funding. The strategic
pursuit of economies of scales can therefore be misleading, based on fallacies that negate the risks of size,
do not account for latent and dependent risks, their moral hazard and significant risk externalities.
The essential question is therefore can economies of scale savings compensate their risks. Such an issue
has been implicitly recognized by Obama’s administration proposals in Congressional committees
calling for banks to hold more capital with which to absorb losses. The bigger the bank, the higher the
capital requirement should be (New York Times, July, 27, 2009, Editorial). However such regulation
does not protect the “commons” from the risk externalities that banks create and the common sustains.
To assess the effects of size and their risk externalities, this paper considers a particular and simple case
based on a firm risk exposure which can lead to a firm’s demise (its capital) and unbounded external
losses for which they assume no consequence. An example is used to demonstrate that such risk exposure
underlying excessive risk taking (motivated by the lure for short term profits) can have accelerating losses
the larger the bank.

Center for Risk Engineering, New York University Polytechnic Institute Page 4
2. Too Big Too Fail and Its Risk Externality.
Given the nature of a speculative position, we assume that the positions has a potential loss probability
distribution bounded above by the firm aggregate capital (its size, consisting of its equity and debt
holdings) or . In some cases, the speculative exposure of trades may be larger
than a firm’s capital. Further, a bank’s loss can have a repercussion on other external losses—the larger
the bank’s loss, the larger the potential external loss. Given a firm’s loss, we let its total loss, including
external losses be given by . As a result, the joint probability distribution of
global financial and firm losses is . A loss resulting
from a firm random exposure of its capital W has thus probability and cumulative distributions:
The effects of size on the aggregate loss are thus a compounded function of the probabilities of losses of
the firm and their external costs. If a firm has a loss whose external consequences (the loss y are
extremely large), then they may be deemed to be “too big to fail” as the negative externalities of its failure
may be too big to bear. In this context, the risks of “too big to fail” firms are similar to “polluters”, the
the greater their risk externalities, the greater their pollution.
The example we consider below assumes a Pareto probability distribution ([9]) for losses conditional on
the bank’s loss. Conditional external losses are bounded below by the bank loss (its capital) and
unbounded above. While, aggregate losses are a mixture probability distribution of the aggregate external
losses. These assumptions result in a fractional hazard rate model bounded by the bank’s capital.
Internal risk exposure (the banks’ capital at risk) is assumed to have an extreme truncated probability to
account for its finite capital at risk. In particular we use a truncated Weibull probability distribution.
Our approach differs from the Copula approach that models co-dependence of losses by the marginal
distribution of each distribution. It also differs from a generalization of the Pareto distribution (or other
probability distributions) that accounts for a potential correlation between the firm and its external losses.
Both such approaches are not be applicable in our case as external losses depend necessarily on the firm
losses but not vice versa. In other words, we assume that external losses are not causal to a bank’s loss
but a bank’s loss is causal to external losses borne by the public at large.
Further, while an inter-temporal framework based on Levy-Wiener processes and fractal diffusion models
can be considered as well, its use is not essential to prove the essential results of this paper. Such an
extension will be considered in a subsequent paper however. The case considered is thus selected for
simplicity and to highlight the effects of a bank’s potential capital loss on its external losses.
Explicitly, let the conditional loss Pareto distribution be:
The loss distribution parameter may be interpreted as the expected loss multiplier “odds” effect for a
given (risk exposure) loss by the bank. The expected external loss is thus . The larger the
“odds” the larger its the risk externalities. For example if a firm loss of 7 Billion dollars has an external
loss of 65 Billion dollars, its parameter is or and .
By the same token since,

Center for Risk Engineering, New York University Polytechnic Institute Page 5
The expected externality multiplier odds effect odds can be further scored and assessed by a logit
distribution. Explicitly, say that:
Then: and with a score defined as a function of both the loss and
economic environmental conditions. A bank whose internal loss is its capital, contribute then to an
expected loss of:
Where is a “Too Big To Bear” index, the larger the index, the larger the external losses and the more
a bank is “too big to fail”. In other words, letting a total capital loss of of 50 Billion dollars, the failure of
the bank’s loss is
Billion dollars.
The unconditional loss probability distribution is then:
The probability of a loss greater than Y and its hazard rate are therefore,
and
If a firm’s expected external loss is then and if it is too big to fail
then . In this case, the external risks of “size” are nonlinear, growing infinitely as the
bank’s size increases.
For demonstration purposes, say that the probability distribution is a constrained extreme
(Weibull) distribution defined by,
The loss probability distribution and its cumulative distribution function are then:
With expected losses:

Center for Risk Engineering, New York University Polytechnic Institute Page 6
The effects of the firm capital size on the expected losses are thus:
The second derivative leads to:
or
Since
The condition for a positive second derivative is:
These conditions establish therefore the conditions for an accelerating loss the larger the firm—a loss that
may be far larger than the firm capital loss.

Center for Risk Engineering, New York University Polytechnic Institute Page 7
Conclusion
The purpose of this paper is to indicate that size matters and its risk externalities may be too big to bear—
in which case firm may be too big to fail. Such firms are “polluters” either by design when they overleverage
their financial bets or speculative positions and are struck by a Black Swan [13], [14]. While
capital set aside (such as VaR—V alue at Risk) may be used to protect their internal losses, such
approaches are oblivious to the far morte important risk extrnalities. For this reason, such firms require
far greater attention and far more regulation. Internalizing risk externalities by ever larger firms is in such
cases inappropriate since the moral hazard and the market power resulting from such sizes will be too
great. Similarly, total controls, total regulation, taxation, nationalization etc. are also a poor answer to
deal with risk externalities. Such actions may stifle financial innovation and technology and create
disincentives to an efficicent allocation of money. Coase observed that a key feature of externalities are
not simply the result of one CEO or Bank, but the result of combined actions of two or more parties. In
the financial sector, there are two predominant parties, Banks that are “too big to fail” and the
Government—a stand in for the public. Banks are entrusted rights granted by the Government and
therefore any violation of the trust (and not only a loss by the bank) would justify either the removal of
this trust or a takeover of the bank. A bargaining over externalities would, economically lead to Pareto
efficient solutions provided that banking and public rights are fully transparent. However, the nontransparent
bonuses that CEOs of large banks apply to themselves while not a factor in banks failure is a
violation of the trust signaled by the incentives that banks have created to maintain the payments they
distribute to themselves. For these reasons, too big too fail banks may entail too large too bear risk
externalities. The result we have obtained indicate that this is a fact when banks internal risks have an
extreme probability distribution (as this is often the case in VaR studies) and when external risks are an
unbounded Pareto distribution.
References:
[1] A Aleksiejuk, J.A.Holyst, A simple model of bank bankruptcies, Physica A, 299, 2001, 198-204
[2] L.A.N. Amaral, S.V. Bulkdyrev, S.V. Havlin, H. Leschron, P. Mass, M.A. Salinger, H.E. Stanley,
M.H.R. Stanley , J. Phys I, France, 1997, 621.
[3] J.P. Bouchaud, M. Potters, Theory of Financial Risks and Derivatives Pricing, From Statistical
Physics to Risk Management, 2nd Ed., , 2003, Cambridge University Press.
[4] Y. Fujiwara, Zipf law in firms bankruptcy, Physica A, 337, 2004, 219-230

