Taleb - Prediction is a wrong word; detect fragility

by Latha Venkate
CNBC
March 28,, 2017

In an interview to CNBC-TV18's Latha Venkatesh, Nassim Taleb, Statistician & Author of The Black Swan spoke about global economy and other related issues.

Q: Let me start with an autobiographical question - you are one of those rare people who profited in the 1987 crash and in the 2007 crisis as well. Can you tell us something about what made you see this crisis coming and how did you profit from them?

A: The first thing is that prediction is a wrong word because in a risk domain we do not talk of prediction. We talk about detection of fragility, so you have to detect what is fragile. If something is fragile eventually it is going to break. You can easily forecast that the coffee cup you have on a table is not going to outlive the table except maybe in rare circumstances. You can safely say that a pilot who is not very good at understanding storms eventually is going to have a funeral. So it's not forecasting; it is to understand what is fragile and what is not. So the first statement is to understand a fragile. The second thing, something that is fragile in a local way that's been your constraint, something systemic are fragile and these collapse.

The crisis of 1987 had no idea about fragility. It's about 30 years ago and I was a trader, by then I was making bets on extreme events but some people substitute their own judgement that of others, but that I didn't take the answer and I said I am going to buy every single option I can. So before '87 there was Plaza Accord in '86 in which the market moved big time in currencies and we thought we are going to make little bit money - that was a business to me and so that is what happened to me. So there are two stories in there and actually reflected into my book - The Black Swan is about the incidence of these events and some domains. So basically what we have to do is to identify the domain in which it can happen. We know that 20 million people killed and penalty will happen to every 10 to 100, which we should basically never, whereas Ebola is more likely to do that. Therefore, identify the domain and second is identify the fragility. The two combined are crisis of 2008.

For crisis of 2008, I was much more prepared. I was more comfortable and had written The Black Swan and I was completely depressed by the interpretation of my ideas about The Black Swan - it really got the point, as they said let's forecast -- that is not our work; detect fragility and the system was very fragile and it was described in The Black Swan as being fragile. So I came back. I thought I was done with trading, you cannot trade for too long, it becomes too stressful. You need time to recover of any activity and trading doesn't allow you that, you always have chronic stress. A chronic stress for 24 years was too much for me but then I started to come back, so I came back. So this is my autobiography. I then wanted to back out of the market. I wanted to be a scholar and initially I got into market not because of any economic reason or anything. I thought it was fun. It was really a fun to trade; trading is a lot of fun and it is like playing for living. So I did that and I got addicted to it.

Q: Since you were once addicted to trading and even though now you are more a full time scholar than a trader, I do want to ask you where you see the top risk today or the top three risks today; after all we have seen a fairly decent Trump rally. There is a risk on across several financial assets. What would you say are the three big risks?

A: The first big risk I see, let's forget about the economy and all that, it is really severe is from the reaction of Ebola. Why did I talk about Ebola because so I can follow-up now on a conversation by telling you what detected is a complete incompetence on a part of US authorities particularly state department in understanding the nature of multiplicative risk. A friend of mine, we analysed the situation and we called up the state department, a friend of mine contacted the state department and he told them every plane that leaves, every person with Ebola will have 500 exposures on a way and we was talking about the plague which was travelling with something like 30 miles a day. This is travelling much faster. These risks you have to recognise and they refused to recognise them and The New York Times published some comment saying it makes no sense to worry about Ebola. It only killed three Americans - this is what I picked up. So the way they reacted to the risks means lack of consciousness on a part of bureaucrats outside Singapore of course; Singapore understand it perfectly that emerging threats when they are systemic and multiplicative, need to be dealt with seriously. And I am afraid that because of antibiotic resistance should we have another plague that would travel very fast. Authorities in the past used to panic very quickly. Today they are talked by the risk management professor who never took risk, never worked for an insurance company, never did anything but these professors of finance for example say don't worry about it, it is statistically rare and stuff like that. So this is what worries me.

Q: I must confess I wasn’t prepared for Ebola as an answer. What is the second big risk?

A: Second one links to it, it can be used by terrorists.

Q: Biological warfare you mean?

A: Exactly. This is what we have to worry about, we don’t have to worry about conventional warfare. Of course it is a good idea for some people to convince you of it so they can sell you weapons but we have to worry about biological warfare first. That coupled with terrorism is a serious threat. So, that would be my second one.

