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Sunday, August 4, 2019

Reading List: Skin in the Game

Taleb, Nassim Nicholas. Skin in the Game. New York: Random House, 2018. ISBN 978-0-425-28462-9.
This book is volume four in the author's Incerto series, following Fooled by Randomness (February 2011), The Black Swan (January 2009), and Antifragile (April 2018). In it, he continues to explore the topics of uncertainty, risk, decision making under such circumstances, and how both individuals and societies winnow out what works from what doesn't in order to choose wisely among the myriad alternatives available.

The title, “Skin in the Game”, is an aphorism which refers to an individual's sharing the risks and rewards of an undertaking in which they are involved. This is often applied to business and finance, but it is, as the author demonstrates, a very general and powerful concept. An airline pilot has skin in the game along with the passengers. If the plane crashes and kills everybody on board, the pilot will die along with them. This insures that the pilot shares the passengers' desire for a safe, uneventful trip and inspires confidence among them. A government “expert” putting together a “food pyramid” to be vigorously promoted among the citizenry and enforced upon captive populations such as school children or members of the armed forces, has no skin in the game. If his or her recommendations create an epidemic of obesity, type 2 diabetes, and cardiovascular disease, that probably won't happen until after the “expert” has retired and, in any case, civil servants are not fired or demoted based upon the consequences of their recommendations.

Ancestral human society was all about skin in the game. In a small band of hunter/gatherers, everybody can see and is aware of the actions of everybody else. Slackers who do not contribute to the food supply are likely to be cut loose to fend for themselves. When the hunt fails, nobody eats until the next kill. If a conflict develops with a neighbouring band, those who decide to fight instead of running away or surrendering are in the front line of the battle and will be the first to suffer in case of defeat.

Nowadays we are far more “advanced”. As the author notes, “Bureaucracy is a construction by which a person is conveniently separated from the consequences of his or her actions.” As populations have exploded, layers and layers of complexity have been erected, removing authority ever farther from those under its power. We have built mechanisms which have immunised a ruling class of decision makers from the consequences of their decisions: they have little or no skin in the game.

Less than a third of all Roman emperors died in their beds. Even though they were at the pinnacle of the largest and most complicated empire in the West, they regularly paid the ultimate price for their errors either in battle or through palace intrigue by those dissatisfied with their performance. Today the geniuses responsible for the 2008 financial crisis, which destroyed the savings of hundreds of millions of innocent people and picked the pockets of blameless taxpayers to bail out the institutions they wrecked, not only suffered no punishment of any kind, but in many cases walked away with large bonuses or golden parachute payments and today are listened to when they pontificate on the current scene, rather than being laughed at or scorned as they would be in a rational world. We have developed institutions which shift the consequences of bad decisions from those who make them to others, breaking the vital feedback loop by which we converge upon solutions which, if not perfect, at least work well enough to get the job done without the repeated catastrophes that result from ivory tower theories being implemented on a grand scale in the real world.

Learning and Evolution

Being creatures who have evolved large brains, we're inclined to think that learning is something that individuals do, by observing the world, drawing inferences, testing hypotheses, and taking on knowledge accumulated by others. But the overwhelming majority of creatures who have ever lived, and of those alive today, do not have large brains—indeed, many do not have brains at all. How have they learned to survive and proliferate, filling every niche on the planet where environmental conditions are compatible with biochemistry based upon carbon atoms and water? How have they, over the billions of years since life arose on Earth, inexorably increased in complexity, most recently producing a species with a big brain able to ponder such questions?

The answer is massive parallelism, exhaustive search, selection for survivors, and skin in the game, or, putting it all together, evolution. Every living creature has skin in the ultimate game of whether it will produce offspring that inherit its characteristics. Every individual is different, and the process of reproduction introduces small variations in progeny. Change the environment, and the characteristics of those best adapted to reproduce in it will shift and, eventually, the population will consist of organisms adapted to the new circumstances. The critical thing to note is that while each organism has skin in the game, many may, and indeed must, lose the game and die before reproducing. The individual organism does not learn, but the species does and, stepping back another level, the ecosystem as a whole learns and adapts as species appear, compete, die out, or succeed and proliferate. This simple process has produced all of the complexity we observe in the natural world, and it works because every organism and species has skin in the game: its adaptation to its environment has immediate consequences for its survival.