Center for Risk Engineering, New York University Polytechnic Institute Page 8
[5] D. Garlaschelli, S. Battiston, M. Castri, VDP Servedio, G.Caldarelli, The scale free nature of market
investment network, Physica A, 350, 2005, 491-499
[6] Y. Ijiri, H.A. Simon, Skew distributions and the size of business firms, North Holland, New York,
1977
[7] Konstantin Kogan and Charles S. Tapiero, Supply Chain Games: Operations Management and Risk
Valuation, Springer Verlag, Series in Operations Research and Management Science, (Frederick Hillier
Editor), 2007
[8] K. Okuyama, M. Takayasu, H. Takayasu, Zipf’ss Law in income distribution of companies, Physica
A, 269, 1999, 125-131
[9] V. Pareto, Le cours d’Economie Politique, Macmillan, London, 1896
[10] M.H.R. Stanley, L.A.N. Amaral, S.V. Bulkdyrev, S.V. Havlin, H. Leschron, P. Mass, M.A. Salinger,
H.E. Stanley, Nature, 397, 1996, 804
[11] Y.U. Saito, T. Watanabe and M. Iwamura, Do larger firms have more interfirm relationships,
Physica A, 383, 2007, 158-163,
[12] D. Stauffer, Introduction to Percolation Theory, Taylor and Francis, London and Philadelphia, A,
1985.
[13] N.N. Taleb, The Black Swan: The Impact of the Highly Improbable, Random House, New York and
Penguin Books, London 2008
[14] NN. Taleb, Errors, Robustness, and The Fourth Quadrant, Forthcoming, International Journal of
Forecasting, 2009
[15] C.S. Tapiero, Consumers risk and quality control in a collaborative supply chain, European Journal
of Operations Research, 182, 683–694, 2007
[16] Tapiero, C. S., Risk Finance and Financial Engineering (tentative title), Wiley, 2010, (Forthcoming,
2 volumes)

Nassim Taleb Video: Says cause of crisis is because people are not rational

Nassim On CNBC- Air date June 10, 2009

The Black Swan Recommended by Ilya Bogard

Here is an Excerpt from Ilya Bogard's "Lessons In Leadership: How to Instigate and Manage Change", published in Tech Republic.


"The most basic requirement for the success of a change you’re making is that it’s real and is interpreted correctly. This is not only because the change may fail, but because what good is an impeccably executed project if it accomplishes exactly what you should not be doing?

——————————————————————————————————————-

I trust you will agree with me that the world has changed dramatically in this short period of time. Scores of business titans have fallen or are fighting for survival, while opportunistic carpe diem challengers have moved ahead. Change is omnipresent and while some transformations are predictable, others have come from nowhere (for this reason, I recommend reading The Black Swan by Nassim Taleb, a read that is not only thought provoking but also immensely enjoyable).

If you’re in a leadership position, it’s incumbent on you to instigate and manage change within your organization. How do you go about it to ensure success?"

Read the Full Article on http://blogs.techrepublic.com.com/tech-manager/?p=1389

About Ilya Bogard:

Ilya Bogorad is the Principal of Bizvortex Consulting Group Inc, a management consulting company located in Toronto, Canada. Ilya specializes in building better IT organizations and can be reached at ibogorad@bizvortex.com or (905) 278 4753.

Myron Scholes' pathetic response to Nassim Taleb

Myron Scholes finally responded, in a pathetic manner, to Nassim Taleb's criticism. With Taleb now being the leader in revolt against the Modern House of Finance and Mathematical Models adopted to measure risk, had this to say about Myron Shcoles: "we have to unmask the charlatans of risk like Myron Scholes".Taleb was quite furious on Scholes. He considers Scholes as the Great Oz because his work on options and derivatives allowed the whole of the financial system to adopt poorly understood products-like the ones that brought AIG down-that hide risk. To Taleb, Scholes' academic work, which enabled the widespread use of complex derivatives, was like 'giving children dynamite.' 'This guy should be in a retirement home doing Sudoku,' Taleb says. 'His funds have blown up twice. He shouldn't be allowed in Washington to lecture anyone on risk.'" Michael Lewis too commented on hazards and harms that the use of Black Scholes Model has brought upon the financial health- "Black-Scholes didn’t work; trillions of dollars’ worth of securities may have been priced without regard to the possibility of crashes and panics. But until very recently, no one has bitched and moaned about this problem too loudly. Lay folk might harbor private misgivings about the clergy, but as lay folk, they are reluctant to express them. Now, however, as the subprime market unravels, the beginnings of a revolt against the church seem to be taking shape".

I had expected that the fathers of Financial Horoscope Models would come up with some decent answer or better still would admit the flaws in their Models with open heart. But, it looks like they dont have the gut and unfortunately still continue to live in fool's paradise. Still sticking to their guns they are not even sophisticated to give a decent reply. All Scholes could say to Taleb's criticism was " If someone says to you, “Go to an old-folks’ home,” that’s kind of ridiculous, because a lot of old people are doing terrific things for society. I never tried sudoku. Maybe he spends his time doing sudoku".

