It is not often that a school of thought comes along at exactly the right time that markets, economists and policymakers are worried about a specific event or crisis. When a book setting out these new views does come along, it is usually ignored, then quietly buried, and then only is quoted by increasingly esoteric sources until the work is driven to the point of irrelevance.

Such a fate is quite likely for two outstanding books released in 2007 – Black Swan [1] and Zoom [2] – both of which capture some original thinking on the state of the markets and the underlying economic structure that supports market mechanisms. While the authors did not in all probability set out to collaborate per se, they may have just produced classically symbiotic tomes.

First, the books on their own merits.

Nassim Nicholas Taleb or NNT for short, famously wrote about planes crashing into buildings in an earlier work [3] in the months preceding the ugly September 11, 2001, incident. He did not attempt to predict that planes could be used for this purpose, only that deterministic probability models are unlikely to factor in such catastrophes. Thus, when he published a book on the limitations of probability models currently employed by market technicians earlier this year, it was almost the natural order of things for markets to experience exactly that type of upheaval.

NNT’s book works on a premise that the human mind fails to adapt adequately to what it does not know and therefore assigns irrelevant (not merely incorrect) probabilities to what it does know. Thus, in the decades and centuries preceding the discovery of Australia it was commonly held that all swans were white, ie the probability of a swan being white was held at 100%. As the early explorers wandered in the Australian bush and discovered black swans, the probability of swans being white suddenly changed. Note here that the “natural” probability of swans being white remained unchanged during the whole period of human existence. What changed was simply our knowledge set.

This apparently esoteric philosophical point has much relevance in markets, especially in what is known as risk management. The ability to quantify risk is based on accepting a certain set of data as the only range of possibilities and assigning a probability distribution such as Gaussian or bell curve to the same. There are problems with selecting a probability distribution based on the available data because expanding the range of data always changes the underlying probability distribution. In effect, what looks like impossible in the probability distribution (say a one in a million chance) may actually be a lot more likely once the underlying data is properly populated.

Choosing the wrong data with the incorrect probability distribution contributed to the creation, rating and trading of dangerously combustible collateralized debt obligations (CDOs) that referenced subprime mortgages (Annus financialitis Asia Times Online, December 22, 2007). The range of defaults actually observed on these securities far exceeded the thresholds set in place by the declarative probability models employed by Wall Street, in turn triggering both price declines and a wider loss of confidence across the financial system (In gold we trust) Asia Times Online, September 8, 2007).

NNT dismisses the work of Paul Samuelson, the patron saint of Wall Street, by showing that the lofty buildings of modern finance taught in the classrooms across the US and Europe today are based on foundations of goat’s cheese. He is not the first one to cross swords with the academic establishment of today, but as William Poundstone [4] found to his chagrin a couple of years ago, obduracy and indifference can undo arguments faster than mere rebuttals ever could.

Continuing the incendiary tactics of Black Swan aimed at the world of finance, Zoom focuses its attention on the car and oil industries. Much of what is written in the book is already well known, but to string the pieces together the way the authors have done must really have taken significant discipline and imagination.

Starting with a catchphrase that “Oil is the problem, cars are the solution”, the authors dismiss any notions of replacing the current way of life enjoyed by the US and Europe in the name of global warming. In other words, the only thing that will change is the how cars are fueled, rather than the total volume of cars sold and used on a daily basis. Many of the arguments laid out by the authors will be familiar to Asia Times Online readers (How central bankers could save the world” Asia Times Online, December 8, 2007) but perhaps not to readers of American and European mainstream publications.

The insider’s view on how oil and car lobbies help to reverse every tentative step suggested by governments and consumers, not to mention discrediting those arguing about climate change, is alone worth the price of admission on this book.

By itself, Zoom represents strong arguments in favor of governments acting today to properly price the negative economic good of air pollution caused by the use of fossil fuels. It lays bare the structure of the oil industry’s lobbies, how the Seven Sisters relate to the national oil companies and what the most likely avenues for solving over-dependence on oil are. For a change, the authors do not assume that alternative fuels such as wind and solar power can be taken for granted; indeed they point out that depletion of proven oil reserves may expand the use of other fossil fuels such as shale and tar sands, in turn triggering even higher pollution from the extraction and refinement processes to continued use of fossil fuels.

The behavior of Asian governments and consumers is paramount in all this. If the billion or so cars that enter the roads of China and India in the next three decades are powered by fossil fuels, the world will be one hot and sooty place. If instead fuel cells and electric batteries power them, the outlook improves dramatically. Make no mistake; Asia is very much the battleground where the forces pushing or reversing global warming will need to win.

