The Black Swan of Cairo - How Suppressing Volatility Makes the World Less Predictable and More Dangerous

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             The Black Swan of Cairo
         How Suppressing Volatility Makes the World
           Less Predictable and More Dangerous

               Nassim Nicholas Taleb and Mark Blyth

                                 Volume 9o • Number 3

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The Black Swan of Cairo
       How Suppressing Volatility Makes the World Less
             Predictable and More Dangerous

                Nassim Nicholas Taleb and Mark Blyth

Why is surprise the permanent condition           extremely fragile, while at the same time
of the U.S. political and economic elite? In      exhibiting no visible risks. In fact, they
2007–8, when the global financial system          tend to be too calm and exhibit minimal
imploded, the cry that no one could have          variability as silent risks accumulate
seen this coming was heard everywhere,            beneath the surface. Although the stated
despite the existence of numerous analyses        intention of political leaders and economic
showing that a crisis was unavoidable. It         policymakers is to stabilize the system by
is no surprise that one hears precisely the       inhibiting fluctuations, the result tends
same response today regarding the current         to be the opposite. These artificially con-
turmoil in the Middle East. The critical          strained systems become prone to “Black
issue in both cases is the artificial suppres-    Swans”—that is, they become extremely
sion of volatility—the ups and downs of           vulnerable to large-scale events that lie far
life—in the name of stability. It is both mis-    from the statistical norm and were largely
guided and dangerous to push unobserved           unpredictable to a given set of observers.
risks further into the statistical tails of the       Such environments eventually experi-
probability distribution of outcomes and          ence massive blowups, catching everyone
allow these high-impact, low-probability          oª-guard and undoing years of stability
“tail risks” to disappear from policymakers’      or, in some cases, ending up far worse than
fields of observation. What the world is          they were in their initial volatile state.
witnessing in Tunisia, Egypt, and Libya           Indeed, the longer it takes for the blowup
is simply what happens when highly                to occur, the worse the resulting harm in
constrained systems explode.                      both economic and political systems.
    Complex systems that have artificially            Seeking to restrict variability seems to
suppressed volatility tend to become              be good policy (who does not prefer stability

      Nassim Nicholas Taleb is Distinguished Professor of Risk Engineering
      at New York University’s Polytechnic Institute and the author of The Black Swan:
      The Impact of the Highly Improbable. Mark Blyth is Professor of International
      Political Economy at Brown University.

                                                                                [33]
Nassim Nicholas Taleb and Mark Blyth
to chaos?), so it is with very good intentions    have been good at fragilizing large corpora-
that policymakers unwittingly increase the        tions through bailouts, and Democrats have
risk of major blowups. And it is the same         been good at fragilizing the government.
misperception of the properties of natural        At the same time, the financial system as a
systems that led to both the economic             whole exhibited little volatility; it kept get-
crisis of 2007–8 and the current turmoil in       ting weaker while providing policymakers
the Arab world. The policy implications           with the illusion of stability, illustrated
are identical: to make systems robust, all        most notably when Ben Bernanke, who
risks must be visible and out in the open—        was then a member of the Board of Gover-
fluctuat nec mergitur (it fluctuates but does     nors of the U.S. Federal Reserve, declared
not sink) goes the Latin saying.                  the era of “the great moderation” in 2004.
    Just as a robust economic system is one          Putatively independent central
that encourages early failures (the concepts      bankers fell into the same trap. During
of “fail small” and “fail fast”), the U.S. gov-   the 1990s, U.S. Federal Reserve Chair
ernment should stop supporting dictato-           Alan Greenspan wanted to iron out the
rial regimes for the sake of pseudostability      economic cycle’s booms and busts, and he
and instead allow political noise to rise to      sought to control economic swings with
the surface. Making an economy robust             interest-rate reductions at the slightest
in the face of business swings requires           sign of a downward tick in the economic
allowing risk to be visible; the same is          data. Furthermore, he adapted his eco-
true in politics.                                 nomic policy to guarantee bank rescues,
                                                  with implicit promises of a backstop—the
SEDUCED BY STABILITY                              now infamous “Greenspan put.” These
Both the recent financial crisis and the          policies proved to have grave delayed side
current political crisis in the Middle East       eªects. Washington stabilized the market
are grounded in the rise of complexity,           with bailouts and by allowing certain com-
interdependence, and unpredictability.            panies to grow “too big to fail.” Because
Policymakers in the United Kingdom and            policymakers believed it was better to do
the United States have long promoted              something than to do nothing, they felt
policies aimed at eliminating fluctuation—        obligated to heal the economy rather than
no more booms and busts in the economy,           wait and see if it healed on its own.
no more “Iranian surprises” in foreign               The foreign policy equivalent is to
policy. These policies have almost always         support the incumbent no matter what.
produced undesirable outcomes. For                And just as banks took wild risks thanks to
example, the U.S. banking system became           Greenspan’s implicit insurance policy, client
very fragile following a succession of pro-       governments such as Hosni Mubarak’s in
gressively larger bailouts and government         Egypt for years engaged in overt plunder
interventions, particularly after the 1983        thanks to similarly reliable U.S. support.
rescue of major banks (ironically, by the            Those who seek to prevent volatility on
same Reagan administration that trum-             the grounds that any and all bumps in the
peted free markets). In the United States,        road must be avoided paradoxically increase
promoting these bad policies has been a           the probability that a tail risk will cause a
bipartisan eªort throughout. Republicans          major explosion. Consider as a thought