The Legend of Nassim Taleb Part 2

Somewhere on http://www.fooledbyrandomness.com Taleb is pessimistic about any change in the way the global house of finance and public policy operates. This he states as his fear despite the fact that The Black Swan has become an all time Bestselling Book in the fields of Economics or Finance. So I have started some research and trying to assess about the reach of Taleb's teachings and ideas. Further to my earlier post here are some more Books that discuss or incorporate Taleb's Ideas:

1- Derivatives: Models on Models By Espen Gaarder Haug. And here is how Haug describes Nassim: " Nassim Taleb was an original thinker a tail event himself, specializing in tail events. He was also not afraid of sharing his knowledge probably because he knew that human nature and the bonus system in most wall street firms would make most traders ignore his ideas anyway.

2- The Long Tail: Why the Future of Business is Selling Less of More
By Chris Anderson
3- Traders, guns & money: knowns and unknowns in the dazzling world of derivatives
By Satyajit Das
4- Identifying and Managing Project Risk By Tom Kendrick: The Author calls 'The Black Swans" the most serious problems.
5- Handbook for Surviving the Global Financial Crisis By Barbara Goldsmith. The Book seems to be a guide to survive the hazards of next black swan yet the author seems to have completely ignored what Taleb had to himself said in this regard.

Contiued...........

Now that I have started it all, it is hard to stop. But it is becoming evident to me that Taleb and his Books have become a great source of reference for varied fields. I desperately need volunteers to continue and broaden the work.

The Legend of Nassim Taleb Part1

Taleb has proven in a very convincing manner as to why the Finance, Economics etc. are pseudo sciences. And why the game Bankers or Quants play i.e. taking large risks based on models or probabilities that do not work in the real world are bound to fail. Most of the critics of Taleb are unfair in that either they havent read the Black Swan or are biased in certain manner or it is their mental models that are hard to change. Taleb's contribution is so immense that it is bringing about a revolution in investment related professions, finance syllabi, management books etc. I am surprised to see how quickly his ideas have been adopted. Here are a few of the examples of books which have incorporated Taleb's Ideas in one way or another, and I am only referring to big ticket authors:

1- When Markets Collide by El Erian
2- Readings in Financial Institution Management by Tom Valentine, Guy Ford
- Sociology and Health: Peter Morall
3- The unthinkable: who survives wen disaster strikes and why by Amanda Ripley
4- Wealthwar and wisdom: Barton Brigg
5- Financial Armageddon: Michael J. Panzer
6- Jump the Curve: 50 essential strategies to help your company stay ahead of the curve
7- Beyond Value at Risk : Kevin Dowd

Taleb's biggest lesson in learning is " To learn the General and not Specific".

Nassim on Reuters

One stop for almost all that is there on The Black Swan and Taleb

I came across this great site http://www.theblackswanreport.com . The site is full of great stuff related to Nassim Taleb's work and is updated regularly with latest material. It has lots of Videos, Interviews, articles and links. A wonderful one stop free shop for Taleb's Fans

Nassim on Bloomberg, Says Geithner Plan bound to fail

Nassim Taleb Blasts Myron Scholes

Taleb's Fantastic Quote on Myron Schloes:

"This guy should be in a retirement home doing Sudoku. 'His funds have blown up twice. He shouldn't be allowed in Washington to lecture anyone on risk.'"

Nassim Taleb Full lengthwith Charlie Rose

Randall On 'Discovery Of Black Swan'

http://video.aol.com/video-detail/randall-on-and039discovery-of-blackswanand039/492626517

Nassim Taleb Discussion with Benoit Mandelbrot

I think this is the first time that Benoit Mandelbrot and Nassim Taleb are together on Screen. Taleb calls Mandelbrot the only flesh and bone teacher he has ever had.

What caused the current Financial Crisis

In near future we are going to see book shops filled with Books on what caused the current financial crisis. But you realy dont need that. Nassim Taleb sums it up all along with the ways to deal with the crisis . The Master Genius takes only five minutes to explain it all. Watch and enjoy the video. 

Taleb Takes Alan Greenspan To Task

Nassim Nicholas Taleb has turned his guns to Alan Greenspan- quite rightly so.