Where the books collide

Almost serendipitously, the two books prove to be symbiotic. Over-dependence on fossil fuels and ignoring the pernicious effects of global warming are of course central to the assumption of what constitutes “normal” standards of living in the US and Europe. The underlying logic is one of “my dad drove a car offering 10 miles per gallon, and I certainly don’t see a reason to change that because my comfort is more important the survival of stupid polar bears”.

The problem with that view of course is that no one asked anyone to sacrifice their comforts for polar bears, only that the price of gasoline in the US is too low to encourage any shift to more economical cars (yes, even at current levels US gasoline is a steal compared to what it costs). In much the same way as NNT lays down in his book, underlying assumptions of how fuels will be found and delivered to the US now look increasingly fantasy-prone.

Today’s sources of oil to the US and Europe (as well as China and India) look increasingly troubled due to a combination of geopolitical and economic factors. The likelihood for oil to hit US$200 per barrel over the course of the next two years looks higher rather than lower at the beginning of 2008. I argued in the previous article that central bankers, trying to keep their economies afloat while ignoring rampant inflationary pressures in hard and soft commodities, had no choice but to usher in a recession at this stage.

Note here that an analysis of historical price moves (the Samuelson school) would have shown in the beginning of 2004 that there is “no” chance of oil hitting $100 per barrel and yet that is exactly where we are now. This is where NNT’s work on using fractal geometry rather than declarative probability models assumes greater relevance. In simple words, understanding the probability of a major terrorist strike in an oil producing country is not a function of historical data, but rather of using more imaginative and forward-looking analysis based on existing dynamics. This vastly changes the pricing of future events, and with it, factors underlying current prices.

Along the line, we should perhaps spare some thought for the hapless researchers employed by oil and car companies in the US and Europe attempting to devise new technologies that maximize profits under the current regime of assumptions. Thus they look for ways to improve fuel mileage from 10 mpg to 25 mpg, quietly ignoring strategies such as electric cars that may push efficiency to 100 mpg. Meanwhile, oil company researchers spend a lot of time discrediting the global warming lobby, while examining ways of exploiting shale and tar sands more efficiently.

This thinking is analogous to a drunk looking for his car keys near the street light even though he lost them in the bushes – the researchers are merely following the path of white swans in attempting incremental, evolutionary ideas rather than the black swan path of revolutionary ideas that may usher in creative destruction.

China and India could do much to leapfrog the US and Europe if only they focused their attention on the future rather than the past. While their central bankers pretend to be intelligent and throw billions in futile rescues of Wall Street, the need of the hour is for these countries to instead buy the best scientific research outfits responsible for examining solar power, fuel cells and the like. Solar power is under-researched because most US and European energy needs are derived from cold-weather problems – heating in winter for example, when solar power will prove unviable. In contrast, countries like India and all of Southeast Asia could certainly benefit from a leapfrogging in solar power technology, especially if alternatives such as fossil fuels are heavily taxed in the US and Europe.

These technology breakthroughs will represent their own black swans in terms of changing today’s geopolitical structures comprehensively. Without the bullying power of oil, Middle-Eastern countries will be rendered irrelevant, even as the vital power-sharing deals with the US changes alongside. Why would the US support irrelevant Saudi monarchs, for example, at the expense of democratic alternatives? Why would China or India kowtow to Islamic interests if Middle Eastern oil did not account for their energy imports? The possibilities are endless, with the only constant being change.

Operation cover-up

All that said, I also have little doubt that the Establishment (financial, oil, car, government) will attempt to quietly bury both books in coming weeks and months. Starting with attempts to discredit the authors based on minor factual deviations, it is highly likely that the books will be treated with increasing suspicion by the mainstream until rebuttals are issued. These will get equal airtime to what the above two books represent, continuing the charade of “fair media” that appears anything but to outsiders such as myself.

My biggest fear with respect to the two books is that they become convenient anchoring points to highlight alternative views. Take Black Swan for example, and already there are attempts to portray extraordinary losses of Wall Street as one-off events, with an underlying statement that such losses are not possible in the future. This twisted use of logic to highlight the possibility of returning health to the patients of Wall Street completely misses the point that risk management with respect to what Wall Street trades is still woefully inadequate to actually controlling or avoiding further losses.

Similarly, Zoom can be used to represent the reasons for car companies to invest in fuel cells and electric car research, albeit without any serious attempt to change underlying dynamics namely an oil tax in the US, accepting higher fuel efficiency targets across the board and forcing oil companies to urgently expand research and deployment of carbon capture technologies. Without carbon capture, the world will continue to stare into the wrong side of the climate change argument.

Worse yet, both books could simply be ignored as policymakers choose to curl up with their copies of Harry Potter instead.

Notes
1. The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb, 2007.
2. Zoom: The Global Race to Fuel the Car of the Future by Iain Carson and Vijay V Vaitheeswaran, 2007.
3. Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life by Nassim Nicholas Taleb, 2001.
4. Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone, 2006.

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