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January 29, 2008

POLICY REVIEW NO. 147 FEATURES


The Optimistic Thought Experiment
by Peter A. Thiel
In the long run, there are no good bets against globalization
________________________________________
And as it was in the days of Noah, so shall it be also in the days of the Son of man. They did eat, they drank,
they married wives, they were given in marriage, until the day that Noah entered into the ark, and the flood
came, and destroyed them all.
Luke 17:2630
FOR THE JUDEO-WESTERN inspiration, it is a mistake of the first magnitude to place too much value on
the things of this world. Those who busy themselves with the meaningless ideologies of politics, or with the
interminable drama of human soap operas, or with the limitless accumulation of wealth, are losing sight of
the impending catastrophe that may unfold towards the end of history. The entire human order could unravel
in a relentless escalation of violence famine, disease, war, and death. The final book of the Bible, the
Book of Revelation, even gives a name and a place: The Battle of Armageddon in the Middle East is the
great conflagration that would end the world. Against this future, it is far better to save one s immortal soul
and accumulate treasures in heaven, in the eternal City of God, than it is to amass a fleeting fortune in the
transient and passing City of Man.
For the rationalists of the eighteenth and nineteenth centuries, as well as for all those who consider
themselves cosmopolitan today, this sort of hysterical talk about the end of the world was deemed to be the
exclusive province of people who were either stupid or wicked or insane (although mostly just stupid).
Scientific inculcation would replace religious indoctrination. Today, we no longer believe that Zeus will
strike down errant humans with thunderbolts, and so we also can rest peacefully in the certain knowledge
that there exists no god who will destroy the whole world.
And yet, if the truth were to be told, our slumber is not as peaceful as it once was. Beginning with the Great
War in1914, and accelerating after 1945, there has re-emerged an apocalyptic dimension to the modern
world. In a strange way, however, this apocalyptic dimension has arisen from the very place that was meant
to liberate us from antediluvian fears. This time around, in the year 2008, the end of the world is predicted
by scientists and technologists. One can read about it every day in the New York Times, that voice of the
rational and cosmopolitan Establishment. Will it be an environmental catastrophe like runaway global
warming, or will it be murderous robots, Ebola viruses genetically recombined with smallpox, nanotech
devices that dissolve the living world into a gray goo, or the spread of miniature nuclear bombs in terrorist
briefcases?
Even if it is not yet possible for humans to destroy the whole world, on current trends it might just be a
matter of time. The relentless proliferation of nuclear weapons remains the most obvious case in point. The
United States became the first nuclear power in 1945; by the 1960s and through the 1980s, at the height of
the Cold War, five declared nuclear states (the U.S., the UK, France, the USSR, and China) maintained a
semi-stable equilibrium (at least as recounted by the historians who know ex post that the Cold War
remained cold); as of today, there are two more known nuclear states (India, Pakistan) and perhaps even
more (Israel, North Korea). And what if there are 20nuclear powers in 2020, or 50 nuclear powers in 2050,
armed with Jupiter missiles that can rain down destruction on enemies everywhere? We suspect the answer
to this question, for we know that there exists some point beyond which there is no stable equilibrium and
where there will be a nuclear Armageddon. A scientific or mathematical calculus of the apocalypse has
replaced the mystic vision of religious prophets. 1
ON THE SURFACE, the worlds financial markets remain eerily complacent. For the most part, they remain
firmly rooted in the nineteenth century, when the march of History and Progress were more optimistic and
certain. Although it encounters perturbations and larger corrections, the climb of the Dow Jones continues
on an inexorable north-easterly path.

The news and business sections seem to inhabit different worlds that coexist on the same planet but rarely
intersect.2 Most financial actors are content to rule their separate kingdom, and to refrain from unprofitable
questions about the integrity of the larger whole. Those who ask too many questions are not given a serious
hearing. Like the deranged orators in London s Hyde Park, the prognosticators of a financial doomsday
have been wrong for too long. Consequently, they have been relegated to a marginal role, if for no other
reason than that they have lost most of their money and have no significant capital left to invest in anything.
More generally, apocalyptic thinking appears to have no place in the world of money. For if the doomsday
predictions are fulfilled and the world does come to an end, then all the money in the world even if it be
in the form of gold coins or pieces of silver, stored in a locked chest in the most remote corner of the planet
would prove of no value, because there would be nothing left to buy or sell. Apocalyptic investors will
miss great opportunities if there is no apocalypse, but ultimately they will end up with nothing when the
apocalypse arrives. Heads or tails, they lose.
In a narrow sense, it seems rational for investors to remain encamped at the altar of the efficient market
and just tend their own small gardens without wondering about the health of the world. A mutual fund
manager might not benefit from reflecting about the danger of thermonuclear war, since in that future world
there would be no mutual funds and no mutual fund managers left. Because it is not profitable to think about
one s death, it is more useful to act as though one will live forever. 3
Such a narrowing of ones horizon cannot, however, be the last word. After all, there exists some connection
between the real world of events, on the one hand, and the virtual world of finance, on the other. For macro
investors, it would be an abdication not to wrestle with the central question of our age: How should the risk
of a comprehensive collapse of the world economic and political system factor into one s decisions?
From the point of view of an investor, one may define such a secular apocalypse as a world where
capitalism fails. Therefore, the secular apocalypse would encompass not only catastrophic futures in which
humanity completely self-destructs (most likely through a runaway technological disaster), but also include
a range of other scenarios in which free markets cease to function, such as a series of wars and crises so
disruptive as to drive the developed world towards fascism, anarchy, or both.