Sitting 17 weeks on the New York Times best-seller list, “Black Swan” outsold former U.S. Federal Reserve Governor Alan Greenspan's “The Age of Turbulence” months ago.
So, how does it feel?
“Greenspan is an empty suit,” he told the Turkish Daily News in Istanbul, one of the latest stops on his lecture tour. “He does not understand economic life and he does not know that he doesn't know. And his book is boring. I despise the man.”
Taleb says the turmoil vindicates him once again. “Greenspan is a man who plays with economic life without understanding its basic structure. In today's world, links between action and consequences are not as visible as they were in the past.”
A major mistake of Greenspan was letting the banking system cluster, he said. “Thus, you end up with a gigantic bank and lose the natural ecology. If a restaurant does not give decent food, the owner goes bust. But banks get clustered. So you end up with one single source of risk and that is JP Morgan!”
“In the U.S., you trade with any bank, you are trading with JP Morgan. I barked about this for years, but then Bear Stearns went bust and JP Morgan ended up taking it,” he said. For Taleb, a system that banks do not go bust means a system that risk is highly concentrated.
He cited an example from another realm. “Which one has more political volatility? Italy or Saudi Arabia? Of course Italy, because they had 62 governments since World War II. But Saudi Arabia has had the same family in power since you guys left them,” he said, referring to the Ottoman Empire. “But Italy has much less risk than Saudi Arabia.”
So, some entities like Bear Stearns do not have volatility but are very risky, while some that are risky do not have volatility. “Greenspan and others do not understand this,” he said. “They never let the banks fail. I want them to fail, because I love the banking system. Finance is too important to be left to U.S. central bankers.”
In his trading days, Taleb was a legend due to a few incredible “hits.” The most legendary of these was in 1987, when he was working for First Boston. At 28 years of age, he made the right bet on Eurodollar futures when nobody else did. On Oct. 19, the Dow Jones Industrial Average declined 22.6 percent, the biggest one-day drop in the United States ever. Eurodollar futures surged after the Fed pumped liquidity into the banking system in a rush, lowering interbank borrowing rates.

Investment choices:
The majority of his personal fortune today is still based on that lucky day. His choice of investing that fortune tells something about Taleb's philosophy. “I like things that are volatile. Instead of investing in medium-risk securities, I invested 90 percent in no-risk government bonds. But my 10 percent is in extremely risky choices.”
“Some businesses, such as biotech, or emerging markets, can benefit from the black swan,” he said. “The problem is, some businesses, like banks in the U.S., have a lot of downside exposure, but no upside exposure.”
The basic rule for Taleb is simple: “If you need a mathematician to understand what you have in your books, you're a blowup.”
“I trained lots of these people,” he continued. “And I tell you, my students were incompetent. I would not give them my car to drive, or even to wash. Mathematics does not work in real life.”
Does “Extremistan” mean the old saying that history repeats itself is not valid anymore? “People tend to learn first order from history. The best example would be the Maginot Line. When Germans came, the French built a wall. What did the Germans do? They went around it,” he continued. “First order thinking is like, ‘Let's make sure we are prepared for a second 22 percent stock market crash.' Because it had never been that worse. But then, the 22 percent crash did not have a predecessor, so history would not have taught you that.”
Taleb has told “the guys at Morgan Stanley” that they are “morons” precisely because of that. “They were doing historical stress testing on their subprime portfolio. But how can you do that when history does not have a predecessor?”
Then he explains his “second order thinking” so rapidly, one might think he cannot repeat these words again: “There is a past, the past's past and the past's future. Then there is today, today's past and today's future. You should work with today's future in relation to today's past the way the past's future worked with the past's past.”
“Simple peasants understand this thinking. But bring in someone with a PhD who works at a bank on risk management, he does not. It's like autism. Thus, the more mathematicians you have in a bank, the more likely it is to blow up.”