None of this is controversial or new. What the author has done in this book is to apply this evolutionary epistemology to domains far beyond its origins in biology—in fact, to almost everything in the human experience—and demonstrate that both success and wisdom are generated when this process is allowed to work, but failure and folly result when it is thwarted by institutions which take the skin out of the game.

How does this apply in present-day human society? Consider one small example of a free market in action. The restaurant business is notoriously risky. Restaurants come and go all the time, and most innovations in the business fall flat on their face and quickly disappear. And yet most cities have, at any given time, a broad selection of restaurants with a wide variety of menus, price points, ambiance, and service to appeal to almost any taste. Each restaurant has skin in the game: those which do not attract sufficient customers (or, having once been successful, fail to adapt when customers' tastes change) go out of business and are replaced by new entrants. And yet for all the churning and risk to individual restaurants, the restaurant “ecosystem” is remarkably stable, providing customers options closely aligned with their current desires.

To a certain kind of “expert” endowed with a big brain (often crammed into a pointy head), found in abundance around élite universities and government agencies, all of this seems messy, chaotic, and (the horror!) inefficient. Consider the money lost when a restaurant fails, the cooks and waiters who lose their jobs, having to find a new restaurant to employ them, the vacant building earning nothing for its owner until a new tenant is found—certainly there must be a better way. Why, suppose instead we design a standardised set of restaurants based upon a careful study of public preferences, then roll out this highly-optimised solution to the problem. They might be called “public feeding centres”. And they would work about as well as the name implies.

Survival and Extinction

Evolution ultimately works through extinction. Individuals who are poorly adapted to their environment (or, in a free market, companies which poorly serve their customers) fail to reproduce (or, in the case of a company, survive and expand). This leaves a population better adapted to its environment. When the environment changes, or a new innovation appears (for example, electricity in an age dominated by steam power), a new sorting out occurs which may see the disappearance of long-established companies that failed to adapt to the new circumstances. It is a tautology that the current population consists entirely of survivors, but there is a deep truth within this observation which is at the heart of evolution. As long as there is a direct link between performance in the real world and survival—skin in the game—evolution will work to continually optimise and refine the population as circumstances change.

This evolutionary process works just as powerfully in the realm of ideas as in biology and commerce. Ideas have consequences, and for the process of selection to function, those consequences, good or ill, must be borne by those who promulgate the idea. Consider inventions: an inventor who creates something genuinely useful and brings it to market (recognising that there are many possible missteps and opportunities for bad luck or timing to disrupt this process) may reap great rewards which, in turn, will fund elaboration of the original invention and development of related innovations. The new invention may displace existing technologies and cause them, and those who produce them, to become obsolete and disappear (or be relegated to a minor position in the market). Both the winner and loser in this process have skin in the game, and the outcome of the game is decided by the evaluation of the customers expressed in the most tangible way possible: what they choose to buy.

Now consider an academic theorist who comes up with some intellectual “innovation” such as “Modern Monetary Theory” (which basically says that a government can print as much paper money as it wishes to pay for what it wants without collecting taxes or issuing debt as long as full employment has not been achieved). The theory and the reputation of those who advocate it are evaluated by their peers: other academics and theorists employed by institutions such as national treasuries and central banks. Such a theory is not launched into a market to fend for itself among competing theories: it is “sold” to those in positions of authority and imposed from the top down upon an economy, regardless of the opinions of those participating in it. Now, suppose the brilliant new idea is implemented and results in, say, total collapse of the economy and civil society? What price do those who promulgated the theory and implemented it pay? Little or nothing, compared to the misery of those who lost their savings, jobs, houses, and assets in the calamity. Many of the academics will have tenure and suffer no consequences whatsoever: they will refine the theory, or else publish erudite analyses of how the implementation was flawed and argue that the theory “has never been tried”. Some senior officials may be replaced, but will doubtless land on their feet and continue to pull down large salaries as lobbyists, consultants, or pundits. The bureaucrats who patiently implemented the disastrous policies are civil servants: their jobs and pensions are as eternal as anything in this mortal sphere. And, before long, another bright, new idea will bubble forth from the groves of academe.