Since the direct approach to our central question leads to paradoxes, absurdities, or at best money-losing
investment schemes, it might prove more profitable to explore the inverse as a thought experiment: What
must happen for there to be no secular apocalypse for what one might call the optimistic version of the
future to unfold? And furthermore, which sectors will do well surprisingly well, in fact if the world
more or less stays intact, even if there are some major bumps and dislocations along the way? Any investor
who ignores the apocalyptic dimension of the modern world also will underestimate the strangeness of a
twenty-first century in which there is no secular apocalypse . If one does not think about forest fires, then
one does not fully understand the teleology of each tree and one badly will undervalue those trees that
are immune to all but the greatest of fires. Even in our time of troubled confusion, there exists a chance that
some things will work out immeasurably better than most believe possible.
As we embark on our ambitious voyage to the ends of the earth, one cautionary note is in order. Thought
experiments are notoriously misleading. Unlike more rigorous forms of scientific investigation, there are no
empirical means to falsify these mental exercises. The optimistic thought experiment exists largely in the
mind. The vistas of the mind are not always the same as reality. One could do worse than to ignore Milton s
seductive promise: The mind is its own place, and in itself, can make a heaven of hell, a hell of heaven.
GLOBALIZATION AND THE HISTORY OF BUBBLES
And the whole earth was of one language, and of one speech. . . . And they said, Go to, let us build us a city
and a tower, whose top may reach unto heaven; and let us make us a name, lest we be scattered abroad upon
the face of the whole earth. And the Lord came down to see the city and the tower, which the children of
men builded. And the Lord said, Behold, the people is one, and they have all one language; and this they
begin to do: and now nothing will be restrained from them, which they have imagined to do.
Genesis 11:1, 36
BY DEFINITION, THE apocalypse would be worldwide in extent. For this reason, the point of departure
for our thought experiment centers on the future of worldwide events that is, on the future of

globalization. In this, we are guided by the hope that the right sort of globalization might prevent the
apocalypse and give us peace in our time.
One can begin with the usual bromides and banalities. Globalization means a breaking down of barriers
between nations; an increase in travel and knowledge about other countries; an increase of trade and
competition among and between the peoples of the world, to the point where there is a more or less level
playing field in the entire world; and the death of all cultures, in the sense of robust systems that exclude
part of humanity. On the level of economics, it means a global marketplace; and on the level of politics, it
means the ascension of transnational elites and organizations, at the expense of all localized countries and
governments.
Even these preliminary observations remind one that globalization remains far from complete. Massive
barriers to trade remain. The nation-state has not withered away. On the crudest of economic measures
say, the difference between the income of a car factory worker in Detroit and in Shenzhen the gulf
between the present and a truly global future remains vast. And on the level of the UN, the WTO, or
Echelon, political unity remains more an aspiration than a reality.
At the same time, the current round of globalization has reached a point equal to or greater than past cycles.
As measured by the percentage of tradable GDP, or the number of people who live in countries different
from their place of birth, or even more abstractly, the connectivity of the world, we stand at a level of
globalization that compares with the previous peak year of 1913.4
It is beyond the scope of this essay either to enumerate all drivers of these trends or to determine whether
the pro- or anti-globalization forces will gain the upper hand in the longer term. Still, the following
conclusion seems safe: Since we are very far from any stable equilibrium, the future is likely to be much
more or much less globalist than the present.
A disturbingly large segment of the global population perceives much of globalization to be injurious.
Admittedly, the free travel of terrorists among the nations of the world does not make the world a better
place; and neither does the unrestricted trade in offensive weapons technologies; and nor does the ability of
criminals to launder ill-gotten gains through offshore banks in Antigua or Vanuatu. In an ever-shrinking
world, groups that once managed to live in relative peace through separateness feel increasingly threatened,
and some react with violence. For every account of globalization that culminates in the capitalist paradise,
there are others in which globalization results in world-wide anarchy or tyranny. At a first approximation,
the best possible future follows the straight and narrow path between these unappealing alternatives. The
narrowness of the path is determined by the combination of the spread of destructive technology and the
difficulty of improving human nature.
In contrast to the divergent future worlds of globalization, all versions of anti-globalization are incoherent.
Of course, one can imagine various details: less trade and travel; more robust boundaries; the elimination of
NGOs; and a turning back of the clock, so as to restore cultural institutions that are in the process of
breaking down. But the pieces do not add up, at least not on the level of the whole world. By its very nature,
anti-globalization cannot be a global political agenda. Every worldwide conference or gathering of antiglobalization activists or politicians necessarily dissolves into self-contradiction or worse, becomes a
deceptive cover for some bad version of globalization, such as a worldwide communist revolution.
While it is theoretically possible for individuals and small communities to opt out of globalization and its
benefits, in practice this is not an option that all people in all countries will choose, at least not based on
their own free will. The momentum towards globalization is hard to resist or to reverse. As a striking case in
point, consider that even North Korea, perhaps the most autarchic state in the world, presents no exception
to this rule. The country has encouraged a certain dysfunctional version of global trade, as it exports heroin,
ballistic missiles, and counterfeit currency, so that its governing clique can import cognac, German cars, and
Swedish prostitutes.
Although the trend towards globalization will not end by individual choice and cannot end by coordinated
global action, one other possibility does remain. Globalization may end by accident or by terrible
miscalculation: It may end by world war. 5 Because there would be no winners in a new world war, every
path away from globalization will end in catastrophe. Thus, in spite of the many uncertainties surrounding

the costs and benefits of a more globally integrated world, investors have no choice but to bet on
globalization. There are no good investments in a twenty-first century where globalization fails 6
THE IDEA OF globalization is not new. It is coeval with the modern West. Starting in the seventeenth
century, the dawn of the modern era, the global state or market has become the sine qua non for this-worldly
peace and security.