From Lebanon to war on terror:
A political “black swan” from Taleb's childhood was the Lebanese civil war. “Nobody saw it coming,” he said. “My father was telling me that it would be over in a week. It went on 17 years. But today, the black swan for Lebanon is peace.”
The black swan takes on another quality if it is spotted. “Anytime you identify a source of randomness, you overestimate its probability and commit mistakes,” Taleb explained. “Today we overestimate terrorism. Give a retard like [George W.] Bush an army and he starts inventing sources of risk.”
The biggest source of risk for humankind is not terrorism but diabetes, which kills 80 million people every year, he argued. “Our reaction to terror causes more people to die than terrorism itself. Nearly 3,000 people died on Sept. 11, 2001. But in the aftermath, many more died due to traffic accidents because they were afraid of flying.” Nearly 600 extra deaths on U.S. and European roads per month after 9/11, he said.
If diabetes is the biggest source of risk today, economists come after it. “We have too many economists,” he said. “The Federal Reserve is dangerous. So is Davos. All pseudo-experts.”

Overoptimization:
Now, this reporter was warned before the interview that Taleb was a “hard one to crack,” and a couple of previous interviews went astray due to colleagues' insistence on asking his prediction on oil prices, the U.S. dollar or the Turkish economy.
This time, Taleb answers without receiving the question in some sort of verbal preemptive strike. “Why did the price of food and oil rise so much?” he said himself. “Because the system is too optimized. A small imbalance of 1 percent in the demand for wheat causes prices to double. But if you look at the facts, demand for wheat is up 2 percent while supply is up 5 percent.”
Such vast price swings tell us that “forecastability in that domain is worse.” So, nobody can guarantee that a barrel of oil will not cost $40 the next day, instead of continuing its rise toward $140. And that is why Taleb is reluctant to predict.
Then, is there an alternative to be paranoid and expect the unexpected? Maybe one has to look at what Karl Marx had said decades ago, a suggestion surprisingly made by prominent businessman İshak Alaton in April.
Taleb strongly disagrees. “According to Marx, the idea is how to turn knowledge into action, and that is pure enlightenment arrogance,” he said. “My point is how to turn absence of knowledge and understanding into action.”
For that, the world has to wait for “Tinkering,” the next book of the trader-turned-philosopher. Until then, ranks of Taleb fans are sure to get more crowded. The world is hungry for new ideas and perspectives, a common phenomenon for times of such deep crises. And that is exactly what Taleb delivers.

The Black Swan Ideas Gaining Momentum

After writing yesterday's post" First Nail In the Coffin.......", here is another article suggesting the death of traditional models of risk management, measuring the economy. I am very much looking forward to a whole new world of ideas.

"WHAT'S WRONG WITH MARKET ECONOMICS AND GDP?" by HAZEL HENDERSON: 24/04/2008

(MaximsNews Network)

UNITED NATIONS - / MaximsNews Network / 24 April 2008 -- The credibility of the economics profession and its macroeconomic and risk models has been shattered by the Wall Street-led financial meltdown. Many analysts see this worst crisis since World War II as the beginning of the end of market fundamentalism as the driver of globalization. Coming into focus is also the fact that the USA is no longer the world’s lone super power. Military force is giving way to the new weapons of choice in today’s geopolitics: currency and cyber-attacks.

Even US Treasury Secretary Henry Paulson (former head of one of the over-leveraged Wall Street investment banks – Goldman Sachs) now calls for regulation of these reckless, risk-taking, private banks. Former options-trader/mathematician Nassim Nicholas Taleb predicted their downfall in The Black Swan (2007), as did former hedge fund "quant" Richard Bookstaber in A Demon of Our Own Design (2007). Ivory tower mathematicians lured to Wall Street’s big bucks simply didn't understand the real behavior of markets – as was demonstrated back in 1998 when their faulty models led to the collapse of hedge fund Long-Term Capital Management and its bail-out orchestrated by the US Federal Reserve.

The Nobel Prize Committee shares some blame by its recognition of the faulty options pricing model, Black-Scholes Merton, with its Bank of Sweden Prize in 1993. In recent editorials, Taleb has called on the Nobel Committee to withdraw this prize while Peter Nobel himself says that the Bank of Sweden should de-link its prize in economics from the Nobels. As I have noted in my previous editorials for IPS, many other scientists agree, since economics is not a science but a profession.

