8 December 2008

Taleb: the story of the turkey....

CHARLIE ROSE: Nassim Nicholas Taleb is here. He is an investment
strategist. He is a professor. He is a philosopher. The firm he advises,
Universal Investments, has reported gains between 50 and 110 percent,
despite the ongoing economic crisis. But he is perhaps best known as an
author. His last book, "The Black Swan: The Impact of the Highly
Improbable" was required reading for many on Wall Street. It argued that
the world is dominated by extreme, improbable events that are more common
than popularly acknowledged. I am pleased to have him back at this table.
We will review some of the old and then put it into context of some of the
new. Welcome back.

NASSIM NICHOLAS TALEB: Thank you for inviting me. I want to mention
one thing, it is not -- only four pages of this book are about finance.

CHARLIE ROSE: And the other...

NASSIM NICHOLAS TALEB: People don’t know the other...

CHARLIE ROSE: The other...


CHARLIE ROSE: ... are centered (ph) on what?

NASSIM NICHOLAS TALEB: History and so on, but people think it is a
finance book because it discusses the story of the turkey and how people in
finance are fooled by random events.

CHARLIE ROSE: And what is the story of the turkey?

NASSIM NICHOLAS TALEB: In the book, I have the story of a turkey that
is fed for 1,000 days by a butcher, and every day confirms to the turkey
and the turkey’s economics department and the turkey’s risk management
department and the turkey’s analytical department that the butcher loves
turkeys, and every day brings more confidence to the statement. So it’s
fed for 1,000 days...

CHARLIE ROSE: Gets fatter and fatter and fatter.

NASSIM NICHOLAS TALEB: Fatter and fatter. On the day when its
comfort will be at its maximum, there is going to be a surprise. There
will be a surprise for the turkey.


NASSIM NICHOLAS TALEB: There will be a surprise for the turkey’s
economics department, all those Ph.D.’s. Will it be -- after all, there’s
maximum (inaudible)...

CHARLIE ROSE: But it’s not a surprise for the butcher, is it?

NASSIM NICHOLAS TALEB: Not a surprise for Charlie Rose as well. Not
a surprise for humans. It’s a surprise for the turkey.

So the whole idea here is we are not to be a turkey. And who is a
turkey? Bankers.

CHARLIE ROSE: Why were bankers turkeys?

NASSIM NICHOLAS TALEB: Because you had an accumulation, a patent
accumulation of hidden risks in the system, coupled with an increase in
complexity in the world. In other words, we had never in the history of
the world have we had a situation of so much complexity, coupled with so
much ignorance at the top. Nowhere have we had such a wedge between what
was going on and our understanding of events. Why?

CHARLIE ROSE: The world is much more complex and interconnected than
we know, and people who are supposed to know don’t know?

NASSIM NICHOLAS TALEB: Because they were fooled by the stability, the
illusion of stability, particularly Bernanke. They were fooled by the
story of the turkey. They were turned into turkeys, you know. The

CHARLIE ROSE: But Bernanke’s study had been about things like the
Japanese fall and the depression.

NASSIM NICHOLAS TALEB: I worried a lot when I read a paper by
Bernanke, a lecture he gave, called "The Great Moderation," in which he was
exactly the turkey. He was saying, oh, look at the stability. And he
found -- like all economists, by something I called the narrative fallacy,
he found explanation to why we have stability. He didn’t think of the

CHARLIE ROSE: Let’s do a couple of things. One, define black swan
and white swan.

NASSIM NICHOLAS TALEB: OK. Before the discovery of Australia, we had
no reasons to believe that swans could be any other color than white. It
was actually -- there was an expression in medieval London that went,
"you’d sooner see a black swan than" -- and it was a statement that
described something impossible, like George Bush getting the Nobel Prize in
physics. That would be, you know, a black swan.

CHARLIE ROSE: That would be one, that would be a black swan.


NASSIM NICHOLAS TALEB: And then, they had -- so they discovered that
continent, Australia, and sure enough, they had to revise a metaphor,
because it was no longer a good metaphor.


NASSIM NICHOLAS TALEB: No matter how many white swans you have seen,
you cannot rule out that one swan could be black.