This already is implicit in the writings of Thomas Hobbes, the definitive political philosopher of modernity.
For Hobbes, the natural state must be replaced by an artificial or virtual world over which humans have full
mastery and control. The telos is replaced by the fear of the end, or the fear of death. 7 And so the classical
virtues, such as courage, magnanimity, or wisdom, give way to peaceableness as the greatest good. In the
state of nature, the war of all against all prevails; but under the artificial human world of the social contract,
humans will become citizens by giving a monopoly on violence to the figure of Leviathan, a powerful
monster that lives at sea. To make explicit what is implicit, Leviathan cannot be merely the master of a
given nation or kingdom, since then the state of nature would still prevail amongst nations and kingdoms.
For Hobbes City of Man to be built, Leviathan must rule all nations and kingdoms and truly be the prince
of this world. He is the mortal god created by the mind of man.
The ideas of Hobbes were elaborated and developed by John Locke, the philosopher of the American
founding, and by Adam Smith, whose Wealth of Nations founded the modern science of economics. Locke
and Smith sought to construct an ever greater Leviathan, in which systems of checks and balances in the
sphere of politics, or global trade and commerce in the sphere of economics, would rule the world.
In the self-understanding of nineteenth-century Britain, history culminated in the empire of commerce. The
British Empire justified its existence because it guaranteed a sphere within which free trade would take
place among the nations of the world. 8 Because trade and commerce occurred at sea, Britain would remain
the leading power so long as it ruled the sea. It is no coincidence that the naval armaments race with
Wilhelmine Germany foreshadowed the eclipse of globalization in the terrible years after 1914.
The Continent shared the ideal of globalization, without the capitalist part. Hegel dreamed of a final
synthesis in which conflict would cease and give way to a peaceful and homogeneous world. He believed
this took place at the Battle of Jena in 1806, in which the forces of the universal Enlightenment prevailed
over the old order. 9 Marx placed these ideas a bit further into the future, when the liquidation of all classes
would bring about the workers paradise. Even Nietzsche, the least peaceable of the philosophers, thought it
best for the blond beast and the natural aristocracy to dominate the planet from Europe.
This brief survey hints at the critical importance of the globalization project to the modern West. At various
points, like a mirage in the desert, the goal of the project has seemed almost within reach, only to fail or be
postponed every time, at least thus far. For the past three centuries, the great rises and falls of the West track
the high and low points of the hope for globalization. And whether by cause or effect or both, the abstract
hopes of a global order also are mirrored in the virtual world of money and finance. The rises and falls of
the globalizing West have been tracked by the peaks and valleys of the stock market. Almost every financial
bubble has involved nothing more nor less than a serious miscalculation about the true probability of
successful globalization .
One already can discern this theme in the first great financial manias of the modern world, the twin booms
of1720 that swept France and Britain. In France, one had the System of John Law, one of the greatest
financial innovators and charlatans of all time. The System s central plan was for the nearly bankrupt
kingdom to achieve solvency by securitizing its debts through the newly chartered Mississippi Company,
whose newly issued paper currency would be backed by the future proceeds from the New World. 10
Speculation reached fevered proportions, as investors scrambled for shares in the Mississippi Company
(later renamed the Company of the Indies) and so a somewhat meritorious idea evolved into a
catastrophic financial bubble. At the height of the boom, the value of the Company approached the value of
France itself much as the market capitalization of the New Economy during the Internet bubble of 1999
2000 rivaled the capitalization of the entire Old Economy.11 The key turning point occurred as investors
realized that globalization would be much harder and take much longer: In the year 1720, the entire
Louisiana Territory had a population of a few thousand Frenchmen, mostly criminal types residing in the

fetid backwater of New Orleans. Respectable people did not really want to move to the New World. 12In the
minds of the speculators, one could perceive a future capitalist paradise even though at the time there
existed only a vast wild land inhabited by wild and savage men; as the bubble receded, that great vision of
the future seemed to be but a dream. 13 Frances finances never recovered. The next real plan to resolve
them, a tax increase by the Estates General in 1789, triggered revolution and the abolition of the monarchy.
In the case of Britain, the financial mania of 1720 centered on the South Sea Company, which proposed to
open the South Seas (and all the great wealth therein) to trade with Britain. By trading with the opposite
pole of the globe, the British empire of commerce would become universal. In the accompanying boom, a
set of new ventures were floated. Because of the speculative nature of these companies, they were called
Bubbles and provided the origin of the term. The Bubble companies included ones for the importation
of Swedish iron, for insuring of horses, for importing beaver fur, for importing tobacco, and exporting
it again to Sweden and the north of Europe, for trading in hair, for carrying on a trade in the river
Orinoco, for the transmutation of quicksilver into a malleable fine metal, and even for carrying on an
undertaking of great advantage; but nobody to know what it is 14 and whose promoter promptly fled
Britain with the proceeds of the offering, never to be heard from again. As in France, the bubble burst as
investors realized that the commercial unification of the globe would prove more stormy and treacherous
than expected. The shares began their precipitous decline with the arrival of an unfriendly missive from
King Philip V of Spain, who refused to open the port cities of South America (in Chile and Peru) to the
trading ships of the South Sea Company. 15 Economic integration between Catholic Spain and Protestant
England would have to wait; not until 1986 would Spain enter the European Union (albeit no longer with
the power to force capitalist change in left-leaning Latin America). The bubble ended in tears: Accounting
frauds were uncovered, the directors of the South Sea Company were found to have engaged in insider
selling (all the while pretending to be engaged in insider buying), and the very concept of a joint stock
company (in which the founders were not personally liable for a company s obligations) was simply
outlawed by Parliament for the next hundred years 16 a reaction even more extreme than the misguided
Sarbanes-Oxley rules that followed the Internet, Enron, and WorldCom busts of 200002. The British stock
market did not recover its level of 1720 until 1815, when the victory at Waterloo promised a less divided
world for the nineteenth century.