        [34]           fore ign affairs . Volume 90 No. 3
The Black Swan of Cairo
experiment a man placed in an artificially      magnitude of the hidden risks and a mis-
sterilized environment for a decade and         understanding of the statistical properties
then invited to take a ride on a crowded        of the system.
subway; he would be expected to die                 What is needed is a system that can
quickly. Likewise, preventing small forest      prevent the harm done to citizens by the
fires can cause larger forest fires to become   dishonesty of business elites; the limited
devastating. This property is shared by         competence of forecasters, economists, and
all complex systems.                            statisticians; and the imperfections of
    In the realm of economics, price con-       regulation, not one that aims to eliminate
trols are designed to constrain volatility on   these flaws. Humans must try to resist the
the grounds that stable prices are a good       illusion of control: just as foreign policy
thing. But although these controls might        should be intelligence-proof (it should
work in some rare situations, the long-term     minimize its reliance on the competence
eªect of any such system is an eventual         of information-gathering organizations
and extremely costly blowup whose cleanup       and the predictions of “experts” in what
costs can far exceed the benefits accrued.      are inherently unpredictable domains),
The risks of a dictatorship, no matter how      the economy should be regulator-proof,
seemingly stable, are no diªerent, in the       given that some regulations simply make
long run, from those of an artificially         the system itself more fragile. Due to the
controlled price.                               complexity of markets, intricate regulations
    Such attempts to institutionally engineer   simply serve to generate fees for lawyers
the world come in two types: those that         and profits for sophisticated derivatives
conform to the world as it is and those         traders who can build complicated financial
that attempt to reform the world. The           products that skirt those regulations.
nature of humans, quite reasonably, is to in-
tervene in an eªort to alter their world and    DON’T BE A TURKEY
the outcomes it produces. But government        The life of a turkey before Thanksgiving
interventions are laden with unintended—        is illustrative: the turkey is fed for 1,000
and unforeseen—consequences, particularly       days and every day seems to confirm that
in complex systems, so humans must work         the farmer cares for it—until the last day,
with nature by tolerating systems that          when confidence is maximal. The “turkey
absorb human imperfections rather than          problem” occurs when a naive analysis of
seek to change them.                            stability is derived from the absence of
    Take, for example, the recent celebrated    past variations. Likewise, confidence in
documentary on the financial crisis, Inside     stability was maximal at the onset of the
Job, which blames the crisis on the malfea-     financial crisis in 2007.
sance and dishonesty of bankers and the             The turkey problem for humans is the
incompetence of regulators. Although it         result of mistaking one environment for
is morally satisfying, the film naively over-   another. Humans simultaneously inhabit
looks the fact that humans have always been     two systems: the linear and the complex.
dishonest and regulators have always            The linear domain is characterized by its
been behind the curve. The only diªerence       predictability and the low degree of
this time around was the unprecedented          interaction among its components, which