But my black swan is not that exception. It’s a little beyond. It is
an exception that plays a huge role -- unlike the bird -- my exception, my
black swan is an event of massive consequences. And I noticed that
throughout history, OK, black swan played a larger and larger role.

CHARLIE ROSE: OK. Tell me some black swans. I mean, 9/11 was
obviously a black swan.

NASSIM NICHOLAS TALEB: 9/11, the great war was a black swan. Because
we had 100 years, like now, of great moderation. If Bernanke lived in
1913, I am sure he would have written a paper saying why we had such
stability in Europe or why wars...

CHARLIE ROSE: Now, why are you so on Bernanke’s case?

NASSIM NICHOLAS TALEB: Not him. It’s just this class of people who
are into economics give and have this illusion, provide us with all these
analytics, the illusion of understanding the world. And that I find it
very dangerous, because the economic establishment -- and I showed them my
book -- as a class, all right, as a class, has been extremely incompetent
in history. It is like medieval medicine. Medieval doctors killed more
patients than they saved.

And the same thing happened -- they can’t predict better than cab
drivers. And they increase the risk.

And I blame this crisis on economists, on financial economists,
particularly because they introduced risk metrics, measurements of risk
that were extremely faulty. They ignored black swans. It is like you give
a pilot a measurement of his risk...

CHARLIE ROSE: What are the black swans they ignored?

NASSIM NICHOLAS TALEB: They ignored large deviations in markets. So
what happened -- if you are a pilot and you don’t think there can be
storms, visibly you are not going to be prepared if you have a storm and
you are going to take a lot of risk. You’re not going to have a parachute.
You won’t have the equipment.

So banks were accumulating a humongous amount of risk.

CHARLIE ROSE: Thinking there would never be a storm.

NASSIM NICHOLAS TALEB: Thinking there would never be a storm, because
of these economic metrics, because of these things that were, you know,
prized with the Nobel, portfolio theory. All these metrics, in fact,
turned bankers into turkeys, and you have a lot more confidence when you
have a metric.

CHARLIE ROSE: So who got it right?

NASSIM NICHOLAS TALEB: A few people. Nouriel Roubini got it right...


NASSIM NICHOLAS TALEB: ... because he probably -- he -- whatever
reason, he got it right. Bob Shiller to some extent.

CHARLIE ROSE: Bob Shiller from Yale got it right.

NASSIM NICHOLAS TALEB: From Yale. Saw that there was a problem in
real estate. But then again, they were finding that -- they were
identifying the pieces that were dangerous in the system.

I looked at it differently. It is like a house of cards. OK? You
know eventually it is going to topple because the structure is bad, not
because, you know, a particular blow is going to topple it. It is because
a structure -- it is like the fragility comes from the structure, not from
a particular component of the structure.

CHARLIE ROSE: Did Nassim get it right?

NASSIM NICHOLAS TALEB: I mean, I stuck my neck. I made a bet. I had
been waiting for this since 2003.

CHARLIE ROSE: Waiting for?

NASSIM NICHOLAS TALEB: For this crisis. Expecting it to happen.

CHARLIE ROSE: Knowing...


CHARLIE ROSE: Knowing that all the signs were there, knowing that
there was this huge over-investment in these securities?

NASSIM NICHOLAS TALEB: No. It is the fact that I was looking at a
plane flown by the pilot, who didn’t know about storms. So, I said, OK, we
have storms. The next storm, all the planes are going to crash together,
and that is what happened. Because I looked that over time, we had a
buildup of risk in the system, coupled with a globalization that made
banks, OK, merge into like one gigantic bank, because of the interlocking
relationship between them.

CHARLIE ROSE: And (inaudible) doing the same thing?

NASSIM NICHOLAS TALEB: All doing the same thing, and they were all
trading with each other. So one fails; the other one has to fail here,
because of the interlocking relationships. And globalization causes this
fragility. So things appear to be stable, but in fact they are fragile.

