All Commentary
Wednesday, March 24, 2010

The Improbable Prose of Nassim Nicholas Taleb

As I get older and more cynical, I tend to look down on the latest “hot” idea or person. Sure, teenage pop stars and the novelist Dan Brown are talented, but they’re not nearly as extraordinary as their popular status would suggest. Every once in a while, though, something impresses me despite such cynicism. Nassim Nicholas Taleb, for example, lives up to the hype surrounding him. Libertarians—especially those versed in Austrian economics—will find Taleb well worth reading.

Taleb is the author of the international bestseller Fooled By Randomness and the blockbuster The Black Swan: The Impact of the Highly Improbable. The books largely overlap, but the second (the focus of the present article) is less liable to misunderstanding, probably because of confusion among readers of the first.

The black swan is a metaphor for the limits of our knowledge and, perhaps more important, our unfounded confidence in our knowledge. The metaphor draws on the familiar notion that before discovering counterexamples in Australia, people in the Old World would have been certain that all swans were white. To be more precise, Taleb lists three attributes of the black swan event his book addresses:

First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

Both of Taleb’s books are filled with “fun facts,” just as Malcolm Gladwell fills his own (bestselling) work. Yet the difference is that Gladwell—in such romps as The Tipping Point and Outliers—never has much of a coherent theory for which his amazing anecdotes are relevant.

Taleb, on the contrary, tells us his thesis up front, then draws on his vast knowledge to illustrate his points. One of his central claims is that people place too much confidence in their estimates. Taleb stresses that the issue is not how smart or how dumb people are. “We certainly know a lot, but we have a built-in tendency to think that we know a little bit more than we actually do, enough of that little bit to occasionally get into serious trouble.”

Taleb strings together sentences of surprising profundity while packing his prose with interesting statistics and stories. When reading The Black Swan, I had to stop noting every “interesting” paragraph in the margins, lest I fill them up.

The book’s prologue alone is an interesting essay, containing such standalone gems as the following:

What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it”; “We do not spontaneously learn that we don’t learn that we don’t learn. . . . Metarules (such as the rule that we have a tendency to not learn rules) we don’t seem to be good at getting”; “Who gets rewarded, the central banker who avoids a recession or the one who comes to ‘correct’ his predecessors’ faults and happens to be there during some economic recovery?

Taleb openly despises those in “suits”—very often mainstream economists or students of finance—who make predictions without bothering to study the record of their previous forecasts. Taleb declares, “Anyone who causes harm by forecasting should be treated as either a fool or a liar. Some forecasters cause more damage to society than criminals. Please, don’t drive a school bus blindfolded.”

Of perhaps most interest to the Austrian reader, Taleb champions Friedrich Hayek and mocks Paul Samuelson (who died in December). In a section titled, “They Still Ignore Hayek,” Taleb lauds the Austrian focus on the pretense of knowledge. Yet of Samuelson, the epitome of the neoclassical mainstream, Taleb issues harsh judgment indeed:

In orthodox economics, rationality became a straitjacket. Platonified economists ignored the fact that people might prefer to do something other than maximize their economic interests. This led to mathematical techniques such as “maximization,” or “optimization,” on which Paul Samuelson built much of his work. . . . I would not be the first to say that this optimization set back social science by reducing it from the intellectual and reflective discipline that it was becoming to an attempt at an “exact science.” By “exact science,” I mean a second-rate engineering problem for those who want to pretend that they are in the physics department—so-called physics envy. In other words, an intellectual fraud.

Coming from a philosopher (or an academic Austrian economist, for that matter), such criticism would not mean much to the so-called experts in various fields. Yet Taleb’s criticisms come with a harsh sting, for he is a respected contributor to the field of quantitative finance; Taleb (and a coauthor), for example, offered a more intuitive derivation of the Black-Scholes formula for option pricing.

Far more important to some readers, Taleb (allegedly) made a boatload of money as a trader. True to his philosophical views, one of his strategies involved using options that went up in value when the underlying asset fell in price. If people really do systematically underestimate the likelihood of improbable (but significant) events, as Taleb claims, then it should be possible to make long-run profits by losing small amounts of money on most wagers but earning large payoffs on a few outliers.

Other Austrian-oriented writers such as Gene Callahan have criticized Taleb for throwing out the baby with the bathwater. Taleb seems to think that the fabric of reality itself is governed by randomness; that much is true. Yet as his discussions of Poincaré’s “three body problem” and modern chaos theory make clear, the central lessons of the book don’t depend on whether the world is “really” determinist or “really” uncertain. It is enough that from a human actor’s limited knowledge, he can never truly predict what is coming down the pike.

Finally, Taleb does not simply throw up his hands in despair. “We cannot truly plan, because we do not understand the future—but that is not necessarily bad news. We could plan while bearing in mind such limitations. It just takes guts.”

By focusing on the extremely improbable outlier, Taleb isn’t warding off theoretical explanations—he is merely rejecting the regrettable tendency of overgeneralization in our theories, where we overfit based on a limited sample size. As Taleb says: “If you want to get an idea of a friend’s temperament, ethics, and personal elegance, you need to look at him under the tests of severe circumstances, not under the regular rosy glow of daily life. Can you assess the danger a criminal poses by examining only what he does on an ordinary day?”

There are many areas where the typical libertarian reader might take issue with Taleb, but this doesn’t detract from the value of his work. For what it’s worth, in response to our correspondence on Benoit Mandelbrot’s work in economics, Taleb sent me a signed copy of his book. The inscription read: “Hope freedom prevails—Nassim.”

  • Robert P. Murphy is senior economist at the Independent Energy Institute, a research assistant professor with the Free Market Institute at Texas Tech University, and a Research Fellow at the Independent Institute.