                      fore ign affairs . May / June 2011                      [35]
Nassim Nicholas Taleb and Mark Blyth
allows the use of mathematical methods           can predict a solar eclipse and the trajectory
that make forecasts reliable. In complex         of a space vessel, but not the stock market
systems, there is an absence of visible          or Egyptian political events. All man-made
causal links between the elements, masking       complex systems have commonalities and
a high degree of interdependence and             even universalities. Sadly, deceptive calm
extremely low predictability. Nonlinear          (followed by Black Swan surprises) seems
elements are also present, such as those         to be one of those properties.
commonly known, and generally misun-
derstood, as “tipping points.” Imagine           THE ERROR OF PREDICTION
someone who keeps adding sand to a sand          As with a crumbling sand pile, it would be
pile without any visible consequence, until      foolish to attribute the collapse of a fragile
suddenly the entire pile crumbles. It would      bridge to the last truck that crossed it, and
be foolish to blame the collapse on the last     even more foolish to try to predict in
grain of sand rather than the structure of the   advance which truck might bring it down.
pile, but that is what people do consistently,   The system is responsible, not the compo-
and that is the policy error.                    nents. But after the financial crisis of
    U.S. President Barack Obama may              2007–8, many people thought that predict-
blame an intelligence failure for the gov-       ing the subprime meltdown would have
ernment’s not foreseeing the revolution          helped. It would not have, since it was a
in Egypt (just as former U.S. President          symptom of the crisis, not its underlying
Jimmy Carter blamed an intelligence              cause. Likewise, Obama’s blaming “bad in-
failure for his administration’s not fore-       telligence” for his administration’s failure to
seeing the 1979 Islamic Revolution in Iran),     predict the crisis in Egypt is symptomatic
but it is the suppressed risk in the statis-     of both the misunderstanding of complex
tical tails that matters—not the failure to      systems and the bad policies involved.
see the last grain of sand. As a result of           Obama’s mistake illustrates the illusion
complicated interdependence and conta-           of local causal chains—that is, confusing
gion eªects, in all man-made complex             catalysts for causes and assuming that one
systems, a small number of possible events       can know which catalyst will produce which
dominate, namely, Black Swans.                   eªect. The final episode of the upheaval in
    Engineering, architecture, astronomy,        Egypt was unpredictable for all observers,
most of physics, and much of common              especially those involved. As such, blam-
science are linear domains. The complex          ing the cia is as foolish as funding it to
domain is the realm of the social world,         forecast such events. Governments are
epidemics, and economics. Crucially, the         wasting billions of dollars on attempting
linear domain delivers mild variations           to predict events that are produced by
without large shocks, whereas the complex        interdependent systems and are therefore
domain delivers massive jumps and gaps.          not statistically understandable at the
Complex systems are misunderstood,               individual level.
mostly because humans’ sophistication,               As Mark Abdollahian of Sentia Group,
obtained over the history of human knowl-        one of the contractors who sell predictive
edge in the linear domain, does not transfer     analytics to the U.S. government, noted
properly to the complex domain. Humans           regarding Egypt, policymakers should

        [36]          fore ign affairs . Volume 90 No. 3
“think of this like Las Vegas. In blackjack,   focus. It is telling that the intelligence
if you can do four percent better than the     analysts made the same mistake as the
average, you’re making real money.” But        risk-management systems that failed to
the analogy is spurious. There is no “four     predict the economic crisis—and oªered
percent better” on Egypt. This is not just     the exact same excuses when they failed.
money wasted but the construction of a         Political and economic “tail events” are
false confidence based on an erroneous         unpredictable, and their probabilities are

                     fore ign affairs . May / June 2011                     [37]
Nassim Nicholas Taleb and Mark Blyth
not scientifically measurable. No matter        tend to be comparatively mild. For exam-
how many dollars are spent on research,         ple, a shift in the ruling coalition from
predicting revolutions is not the same as       Christian parties to Hezbollah is not such
counting cards; humans will never be able       a consequential jump in terms of the
to turn politics into the tractable random-     country’s economic and political stability.
ness of blackjack.                              Switching equilibrium, with control of
    Most explanations being oªered for the      the government changing from one party
current turmoil in the Middle East follow       to another, in such systems acts as a shock
the “catalysts as causes” confusion. The        absorber. Since a single party cannot have
riots in Tunisia and Egypt were initially       total and more than temporary control, the
attributed to rising commodity prices, not      possibility of a large jump in the regime
to stifling and unpopular dictatorships.        type is constrained.
But Bahrain and Libya are countries with            In contrast, consider Iran and Iraq.
high gdps that can aªord to import grain        Mohammad Reza Shah Pahlavi and Sad-
and other commodities. Again, the focus is      dam Hussein both constrained volatility
wrong even if the logic is comforting. It is    by any means necessary. In Iran, when
the system and its fragility, not events,       the shah was toppled, the shift of power to
that must be studied—what physicists call       Ayatollah Ruhollah Khomeini was a huge,
“percolation theory,” in which the proper-      unforeseeable jump. After the fact, analysts
ties of the terrain are studied rather than     could construct convincing accounts about
those of a single element of the terrain.       how killing Iranian Communists, driving
    When dealing with a system that is          the left into exile, demobilizing the demo-
inherently unpredictable, what should be        cratic opposition, and driving all dissent
done? Diªerentiating between two types          into the mosque had made Khomeini’s
of countries is useful. In the first, changes   rise inevitable. In Iraq, the United States
in government do not lead to meaningful         removed the lid and was actually surprised
diªerences in political outcomes (since         to find that the regime did not jump from
political tensions are out in the open).        hyperconstraint to something like France.
In the second type, changes in govern-          But this was impossible to predict ahead
ment lead to both drastic and deeply            of time due to the nature of the system
unpredictable changes.                          itself. What can be said, however, is that
    Consider that Italy, with its much-         the more constrained the volatility, the
maligned “cabinet instability,” is economi-     bigger the regime jump is likely to be. From
cally and politically stable despite having     the French Revolution to the triumph of
had more than 60 governments since              the Bolsheviks, history is replete with
World War II (indeed, one may say Italy’s       such examples, and yet somehow humans
stability is because of these switches of       remain unable to process what they mean.
government). Similarly, in spite of consis-
tently bad press, Lebanon is a relatively       THE FEAR OF RANDOMNESS
safe bet in terms of how far governments        Humans fear randomness—a healthy
can jump from equilibrium; in spite of          ancestral trait inherited from a diªerent
all the noise, shifting alliances, and street   environment. Whereas in the past, which
protests, changes in government there           was a more linear world, this trait enhanced