So I was worried about it. It’s not like I was making bets on it. I
was telling everyone who would want to listen to me to watch out, that the
banking system was prone to collapse. Not to trade with banks, not to have
their money (ph) exposure to banks. To watch out that we were going to
have inflation stemming from that collapse, that the leverage, that
monstrous leverage was eventually going to lead to some form of penalty,
and that we had bubbles caused by debt, not bubbles caused by asset
inflation, but bubbles caused by accumulation of debts. That these were a
lot more vicious than asset bubbles.

And nobody would listen -- wanted to listen to me at the time.

I waged a war against something called value at risk, you know? A
measure of risk that to me was charlatanism, didn’t measure risk. That
these metrics were not -- would not -- could not deal with rare events.
And you know that risk comes from rare events.

So I realized that the system was way too fragile. And I started -- I
became obsessive about it. When my book came out, I started listening to
the criticism, and I realized that nobody attacked my central point. I
thought that someone would come up with some convincing argument.

Two, three months after the publication, I went for the jugular. I
said, this thing is going to go. And, in fact -- so.

CHARLIE ROSE: But did you put your money where your ideas were?


CHARLIE ROSE: So you made a lot of money on the down?

NASSIM NICHOLAS TALEB: I don’t -- you know, I protected people. I
made money for my clients, to protect them. I made some for myself, to
protect myself. Right? I protected people. I don’t want to boast that --
it is not a good thing to make money when other people are losing their
shirts, but let’s put it this way, I didn’t get hurt.

CHARLIE ROSE: You were on the right side of the trend.

NASSIM NICHOLAS TALEB: I was on the right side of the trade. But I
did not -- I made sure that nobody in my family members had banks
preferred, that effectively if I could convince them not to own stocks,
they would not own stocks. And you know, people close to me were 100
percent in cash.

And so I really stuck my neck out, and of course we made several
hundred million dollars for our clients, to just protect them.

CHARLIE ROSE: My understanding of your philosophy is that you should
be about 80, 90 percent in safe securities, cash or municipal bonds or
treasuries, and about 15 to 20 percent in very risky investments. That’s
the kind of...

NASSIM NICHOLAS TALEB: Yes. So what I keep telling people...

CHARLIE ROSE: ... portfolios suggestions -- makeup you suggest.

NASSIM NICHOLAS TALEB: Exactly. I was telling the people to be
bimodal. In other words, to take a lot of risk...

CHARLIE ROSE: Very high risk.

NASSIM NICHOLAS TALEB: Very high risk for small amounts, and no risk
in large amounts. It beats having a medium-risk investment, because we
don’t know if it’s medium-risk. These metrics, you know, by the
establishment, economic establishment, don’t measure risks properly. So
you know if you have zero risk, it’s zero risk. If you have cash and very
risky instruments.

And also, if you have cash, you have your powder dry, so -- and it is
a general idea, a general idea about how society should increase

CHARLIE ROSE: OK. Let’s look at where we are today.


CHARLIE ROSE: Tell me where we are going.

NASSIM NICHOLAS TALEB: Where we are going, capitalism II will be very
different. Number one, banks will be utility companies, because we no
longer will tolerate to privatize -- we don’t privatize the gains and
socialize the losses anymore. If you and I are going to bear the losses of
bankers, you don’t want them to be paid bonuses for five or six or seven
years, OK, and then bail them out. No more of that.

So banks are going to converge to utility companies, because if you go
to Detroit or L.A., you want to be able to get cash from a cash machine,
right? It is a utility. OK? So banks are going to go there.

Now, risk taking -- we are going to be massively deleveraged, because
banks not being able to lend, OK, we are going to have a different class of
risk taking. People like myself, like you will be able to take risks under
the condition that the society will not bail us out if we’re wrong. So it
is going to be a different brand of capitalism.

So you will have less debt, so less debt investments, and more
investment in upside. In other words, you know, you have asymmetry, recent
asymmetry that developed, say, particularly in the late phases of our
Western capitalism. Is that you have some people buy the debt -- in other
words, they have almost no upside, and only downside, and some people have
almost no downside for all the upside. You see? And that will change.
You will have more symmetry. In other words, you invest, you take all the
risk, you take a portion of the upside and you take a portion of the

CHARLIE ROSE: So what happens to hedge funds?