Meanwhile, the long-simmering critiques of money-based GDP/GNP national accounts are coming to a head. These popular critiques, including my own, were summarized by the late Senator Robert F. Kennedy in 1968 in a speech delivered to the University of Kansas. Even GDP's creator, Simon Kuznets, worried about using GDP as an overall indicator of national progress and well-being, saying that “the welfare of a nation can scarcely be informed from a measure of national income.”

The cracks in GDP as a scorecard of national progress began appearing at the UN Earth Summit in Rio de Janeiro in 1992, followed by the European Parliament's conference in 1995 on "Taking Nature Into Account." In November 2007, the European Parliament again took up the issue at the urging of the European Commission (www.beyond-gdp.eu). Its “Beyond GDP” debate was keynoted by EU President José Manuel Barroso of Portugal before almost 700 parliamentarians and statisticians of sustainability and quality of life. Statisticians themselves also emphasized the need for better measures of national progress, with over 13,000 attending their conference in Istanbul, convened by the OECD (Organization for Economic Co-operation and Development) in June 2007. And, EU Commissioner of Economic Policy Joaquín Almunia noted that GDP “cannot distinguish between economic activities that have a negative or positive impact on wellbeing. In fact, war and natural disasters may register as an increase in GDP.”

By March 2008, the US Senate picked up these critical debates and the plethora of new, broader indicators of health, education and environment. The Senate's Committee on Commerce held its own hearing on "Rethinking GDP as a Measure of National Strength" – a low-key academic exploration on how all of these new measures of overall quality could be used to correct all the now-recognized errors in GDP that economic textbooks perpetuate.

In its March 13, 2008 issue, even The Economist weighed in with "Grossly Distorted Picture," criticizing the widespread focus on GDP-growth. This "growth fetish" has long been the subject of countless critiques by environmentalists and even a few economists. To see this journal of economic and free-trade orthodoxy now also criticizing GDP-growth signals a tipping point in this long debate. Echoing so many earlier critiques, The Economist pointed out that a better measure than rates of GDP-growth would be to compare GDP per head – a much more tangible sign of progress that takes into account the growth of population. For example, Japan's GDP growth has been about 2.1% over the past five years, while GDP in the USA has grown 2.9%.

Yet, comparing the average growth of income per capita between the two countries, a different story emerges: the USA saw only a 1.9% increase while Japanese citizens’ income grew by 2.1%. This was among the reasons I have urged Japan to shift from GDP growth to quality-of-life indicators (Nikkei Ecology, August 2000). I pointed out that Japan had matured beyond the need for more material growth and could now concentrate on higher-level services and improving quality of life. Japan’s average income-per-head also was greater because Japan's population is shrinking while the US population is rising. India has enjoyed rapid GDP-growth, but its population has grown much faster, leaving more people to share that income.

The Economist is correct that the growth of average income per capita is the more realistic indicator. But, they omit another problem with these GDP measures: averaging per capita of growth in incomes masks how that income is distributed. Averaging incomes across the whole population could mean that a country might have a few billionaires while most of its citizens live in poverty.

Let’s agree that GDP has outlived its usefulness (started as a World War II measure of war production). There are now many new, better indicators, from the Canadian Index of Wellbeing (CIW), the UN's Human Development Index (HDI), the World Bank’s Wealth Index to Genuine Progress Index (GPI), Bhutan's Gross National Happiness (GNH) to the Calvert-Henderson Quality of Life Indicators I created with the Calvert Group of socially responsible mutual funds (the only private-sector effort so far, updated regularly at www.calvert-henderson.com).

Once again, the public is ahead of the experts and politicians on this issue. A GlobeScan survey in 10 countries in November 2007, in conjunction with the Beyond GDP Conference in the European Parliament, found large majorities in India, Russia, Germany, France, Italy, Britain as well as Australia, Brazil and Kenya favored broader scorecards of progress beyond money-based GDP, including indicators of health, education and environment. Real wealth and progress can never be quantified only in money. The economics textbooks are overdue for revision.

Hazel Henderson is author of Ethical Markets: Growing the Green Economy (2007) and other books. She co-organized the Beyond GDP Conference in Brussels, representing the Club of Rome. www.hazelhenderson.com