As one fast-forwards through the centuries of the modern world, the pattern repeats. In the late nineteenth
century, railroad companies were at the center of financial speculation because they provided the locomotive
for uniting the world. In the years that preceded 1914, the financial boom centered on the economic
development of far-away places, most notably Russia, the great power whose peaceful integration into
Europe would have enabled a more stable twentieth century.
In the boom of the 1920s, the speculation focused on car companies (of which no fewer than 300 were
created in the U.S.) and on radio businesses, two technologies that promised to bring the world together.
RCA in 1929 was theAOL of 1999; whereas the Dow subsequently declined by about 88 percent, shares in
RCA fell by over 97 percent as the hopes for globalization abated.17 Near the peak of the boom, in 1928,
the nations of the world signed the Kellogg-Briand treaty, which outlawed all war in anticipation of a
globally unified world. Within two years, this bubble had burst. In 1930, Congress enacted the SmootHawley tariff a declaration of a global trade war, as it were and the collapse of the globalizing
economies began in earnest. The nadir of globalization (and of the equity markets, as measured globally in
inflation-adjusted terms) was not reached until 1949, when China became Maoist, and the most populous
country in the world effectively seceded from the rest of humanity.
Financial bubbles and exaggerated stories about globalization are nearly synonymous because the greatest
uncertainties about the future of the world have involved questions about the rate and the nature of
globalization 18Such great uncertainty is the precondition for the great errors needed for great bubbles.
Investors hopes and fears about the future will concentrate in those areas most levered to globalization.
Conversely, it is unlikely that one could even start a mania surrounding the shares of a utility company or a
regional business in secular decline, where the range of possible outcomes is more limited. 19

Even the most preposterous bubbles of recent decades Japan in the late 1980s and high-end real estate
today would have been far more restrained, had they not been stoked much further by the narrative of
globalization.
In the case of Japan, the most insular of developed countries, the bubble of the late 1980s took off as people
began to believe that Japan Inc. might actually run the entire planet. Management textbooks declared that
the Japanese corporate model represented a sort of Hegelian final synthesis for harmonious labormanagement relations; because no better model existed, Japanese corporatism represented the end of history.
20 Zaitech financial engineering, under the auspices of the omniscient MITI, would do the rest. Only by
drawing this extraordinary conclusion could the Nikkei account for almost half the world s market
capitalization in 198921 and could the land underneath the emperors palace in downtown Tokyo be
deemed to be more valuable than the entire state of California.22
One sees the same with the real estate mania of recent years, where necessarily local markets have been sold
and oversold as the keys to the global economy. The greatest booms have taken place in the cities that will
centralize the world of the future: Shanghai for China, Dubai for the Middle East, Manhattan for the U.S.,
23 and above them all, the city of London, which seems destined to become once more the City of London
and therewith the City of Man, or at least of the world s billionaires (which may be the same thing). As of
early 2007, the boom in London had reached the point at which realtors specializing in large estates had
almost nothing left to sell, as most of the properties have been taken off the market by Saudi royals, Russian
oligarchs, and Indian industrialists.
THE GREATEST GLOBALIZATION STORY EVER
The merchandise of gold, and silver, and precious stones, and of pearls, and fine linen, and purple, and silk,
and scarlet, and all thyine wood, and all manner vessels of ivory, and all manner vessels of most precious
wood, and of brass, and iron, and marble, And cinnamon, and odours, and ointments, and frankincense, and
wine, and oil, and fine flour, and wheat, and beasts, and sheep, and horses, and chariots . . .
Revelation 18:1213
IN RECENT YEARS, the pace and amplitude of these booms has accelerated tremendously, in complete
contradiction to the widespread notion that markets are becoming more smooth and efficient over time.
During the last quarter century, the world has seen more asset booms or bubbles than in all previous times
put together: Japan; Asia (ex-Japan and ex-China) pre- 1997; the internet; real estate; China since 1997; Web
2.0; emerging markets more generally; private equity; and hedge funds, to name a few. Moreover, the
magnitudes of the highs and lows have become greater than ever before: The Asia and Russia crisis, along
with the collapse of Long-Term Capital Management, provoked an unprecedented 20-standard-deviation
move in financial derivatives in199824 the Nasdaq at 5,000 in 2000 was farther from equilibrium than the
Dow at 350 in 1929, perhaps the greatest previous distortion; no 10-year government bond yield ever fell to
0.44 percent in all of history, until this happened with JGBs in 2003; as measured by the buy/rent ratio (or
any number of other indicators), U.S. real estate prices in2005 were more distorted than in 1929<, 1979, or
1989, or at any other time in history; and no emerging market had ever reached a P/E of 62, as Chinas
Shanghai A Shares index did in 2007. It has not been a good time for those investors who are merely sane.
Consider the strangeness of the American context. One would not have thought it possible for the internet
bubble of the late 1990s, the greatest boom in the history of the world, to be replaced within five years by a
real estate bubble of even greater magnitude and worse stupidity. Under more normal circumstances, one
would not have thought that the same mistake could happen twice in the lifetimes of the people involved.
One might be tempted to invoke extraordinary psychosocial explanations for example, that all of this was
driven by baby boomers who destroyed their minds on drugs in the 1960s and therewith merit the dubious
distinction of being Americas Dumbest Generation. But when one surveys the many other bubbles that have
proliferated throughout the world, one realizes that this cannot be the whole truth.