        [38]          fore ign affairs . Volume 90 No. 3
The Black Swan of Cairo
fitness and increased chances of survival,       imposition of peace through repeated
it can have the reverse eªect in today’s         punishment lies at the heart of many
complex world, making volatility take the        seemingly intractable conflicts, including
shape of nasty Black Swans hiding behind         the Israeli-Palestinian stalemate. Further-
deceptive periods of “great moderation.”         more, dealing with seemingly reliable
This is not to say that any and all volatility   high-level o⁄cials rather than the people
should be embraced. Insurance should             themselves prevents any peace treaty signed
not be banned, for example.                      from being robust. The Romans were wise
    But alongside the “catalysts as causes”      enough to know that only a free man under
confusion sit two mental biases: the illusion    Roman law could be trusted to engage in a
of control and the action bias (the illusion     contract; by extension, only a free people
that doing something is always better than       can be trusted to abide by a treaty. Treaties
doing nothing). This leads to the desire to      that are negotiated with the consent of a
impose man-made solutions. Greenspan’s           broad swath of the populations on both
actions were harmful, but it would have          sides of a conflict tend to survive. Just as no
been hard to justify inaction in a democracy     central bank is powerful enough to dictate
where the incentive is to always promise a       stability, no superpower can be powerful
better outcome than the other guy, regard-       enough to guarantee solid peace alone.
less of the actual, delayed cost.                    U.S. policy toward the Middle East has
    Variation is information. When there         historically, and especially since 9/11, been
is no variation, there is no information.        unduly focused on the repression of any
This explains the cia’s failure to predict       and all political fluctuations in the name
the Egyptian revolution and, a generation        of preventing “Islamic fundamentalism”—
before, the Iranian Revolution—in both           a trope that Mubarak repeated until his
cases, the revolutionaries themselves did        last moments in power and that Libyan
not have a clear idea of their relative          leader Muammar al-Qaddafi continues
strength with respect to the regime they         to emphasize today, blaming Osama
were hoping to topple. So rather than sub-       bin Laden for what has befallen him. This
sidize and praise as a “force for stability”     is wrong. The West and its autocratic Arab
every tin-pot potentate on the planet,           allies have strengthened Islamic funda-
the U.S. government should encourage             mentalists by forcing them underground,
countries to let information flow upward         and even more so by killing them.
through the transparency that comes with             As Jean-Jacques Rousseau put it, “A
political agitation. It should not fear fluc-    little bit of agitation gives motivation to
tuations per se, since allowing them to be       the soul, and what really makes the species
in the open, as Italy and Lebanon both           prosper is not peace so much as freedom.”
show in diªerent ways, creates the stability     With freedom comes some unpredictable
of small jumps.                                  fluctuation. This is one of life’s packages:
    As Seneca wrote in De clementia,             there is no freedom without noise—and
“Repeated punishment, while it crushes           no stability without volatility.∂
the hatred of a few, stirs the hatred of
all . . . just as trees that have been trimmed
throw out again countless branches.” The

                      fore ign affairs . May / June 2011                        [39]
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