Now lets us talk finance. We had a crisis due to fragility of the financial system, too much debt, many people who shouldn’t lend were lending and many people who shouldn’t borrow were borrowing. Simple debt cycle that happened to correct like the forests. Forest has fires, clean ups the bad material. They kept perpetuating it with low interest rates under Greenspan.

What did the US government do in conjunction with the Federal Reserve and don’t tell me it is independent of the Obama regime. So, what did they do? They kept interest rates very low and they let debt accumulate, transferred from individuals to the public sector, with hidden debt accumulating in form of all of the student loans but then much more seriously our liabilities with social security and all of that.

So, now what do we have? We have a huge amount of debt, the government has USD 10 trillion more than it did before and interest rates are zero, so, the government deficit seems to be out of control.

What if interest rates rose? Interest rates when they are at zero, first of all it is concave, in other words it is just like any ponzi scheme – you need to do more and more to keep it in place at the end. So, lower interest rates below 3 percent made no sense.

Now we have something that is completely ineffective. You can no longer lower rates if you faced any further crisis and the resultant is printing money. So, now what’s the situation we are facing today? It is that we need to raise interest rates back up to normal levels say at least 3 percent. How do you do that? By raising rates. What happens when you raise rates? When you raise rates 0.25 points at a time, it’s not going to work. You are not going to get there.

I remember in 1994 when Greenspan abruptly raised rates in United States financial markets did okay but worldwide – oh my god. We had for 2-3 years all this money flowing back to the states.

So, we might be faced with a situation of say Tequila sort of crisis, facing the increase of interest rates in United States.

Q: The previous hike of the US Federal Reserve did not evoke such strong reactions in financial markets. They were practically very well awaited, people were almost begging for a hike. Do you think things can still get out of hand? Of course Trump is speaking of more debt now – fiscal debt and how do you see therefore bond markets?

A: First of all we haven’t seen the effect of last hike. After Greenspan some effects came upto a year later. However we have seen the effects of the monetary policy that we were doing before, inflating asset values.

In fact during the Obama regime, it was the most interesting regime where we had stability at the expense of a median income that was increasing and a shift to inequality that was monstrously increasing simply because either people who had assets got richer and also because globalisation took place in that period of time and it had the effect whether we like it or not of causing winner take all effect.

We spoke about the three risks, let me tell you what I think is not a risk. What is not a risk is this reaction – the Brexit reaction, the Trump reaction, it is a reaction by the grandmother, saying, there is something we don’t understand. When Nigel Farage speaks, they say I understand it, at least I know if he right or wrong. Whereas with the other guys we don’t know if they are right or wrong. When he went to Brussels, what we had in Europe was a symptomatic effect of last events as a concentration of a class of people who are bureaucrats, who have proved serial incompetence, they are not in business and also because they are not penalised for their mistakes. I don’t know many businesses in which a person making a mistake is not penalised. Whereas there it is completely insulated from that system. So, that class of people, you look at examples of how many documents they have regulating but they can’t control borders, they can’t control anything essential. So, what we have now is divorce between the notion of Europe and bureaucrats of Brussels.

Q: Let us talk of the two risks separately. You spoke about Greenspan’s rate hike impact coming in much later. So, you still think that as the Federal Reserve hikes rates, we could still see some fairly drastic impact in financial markets a year down the line?

A: The first thing you have to realise is already when you hike rates you are increasing the borrowing cost of the next government which are considerably higher today than they were in the past. 100 basis points is something like several hundred million dollars more. We are talking about increasing USD 53 billion defence spending, we don’t realise that 100 basis points or 200 basis points in expenditure is going to make that look like Friday afternoon pocket money for children. That is one thing you have to worry about. 25 basis points is symbolic and in effect other than US government and banks it doesn’t seem to impact people because nobody is borrowing. The point is only government is the one borrowing. If you look at the health of companies it is a completely different dynamics.

Q: Do you think Europe is a big risk? We have got elections in France and Germany also coming up or do you think like Brexit, that is the known risk?

A: To me Brexit was good news and effectively, from the beginning - I went on CNBC - before the Brexit, I went before the election of Trump to make sure to make my point is that should Trump be elected for number one, of course, I said it is not necessarily a bad thing that people tell you but that was not Trump that I was plugging. I was plugging the idea that if he is elected, the markets are not going to collapse.