NASSIM NICHOLAS TALEB: I think the hedge funds that we have today, a
lot of them are going to disappear, and they deserve to disappear, OK? A
lot of them never made a penny for their clients. They have taken a lot of
hidden risk that looked good, but in fact they were hiding a lot of hidden

But I think there is a role for hedge funds, to finance companies, by
mature hedge funds, you see? The second -- those who will survive. You’re
going to have, of course, survival, OK, of a different class of people than
the ones who thrived during the Bernanke-Greenspan era. OK?

So you will have hedge funds taking risks, and they will be the ones
taking risks, hedge funds. But then, you know that society, the
responsible people, society is not there to bail them out. You know, take
risks, but the class of risk that they will be taking is going to be more
on the equity side than on the debt side.

CHARLIE ROSE: You think all this began way back in the early Reagan
administration, we became obsessed with profit and quarterly earnings. And
it just continued. And we all fell in love with equities and lost all
sense of proportion.

NASSIM NICHOLAS TALEB: I think what happened -- I don’t know if it is
Reagan or so on. As you can see, over time...

CHARLIE ROSE: You know the time.

NASSIM NICHOLAS TALEB: Yes. Overtime, we have had a switch, OK, to a
trust -- not the market that’s bad. The problem is these analysts, 35-
year-old analysts or maybe sometimes 29-year-old analysts, OK, looking at
your numbers, OK, and running, in fact, your company. What do you do? You
are going to provide them what numbers you want. How? Cosmetically. You
are going to make sure that you look good in the short-term, and there is a
certain way to look good.

I learned from -- how to cook numbers. When you are a trader...

CHARLIE ROSE: You learned how to cook numbers?

NASSIM NICHOLAS TALEB: Yes, there are some metrics. You want to look
stable, OK. If you engage in loans that don’t blow up often, all right,
you look stable most of the time. So your metrics look great, until you
blow up.

So you learn as a trader that if someone gives you a metric, you can
game it, there is a way to game it. And the system, capitalism games that
metric by giving the illusion of profits, OK, while taking hidden risks,
and that came out of that atmosphere that developed with this orthodoxy of
markets being smart.

Markets are stupid. They can be fooled by numbers. You can fool

CHARLIE ROSE: Yes. Now, is that one of the great discoveries we are
making now, that in capitalism, in its respect for markets, does not
appreciate that markets can be wrong and can be foolish and can be -- they
do not have a perfect sort of regulation?



NASSIM NICHOLAS TALEB: And I looked at numbers. Markets are horrible
at predicting rare events. In an environment, complex environment,
dominated by black swans, by rare events, markets are not very good.

CHARLIE ROSE: But let me go -- you mentioned Nouriel Roubini, who has
been here and who has become well-known as someone who has predicted this
and saw it coming, and scares the hell out of people when he comes and sits
where you do, because he sees it as getting worse, and even suggests
sometimes it may mark the decline of America. How bad do you think...

NASSIM NICHOLAS TALEB: I think it is worse than Roubini thinks.

No, I -- I had the same story, haven’t changed my story since -- and
what convinced me of this is that we switched from an environment of
inflation, hyperinflation, where people are afraid of commodity prices
rising, to a total deflation in no time. Look at inflation bonds.

So let me tell you why I am afraid, because everybody is referring to
one precedent, the 1929 crisis. That crisis took a long time and didn’t
involve a lot of countries.

Today, today, you cancel an order, a Christmas order here...

CHARLIE ROSE: It goes down the line.

NASSIM NICHOLAS TALEB: It shuts -- the factory closes in China hours
later. Right? So you realize runs on a bank today -- all right -- so
things happen very quickly.

So I think it is going to happen very quickly. It is going to be a
lot worse.

CHARLIE ROSE: What is going to happen very quickly? A collapse? A
collapse of...



CHARLIE ROSE: Tell me what. I have a hard time -- I have a hard time
ever getting anybody to say to me, you know, how bad is it going to be and
how will we know, and what will be the manifestations of the badness?