The most straightforward explanation begins with the view that all of these bubbles are not truly separate,
but instead represent different facets of a single Great Boom of unprecedented size and duration. As with the
earlier bubbles of the modern age, the Great Boom has been based on a similar story of globalization, told

and retold in different ways and so we have seen a rotating series of local booms and bubbles as investors
price a globally unified world through the prism of different markets.
Nevertheless, this Great Boom is also very different from all previous bubbles. This time around,
globalization either will succeed and humanity will achieve a degree of freedom and prosperity that can
scarcely be imagined, or globalization will fail and capitalism or even humanity itself may come to an end.
The real alternative to good globalization is world war. And because of the nature of today s technology,
such a war would be apocalyptic in the twenty-first century. Because there is not much time left, the Great
Boom, taken as a whole, either is not a bubble at all, or it is the final and greatest bubble in history .
But because we do not know how our story of globalization will end, we do not yet know which it is. Let us
return to our thought experiment. Let us assume that, in the event of successful globalization, a given
business would be worth $ 100/share, but that there is only an intermediate chance (say 1:10) of successful
globalization. The other case is too terrible to consider. Theoretically, the share should be worth $ 10, but in
every world where investors survive, it will be worth $100.25 Would it make sense to pay more than $10,
and indeed any price up to $100? Whether in hope or desperation, the perceived lack of alternatives may
push valuations to much greater extremes than in nonapocalyptic times.
The reverse version of this sort of investment would involve the writing of insurance and reinsurance
policies for catastrophic global risk. In any world where investors survive, the issuers of these policies are
likely to retain a significant portion of the premium regardless of whether or not the risks were priced
correctly ex ante. In this context, it is striking that Warren Buffett, often described as the greatest investor of
all time, has shifted the Berkshire Hathaway portfolio from value investments (no internet, no growth,
often just businesses with stable cash flows) to the global insurance and reinsurance industries (perhaps one
of the purest bets on the optimistic thought experiment).26
If the preceding line of analysis is correct, then the extreme valuations of recent times may be an indirect
measure of the narrowness of the path set before us. Thus, to take but one recent example, in 1999 investors
would not have risked as much on internet stocks if they still believed that there might be a future anywhere
else. Employees of these companies (most of whom also were investors through stock option plans) took
even greater risks, often leaving stable but unpromising jobs to gamble their life fortunes. It is often claimed
that the mass delusion reached its peak in March 2000; but what if the opposite also were true, and this was
in certain respects a peak of clarity? Perhaps with unprecedented clarity, at the market s peak investors and
employees could see the farthest: They perceived that in the long run the Old Economy was surely doomed
and believed that the New Economy, no matter what the risks, represented the only chance. Eventually, their
hopes shifted elsewhere, to housing or China or hedge funds but the unarticulated sense of anxiety has
remained.
Such an extreme combination of hope and despair can be found in many places. On the level of the
individual, there is the aspiring actor or model in Los Angeles, dreaming that the crowd s indifference may
transform itself overnight into the adulation of the global audience. On the level of the nation, there is Israel,
where entrepreneurs are racing to build the world s next great technology companies, against a background
in which everything might be destroyed overnight. There was a time when one would have singled out the
actor in LA or the migr to Israel as suffering from a divided consciousness of sorts, but that time is past.
All of us now find ourselves in a similar predicament.
Just as the risk of a secular apocalypse defines the limits of our world, one might speak of the risk of a
personal apocalypse that defines the limits of our lives. By way of illustration, the subprime housing
boom in the United States is not simply the result of extreme optimism about the prospects for housing, but
also a reflection of the brutal fact that tens of millions are approaching retirement in an actuarially bankrupt
state. In effect, the two choices are: 1) continue on the present course to certain destitution in old age; or 2)
roll the dice on the housing boom as the last chance to build wealth, and hope against hope that one gets out
in time. The personal and secular levels intersect, in that lives of quiet desperation paradoxically may
surface as ebullient market bubbles.
None of the foregoing detracts from the earlier claim that the greatest investments of our time remain those
most highly levered to genuine globalization. But because the line between good and bad (or no)

globalization is very thin, catastrophic approximations abound. The difficulty of the challenge can be
illustrated by considering three related examples: the China bubble, the Web 2.0 bubble, and the hedge
fund bubble, which relate to the globalization of labor, technology, and finance, respectively, and are
properly seen as contemporary facets of the Great Boom. They are the dark matter that is reshaping the
human world and that may hopefully counteract the dark energy that is making things fall apart.
1: THE CHINA BUBBLE
THE RISE OF China seems to be the most important political trend of the new millennium. If its annual
growth rate of 10 percent a year can be sustained, China will become the worlds leading economic power in
about20 years. Never before would so many people have been lifted out of poverty in so short a time. On the
other hand, there remains the unanswered question of how China will use its newfound power.
With respect to the rest of the world, Chinas emergence will be a positive development so long as it remains
deflationary. Under the free trade theories of Smith and Ricardo, the globalization of the labor market will
make goods cheaper for consumers throughout the developed world, and the benefits of cheaper goods
should more than offset the costs of displaced industries and workers.
An important caveat to this free-trade regime is that it depends on a static world of sorts: If China s
economy achieves significant internal growth and China begins to consume more resources, especially
energy, then its growth may prove less beneficial for Western consumers. Money saved on cheaper goods at
Wal-Mart would then need to be spent on more expensive gasoline at the pump. In the world of Peak Oil,
China s emergence may represent a dangerous development, at least in the intermediate term.27
However that may be, there is no good scenario for the world in which China fails. The short-term
consequences of such a failure would include a lack of cheap capital from a Chinese savings glut; fewer
cheap goods from China; massive political unrest within China; and deep recessions throughout East Asia
and most emerging markets, whose derivative growth is the caboose to China s locomotive. And so we are
led to ask: To the extent that China involves a leveraged play on globalization, should one therefore simply
invest in the Chinese stock market? In our optimistic thought experiment, one might expect China to
outperform the rest of the world in every good scenario.