Q: I remember, November 3, you said Trump could get elected and he won't be apocalyptic.

A: He will not be. Exactly, so stop worrying about this and something tells me that the healthiest Europe is a Europe that is managed by the smallest amount of people in Brussels.

Q: You mean the breakup of Europe will not be apocalyptic?

A: It is not a breakup. We live in a world of uberising relationships. So if you take the relationships of France with Morocco for example, you don't have to call Brussels to ask him for permission to do something. What is the aim of Europe? First of all, one thing about Europe that few understand that the notion of Europe isn't the classical Europe. That notion of Europe that they have is the Frankish Europe of Aix-la-Chapelle and Aachen and Germany of Charlemagne because the classical Europe is a Mediterranean. It is around the Mediterranean.

Q: Closer to your home town?

A: So, I am saying the Byzantine, that is a Roman empire, was the Byzantine Empire. So that is a classical Europe and then what you had out there is the rival to Byzantine. When Byzantine was there, these people who called themselves holy roman emperor and they had three things wrong. They were neither holy nor roman, Roman was Byzantium, Constantinople. He was the real emperor.

So, the EU may end up and actually Martin Walls has made a similar remark, will end up as some paper organisation where people can go when they are fired from their job or when you want to get rid of them in Paris, you send them to Brussels or it is like sending someone to Coventry. It may survive that way because the holy Roman Empire survived a thousand years doing nothing. So you have to think about it, they had no power. So that is the notion. So you have to separate the idea of Europe and also understand that countries are adults.

For example, take the UK. The UK wants, I put the question when I was I think, with David Cameron and he called it slander. I said, who do you identify with? And English speaking Indian person or someone from Poland? Who can you have dinner with? You sit down, you can communicate with someone brought up in Delhi, but you cannot communicate with someone brought up in Krakow. You get the idea? So why are we doing this? So you will say, it is of no European risk.

So forget the notion of people being able to do deals together just like United States can do a deal now with Ireland hopefully and the UK where Americans can go work there, they can come work here, you can make agreements. So, you see the idea? So, countries are adults. But Norway and Switzerland, the two most successful countries in Europe are not in the EU. And people then worry about movement of population. Ireland and Cyprus are not in Schengen.

So, it is like all these arguments seem to be like someone reacting without having a proper argument, sort of like if a lady goes in and tells her husband, listen I am divorcing you, goodbye. And then he has to come up with 10 arguments immediately, a not very well processed argument. These are the arguments used in favour of EU and against Brexit. I do not see any of them as economically reasonable nor even politically reasonable. The world does not like bureaucrats. Ancient Egypt and China collapsed after they bureaucratised the system.

Q: Well that is one worry less. We should not worry about a confederating or perhaps, a splitting Europe. Let me come to India. We just had a gigantic experiment where our government changed 86 percent of the currency. A kind of demonetisation. Did you read about it? Any first comments? We seem to have come out of it with minor bruises.

A: My first comment is that whenever economists tell you something is apocalyptic, it is not going to be. So, I do not know if it is good or bad but something was conveyed to me that a friend called me up and said, and actually I came to India right after that. And he said, every single economist said it made no sense, or at least economists that he knew said it made no sense. I said, every single economist said it made no sense, probably it is at least neutral. So, it does not have to be neutral. So, that is my idea. That is only thing I know about it. Now I do not understand the dynamics of what is going on, this I do not understand nor do I need to know. And I do not know much about India. I know stuff about India, but that is not the kind of stuff I understand.

Q: I do not know how well you know our Prime Minister, Narendra Modi. He in a sense, single-handedly went into demonetisation. Do you think he is really making India anti-fragile?

A: This I am going to tell you what I think I know about India from conversation and from visiting several clients. Every single Indian I meet tells me the same thing. They think that these sectors that do very well are sectors in which the government tried not to improve too much. I believe in government and I have heard Modi saying the government should not do to many things, but what the government does, should do it very well.

So that is the idea. That is what I heard. But the problem is again to destroy the crust of people who make life difficult for others while genuinely thinking they are improving the system and reallocating. And the other thing is the first thing and it looks like it is part of the programme. Now in two years, I do not know how much was done in reducing the role of these things and hindering rather than advancing.
And the second point that there was some element of decentralisation floating. And I think the decentralisation makes things look messy but better.