(If you think this hypothetical example is unrealistic, see the career of one Robert Rubin. “Bob”, during his association with Citigroup between 1999 and 2009, received total compensation of US$126 million for his “services” as a director, advisor, and temporary chairman of the bank, during which time he advocated the policies which eventually brought it to the brink of collapse in 2008 and vigorously fought attempts to regulate the financial derivatives which eventually triggered the global catastrophe. During his tenure at Citigroup, shareholders of its stock lost 70% of their investment, and eventually the bank was bailed out by the federal government using money taken by coercive taxation from cab drivers and hairdressers who had no culpability in creating the problems. Rubin walked away with his “winnings” and paid no price, financial, civil, or criminal, for his actions. He is one of the many poster boys and girls for the “no skin in the game club”. And lest you think that, chastened, the academics and pointy-heads in government would regain their grounding in reality, I have just one phrase for you, “trillion dollar coin”, which “Nobel Prize” winner Paul Krugman declared to be “the most important fiscal policy debate of our lifetimes”.)

Intellectual Yet Idiot

A cornerstone of civilised society, dating from at least the Code of Hammurabi (c. 1754 B.C.), is that those who create risks must bear those risks: an architect whose building collapses and kills its owner is put to death. This is the fundamental feedback loop which enables learning. When it is broken, when those who create risks (academics, government policy makers, managers of large corporations, etc.) are able to transfer those risks to others (taxpayers, those subject to laws and regulations, customers, or the public at large), the system does not learn; evolution breaks down; and folly runs rampant. This phenomenon is manifested most obviously in the modern proliferation of the affliction the author calls the “intellectual yet idiot” (IYI). These are people who are evaluated by their peers (other IYIs), not tested against the real world. They are the equivalent of a list of movies chosen based upon the opinions of high-falutin' snobbish critics as opposed to box office receipts. They strive for the approval of others like themselves and, inevitably, spiral into ever more abstract theories disconnected from ground truth, ascending ever higher into the sky.

Many IYIs achieve distinction in one narrow field and then assume that qualifies them to pronounce authoritatively on any topic whatsoever. As was said by biographer Roy Harrod of John Maynard Keynes,

He held forth on a great range of topics, on some of which he was thoroughly expert, but on others of which he may have derived his views from the few pages of a book at which he happened to glance. The air of authority was the same in both cases.

Still other IYIs have no authentic credentials whatsoever, but derive their purported authority from the approbation of other IYIs in completely bogus fields such as gender and ethnic studies, critical anything studies, and nutrition science. As the author notes, riding some of his favourite hobby horses,

Typically, the IYI get first-order logic right, but not second-order (or higher) effects, making him totally incompetent in complex domains.

The IYI has been wrong, historically, about Stalinism, Maoism, Iraq, Libya, Syria, lobotomies, urban planning, low-carbohydrate diets, gym machines, behaviorism, trans-fats, Freudianism, portfolio theory, linear regression, HFCS (High-Fructose Corn Syrup), Gaussianism, Salafism, dynamic stochastic equilibrium modeling, housing projects, marathon running, selfish genes, election-forecasting models, Bernie Madoff (pre-blowup), and p values. But he is still convinced his current position is right.

Doubtless, IYIs have always been with us (at least since societies developed to such a degree that they could afford some fraction of the population who devoted themselves entirely to words and ideas)—Nietzsche called them “Bildungsphilisters”—but since the middle of the twentieth century they have been proliferating like pond scum, and now hold much of the high ground in universities, the media, think tanks, and senior positions in the administrative state. They believe their models (almost always linear and first-order) accurately describe the behaviour of complex dynamic systems, and that they can “nudge” the less-intellectually-exalted and credentialed masses into virtuous behaviour, as defined by them. When the masses dare to push back, having a limited tolerance for fatuous nonsense, or being scolded by those who have been consistently wrong about, well, everything, and dare vote for candidates and causes which make sense to them and seem better-aligned with the reality they see on the ground, they are accused of—gasp—populism, and must be guided in the proper direction by their betters, their uncouth speech silenced in favour of the cultured “consensus” of the few.