NASSIM NICHOLAS TALEB: OK. I see, let me tell you, it is like I
don’t like prediction, but -- except in a situation where if you are in a
satellite and you see clouds coming, you know you are going to have rain.
OK? You are not doing any mathematical thing. You see a satellite.

And here, I see this deck of orders, how much people have to sell.
And the two sources of selling...

CHARLIE ROSE: Inventory. Inventory.

NASSIM NICHOLAS TALEB: Inventory. OK? How much people have -- hedge
funds have to deleverage.


NASSIM NICHOLAS TALEB: So they have got to sell their stuff. They
still haven’t sold what they need to sell.

CHARLIE ROSE: Because if they sell, they have to sell at a huge loss
and nobody wants to buy it? Is that the idea?

NASSIM NICHOLAS TALEB: No, no. Because they are selling over time.
Every time we have good news, the market rallies, and then they sell, all
right? So, you know, number one, we have a deck what you call, we have
inventory to go.

Second one, think now of -- the people are disillusioned with the
market. Think of someone turning 64. His 401(k) today is half of what
it was probably if he’s lucky. Or I mean, it can be worse, depends on what
he has in it. Has much less money to retire. Depends on his allocation,
could be between 25 percent less to 75 percent. What is he going to do?

CHARLIE ROSE: I don’t know. Tell me.

NASSIM NICHOLAS TALEB: He is not going to buy stocks.

CHARLIE ROSE: What is he going to do?

NASSIM NICHOLAS TALEB: So it is sort of like that Ponzi scheme of
buying stocks is over. All right?

CHARLIE ROSE: So -- you’re right. What is he going to do?

NASSIM NICHOLAS TALEB: He needs -- doesn’t he need cash...


NASSIM NICHOLAS TALEB: ... to pay for his retirement?

CHARLIE ROSE: His rent and his food...

NASSIM NICHOLAS TALEB: His whatever. His rent and his cigars or
whatever -- he has to sell. He has to sell stocks to buy cigars.


NASSIM NICHOLAS TALEB: OK. So this person has to sell. So now we
have inventory to go.

CHARLIE ROSE: So now you are evaporating savings.

NASSIM NICHOLAS TALEB: And who is going to buy?


NASSIM NICHOLAS TALEB: I don’t know. Not me. I mean, I don’t know
if you heard, you have the intention of buying stocks, there’s no -- people
don’t have money. So pension funds are suffering. University endowments
are suffering. Everybody is suffering.

Now I tell people, if the system is so fragile that everybody is
hoping for a rise, all right, the only solution is for society not to
depend on asset values anymore. So capitalism II will be some kind of
independence from asset values. To achieve that state of capitalism II,
you need a huge amount of deleveraging, and unfortunately a lot of selling
of securities.

To reach capitalism II, which will be a society that is more stable --
we are in a complex environment...

CHARLIE ROSE: Define capitalism II for me.

NASSIM NICHOLAS TALEB: Banks become utility companies. A lot less
debt. Less speculation in asset values, all right? You make fewer -- a
barber, you make your money shaving people and cutting hair and so on, and
talking to them, rather than money in the stock market. Or if you’re a
dentist, dentists used to make money in dentistry, and then later on they
started making money in investments. You go back to making money in

So we’re seeing people reverting to old habits. And of course that
can be achieved with a decrease of the allocation to assets, unfortunately.

Stocks -- there is no reason for stocks not to be much cheaper than
they are today.

CHARLIE ROSE: So what is going to happen to commodity prices,
especially oil?

NASSIM NICHOLAS TALEB: I don’t know, but I know that we are going
have massive deflation. The overhang of debt, massive deflation. Debt
needs to be reduced. And I think Paulson seems to be doing a good job,
particularly that they were part of the cause of what happened, you know,
it is quite commendable.

CHARLIE ROSE: All right. This book is called "The Black Swan: The
Impact of the Highly Improbable." Nassim Nicholas Taleb. Thank you again.
Great to have you back.

NASSIM NICHOLAS TALEB: Thank you for inviting me. Thanks a lot.
Thank you.

CHARLIE ROSE: Pleasure. Thank you.

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