If there is a catastrophic approximation embedded in this analysis, then it consists of the conflation between
China as a real economy and China as a financial instrument. To say the least, there are many eerie
parallels between the Chinese stock market of early 2007 and the Nasdaq of early 2000: an abstract story of
long-term, exponential growth; rampant speculation; and unprofitable or overvalued companies.
One intermediate possibility is that the China of 2014 will be like the internet of 2007 much larger, but
with winners very different from the ones that investors today expect. The largest New Economy business is
Google, a company that scarcely registered in early 2000. Might it also turn out that the greatest Chinese
companies of 2014 will be concerns that are private and tightly controlled businesses today, rather than the
high-profile and money-losing companies that have been floated by the Chinese state?
At the very least, outsiders need to understand that China is controlled for the benefit of insiders. The
insiders know when to sell, and so one would expect the businesses that have been made available to the
outside world systematically to underperform those ventures still controlled by card-carrying members of
the Chinese Communist Party. China will underperform China, and a China bubble exists to the extent
that investors underestimate the degree of this underperformance.28
This limitation also may be framed in terms of globalization. In important respects, China as a financial
economy is sustained by the absence of globalization in particular, by the enormous amounts of capital
trapped within Chinas borders that must either suffer slow death from inflation (now running higher than
Chinese bank deposit rates) or brave the acute sense of vertigo of the elevated stock market. Because the
free convertibility of the renminbi would dampen equity speculation, a long China position is not a
forecast that financial globalization will succeed, but rather a bet that its internal contradictions will persist.
2: THE TECHNOLOGY BUBBLE
THE GROWTH OF the internet promises to unite the human race in an unprecedented way. For the first
time, through email, blogs, and websites, the stories of each of our lives can be shared, across the
boundaries of a still-divided political and cultural world. Moreover, this momentum seems unlikely to

reverse, even if there is significant turbulence in the years ahead. One must not forget that the U.S. military
funded the internet as a communications platform to survive even a limited nuclear war.
As with China, the next generation of technology businesses represents a leveraged bet on globalization. But
unlike China, the internet already has seen one large boom and bust cycle. The valuations may be a bit more
reasonable this time around, as investors continue to climb a wall of worry and think about the possibility of
a second internet crash.
There are some promising signs. The next generation of internet businesses cost less in computing power;
revenue models have become more robust; growth remains fast; and more entrepreneurs are focused on
perfecting their products than on issues of salesmanship.
On the other side, however, there exists one decisive problem. Virtually no Web 2.0 companies have sold
stock to the public through IPOs. If one desired to deploy substantial capital into the next wave of internet
businesses, this would prove almost impossible to do. Even with respect to venture capital and angel
investing, the extreme distribution of outcomes imposes a severe challenge on any positive expected returns.
29
For those determined to proceed, the following guidepost might be useful. As with the distinction between
China and China, there also exists a critical distinction between technology and investments called
technology. To take a particularly easy case from the prior technology bubble, a technology company
that sells pet food online by purchasing Super Bowl advertisements offline may not be a technology
company at all. The solutions to hard engineering problems are not necessarily valuable, but it is unusual for
the solutions to easy engineering problems to have much value in the long term.
A more subtle technology bubble may be occurring this time. A large number of large capitalization
companies are effectively short innovation: companies such as Microsoft, Dell, IBM, Cisco, HP, and others.
They benefit by modest changes to the status quo, but are threatened by massive innovation. This does not
mean there are not massively innovative companies out there: Google and Intel, to name the two bestknown brands, are. Merely, there is a difference between technology and technology. After all, even GM
uses an impressive amount of electronics and computers.
Technology entrepreneurs and investors would do well to return to hard and important problems. As
globalization proceeds apace, the decisive unsolved problem concerns the issue of security. There remains a
tremendous need for real defense against the proliferation of destructive technologies reaching well
beyond the Orwellian defense industry, with its proclivity for constructing new contraptions that kill large
numbers of people. Along with the New Economy and New Media, there should exist a valuable sector that
could be described as New Defense at least in any twenty-first century in which humanity does not blow
itself up. The absence of such a sector serves as a subtle reminder of the complacent myopia of Silicon
Valley venture capitalists investing in technology.
3. THE HEDGE FUND BUBBLE
BROADLY SPEAKING, HEDGE funds buy and sell mispriced assets. In todays globalizing and
unbalanced world, there are many seemingly mispriced assets and correspondingly many opportunities to
pursue ever-increasing fortunes.
If the Great Boom ends well, then the hedge fund industry will outperform other sectors less levered to
globalization; in that future, there would turn out to have been no hedge fund bubble, just as there ultimately
would be no China or technology bubbles. Inversely, a world where global financialization stops is a bad
world for hedge funds, but also for just about everything else. In such a world, global investing would no
longer be possible. So would it be correct to invest in hedge funds as a way to invest in the Great Boom?
>As in the case of China and technology, one may draw a critical distinction between hedge funds and
hedge funds. The distinction centers on the question of which kinds of assets are genuinely mispriced for
the path towards good globalization.
What is the line between a market for cheap imports and a market for indentured labor in Burma?
Hedge funds (and hedge funds) seek high returns without the regulations that hamstring mutual funds and
using leverage unavailable to mutual funds and even (except to a limited extent) to individual investors. The
difference between a hedge fund and a hedge fund is this: a hedge fund seeks to allocate capital from less

efficient uses to more efficient uses; a hedge fund seeks trading strategies. Mostly, hedge funds merely
seek to replicate successful strategies of the past until they dont work.