One of the reasons we seem to have many more IYIs around than we used to, and that they have more influence over our lives is related to scaling. As the author notes, “it is easier to macrobull***t than microbull***t”. A grand theory which purports to explain the behaviour of billions of people in a global economy over a period of decades is impossible to test or verify analytically or by simulation. An equally silly theory that describes things within people's direct experience is likely to be immediately rejected out of hand as the absurdity it is. This is one reason decentralisation works so well: when you push decision making down as close as possible to individuals, their common sense asserts itself and immunises them from the blandishments of IYIs.

The Lindy Effect

How can you sift the good and the enduring from the mass of ephemeral fads and bad ideas that swirl around us every day? The Lindy effect is a powerful tool. Lindy's delicatessen in New York City was a favoured hangout for actors who observed that the amount of time a show had been running on Broadway was the best predictor of how long it would continue to run. A show that has run for three months will probably last for at least three months more. A show that has made it to the one year mark probably has another year or more to go. In other words, the best test for whether something will stand the test of time is whether it has already withstood the test of time. This may, at first, seem counterintuitive: a sixty year old person has a shorter expected lifespan remaining than a twenty year old. The Lindy effect applies only to nonperishable things such as “ideas, books, technologies, procedures, institutions, and political systems”.

Thus, a book which has been in print continuously for a hundred years is likely to be in print a hundred years from now, while this season's hot best-seller may be forgotten a few years hence. The latest political or economic theory filling up pages in the academic journals and coming onto the radar of the IYIs in the think tanks, media punditry, and (shudder) government agencies, is likely to be forgotten and/or discredited in a few years while those with a pedigree of centuries or millennia continue to work for those more interested in results than trendiness.

Religion is Lindy. If you disregard all of the spiritual components to religion, long-established religions are powerful mechanisms to transmit accumulated wisdom, gained through trial-and-error experimentation and experience over many generations, in a ready-to-use package for people today. One disregards or scorns this distilled experience at one's own great risk. Conversely, one should be as sceptical about “innovation” in ancient religious traditions and brand-new religions as one is of shiny new ideas in any other field.

(A few more technical notes…. As I keep saying, “Once Pareto gets into your head, you'll never get him out.” It's no surprise to find that the Lindy effect is deeply related to the power-law distribution of many things in human experience. It's simply another way to say that the lifetime of nonperishable goods is distributed according to a power law just like incomes, sales of books, music, and movie tickets, use of health care services, and commission of crimes. Further, the Lindy effect is similar to J. Richard Gott's Copernican statement of the Doomsday argument, with the difference that Gott provides lower and upper bounds on survival time for a given confidence level predicted solely from a random observation that something has existed for a known time.)

Uncertainty, Risk, and Decision Making

All of these observations inform dealing with risk and making decisions based upon uncertain information. The key insight is that in order to succeed, you must first survive. This may seem so obvious as to not be worth stating, but many investors, including those responsible for blow-ups which make the headlines and take many others down with them, forget this simple maxim. It is deceptively easy to craft an investment strategy which will yield modest, reliable returns year in and year out—until it doesn't. Such strategies tend to be vulnerable to “tail risks”, in which an infrequently-occurring event (such as 2008) can bring down the whole house of cards and wipe out the investor and the fund. Once you're wiped out, you're out of the game: you're like the loser in a Russian roulette tournament who, after the gun goes off, has no further worries about the probability of that event. Once you accept that you will never have complete information about a situation, you can begin to build a strategy which will prevent your blowing up under any set of circumstances, and may even be able to profit from volatility. This is discussed in more detail in the author's earlier Antifragile.

The Silver Rule

People and institutions who have skin in the game are likely to act according to the Silver Rule: “Do not do to others what you would not like them to do to you.” This rule, combined with putting the skin of those “defence intellectuals” sitting in air-conditioned offices into the games they launch in far-off lands around the world, would do much to save the lives and suffering of the young men and women they send to do their bidding.

Posted at August 4, 2019 21:14