As with China/China and technology/technology, the existence of middle cases of entities that are
neither pure hedge fund nor pure hedge fund does not rob the distinction of meaning. And the difference is
not be confused with belief in efficient markets. To the contrary, the proliferation of hedge funds insures
that there are plenty of market inefficiencies for profitable trading.
Thus, the widespread strategy of short low-risk, long high-risk may not be equivalent to long good
globalization, at least not in every specific context. Ultimately, one might expect a convergence between
the emerging and developed markets; but if one ignores the serious issues of corruption and bad governance
in the emerging world and correspondingly overvalues those markets, then one will not reward the kind of
behavior that leads to good globalization, and good globalization may become less likely. Or, to take an
even more obvious example: Good globalization is more likely to occur in a world where people have a long
time horizon. Subprime credit, payday loans, housing consumption dressed up as housing investment, and
depletion of energy (and everything else) are all high-risk trajectories that will prove detrimental to the
ultimate success of the Great Boom.
More generally, there remains the question of what kinds of things can be bought and sold in a world where
the trajectory to good globalization takes place. Are certain kinds of markets simply incompatible with good
globalization? The buying and selling of illegal drugs, dangerous weapons, or laundered money may result
in great short-term profits but tremendous long-term costs. Where does one draw the correct line between a
market for cheap imports and a market for indentured labor in Burma? Or between cheaper diamonds and a
bloody war to acquire those diamonds in Congo?
These questions about market limits become most acute with human beings: the elimination of all labor laws
(including laws against immigration, child labor laws, or laws setting minimum wages or maximum work
weeks), the legalization of pornography and prostitution, the creation of a spot and a futures market for
human organs. The culmination of the series would involve the creation of a marketplace for the buying and
selling of something like the stuff of the minds of men. And at this point, one could be forgiven for thinking
that the optimistic thought experiment which turns out to be nothing more or less than the central idea
of modernity may have gone terribly wrong.
THE OTHER WAY
And I saw a new heaven and a new earth: for the first heaven and the first earth were passed away; and there
was no more sea.
Revelation 21:1
OURS IS AN age in which classic wisdom has failed. Those investors who limit themselves to what seems
normal and reasonable in light of human history are unprepared for the age of miracle and wonder in which
they now find themselves. The twentieth century was great and terrible, and the twenty-first century
promises to be far greater and more terrible. Classic investment strategies no longer work in a world where
ordinary economic cycles are broken. The limits of a George Soros or a Julian Robertson, much less of an
LTCM, can be attributed to a failure of the imagination about the possible trajectories for our world,
especially regarding the radically divergent alternatives of total collapse and good globalization. 30
Seven years later, the markets have come full circle. The retreat towards tactical cleverness hides a lazy
agnosticism about the most fundamental questions of our age. Because we find ourselves in a world of retail
sanity and wholesale madness, the truly great opportunities exist in the wildly mispriced macro context
rather than in the ever-diminishing spreads on esoteric financial markets or products. Indeed, one could go
even further: What is truly frightening about the twenty-first century is not merely that there exists a
dangerous dimension to our time, but rather the unwillingness of the best and brightest to try and make any
sense of this larger dimension.
In every possible future, all of todays bubbles will burst, and their ideological scaffolding will prove to be
but lint in the winds of history.
From a contrarian perspective, one could be more optimistic if others were not so naively optimistic. The
best possible world is not an impossible or self-contradictory world. Even in the best possible future, destiny

will not be kind to Miami condo brokers, investors underwriting negative-interest rate mortgages,
consumers with a naive faith in Saudi Arabia s infinite oil resources (and an even stranger belief that it is in
Saudis interest to keep oil prices low), or baby boomers who act as though a negative savings rate is the
best investment strategy in a country headed for massive demographic transition. In every possible future,
all of today s bubbles will burst, and their ideological scaffolding will prove to be but lint in the winds of
history.
The waning of globalization in the near future will be a reaction to the excesses of the recent past. Bubbles
have begun to implode across the globe, laying bare the fraudulence of China, technology, hedge
funds, and their like. As the world's economy weakens, so will support for the globalist orthodoxy, the
political tenability of which rests heavily on the ability of the doctrine to literally deliver the goods. Some
policymakers seem to sense this already, with the most immediately obvious of these being the Fed. In this
view, the Fed s morally hazardous accommodations are best understood not as a perplexing and facile sop
to bankrupt homeowners but as a desperate effort to stave off a recession that will end the debate on
globalization for years to come.
As with many last-ditch efforts, the Feds gambit entails several potentially catastrophic trade-offs, chief
among them the revival of inflation. Whatever may be said of the soundness of the Feds policy in the
faltering United States, loose monetary conditions are not appropriate for the near-runaway economies of
other nations with dollar-linked economies, notably China and much of the Middle East. The Fed s
iatrogenic policies have already caused considerable inflation in these economies and, especially disturbing
for students of history, a massive spike in the price of oil. At some point, the tensions caused by wild
inflation, collapsing currency accords, and expensive oil will resolve, but only the most deluded Pollyannas
could believe the result will be an increase in global harmony and integration.
Despite all this, the world may yet resume the globalist path. The narrative of the past four centuries has not
been one of continuous progress, but strewn beneath the stories of cupidity and strife there lies the story of
the powerful impulse toward globalization and of the transformational effects of technology. In this context,
a near-term backlash against globalization should not be confused with the end of the world, though a
wholesale rollback could represent the ultimate catastrophe.
For the policymaker as for the investor, the challenge is to find a way between the Scylla of outdated
wisdom and the Charybdis of nihilistic cleverness. The agon between globalization and its alternative will
be close at least in the sense that individual choices will prove to be of decisive significance. In this, we
are opposed to the reigning faith in efficient markets. Unlike the faith in efficient markets, however, ours is
a faith that seemingly still cannot be named.
________________________________________
Peter Thiel is the president and portfolio manager of Clarium Capital Management, a global macro hedge
fund, and the chairman of the board of Palantir Technologies, Inc. He co-founded and served as the
chairman and CEO of PayPal, Inc., the worlds largest e-payments company.
________________________________________
1 Within the Roman Catholic Church, the last sermons of the liturgical year (on the Sundays after Pentecost)
were often used to remind the congregation of the passing nature of this world and of the terrors of the end
times. Understandably, this dimension began to be downplayed even as its possibility was actualized.
2The historian Niall Ferguson has described this as the paradox of the newspaper, and argues for a
greater effort to reconcile the sickening content of the news section with the sanguine stories of the business
section. Stephen S. Roach, The Teflon of Lyford, Morgan Stanley Global Economic Forum (November
13, 2006).
3 Thus, whereas the Etruscans despaired about the ultimate decline of their society, the Romans could face
each day in the certain knowledge that the city of Rome would be eternal. Johann Jakob Bachofen, The
Myth of Tanaquil, in Myth, Religion and Mother Right: Selected Writings of Johann Jakob Bachofen,
trans. Ralph Manheim (Princeton University Press, 1992).

4 See, for example, Peter B. Kenen, Jeffrey R. Shafer, Nigel L. Wicks, and Charles Wyplosz, International
Economic and Financial Cooperation: New Issues, New Actors, New Responses (Centre for Economic
Policy Research,2004).
5 A world war may well result in global anarchy (most likely combined with many local tyrannies). In this
respect, there would be a certain convergence between anti-globalization and a bad trajectory of
globalization; they would be different paths to the same outcome. To put the matter somewhat differently,
the competition close to the core of globalization may become military competition. If this competition
spirals out of control, one may run into a version of the apocalypse.
6 This is the necessary condition for our optimistic thought experiment. The sufficient condition requires a
further elaboration: One would need to delineate the different versions of globalization, so as to identify
which one could save the world. Because this second part is more difficult and controversial, I make only
occasional references between the lines, as it were to the latter.
7 Thomas Hobbes, Leviathan, Chapter XIII: Of the Natural Condition of Mankind as Concerning Their
Felicity and Misery.
8The term imperialism did not have negative connotations in the nineteenth century, since some sort of
empire was seen as the precondition for global trade. The decisive attack on imperialism can be traced to
John Hobson s book,Imperialism: A Study (published in 1902, against the backdrop of the unpopular Boer
War), a Marxist and anti-Semitic tract that argued that international Jewish financiers were the true
beneficiaries of imperialist policies.
9 In the battle, Napoleon routed the Prussian and Saxon armies, highlighting the need for reform in the nearfeudal Germanic principalities. Those reforms paved the way for the dynamic resurgence of Germany in the
following decades.
10The initial focus of the Mississippi Company involved trade with the Louisiana Territory, but in 1719 the
Companys monopoly was expanded to include the East Indies, China, and the South Seas.
11 On Thursday, the Nasdaq Composite finished over 5000 for the first time. The indexs sizzling
performance over the past year has delighted investors and raised a possibility that would have been
unthinkable not too long ago: If current trends continue, Nasdaq-listed stocks will surpass New York Stock
Exchange issues in market value within the next year. As the accompanying table shows, the market
capitalization of the 4,600 companies listed on the Nasdaq jumped to $6.6 trillion in late February, up 150%
from the start of 1999. At the same time, the value of the3,000 U.S. companies traded on the Big Board
totals an estimated $10.2 trillion, down over $800 billion since yearend and up about $200 billion since the
start of 1999, according to Bianco Research, a Barrington, Illinois firm that tracks the market. Andrew
Barry, Tortoise and Hare, Barrons (March 13, 2000).
12 As confidence began to ebb, the Company hit upon the idea of hiring a group of day-laborers and
parading them around the city of Paris complete with the shovels and pick-axes they would use to mine
gold in the expanse of Louisiana. They left Paris for the ports and thence the New World; but when word got
back to Paris that virtually none had boarded the ships destined for America, the shares of the Company
resumed their terrific plunge. Charles Mackay, Memoirs of Extraordinary Popular Delusions and the
Madness of Crowds (1869), 31.
13 And yet, in some ways it was not entirely a dream: The value of the Louisiana Territory in 2007 is greater
than the value of all of France. Still, the bubble was unreal, at least in the sense that almost none of this
future wealth was captured by French speculators comfortably lounging about Parisian salons in the
eighteenth century.
14Mackay, Memoirs, 5760.
15 Mackay, Memoirs, 46.
16Larry Allen, The Global Financial System 17502000 (Reaktion, 2004) 52.
17RCA soared from $11 in 1924 to $114 in September 1929, only to fall back to under $3 by 1932.
Incredibly for the1920s, RCA paid no cash dividends at all, and had reached a P/E of 72 by the time of its
peak.

18Technology is the one other domain that yields equally massive divergences in possible trajectories. If the
two are combined, one can see why technologies involving globalization (such as the internet) almost
necessarily result in great miscalculations, and great booms and busts.
19 If one reduces globalization to the elimination of all barriers, then the most literal interpretation of
globalization would entail the conquest of outer space. The boom of the1950s and 1960s centered on the
final frontier and tapped into the imaginary worlds of science fiction. The space boom returned to earth in
the 1970s, as disappointed investors and governments realized that almost nothing of value was to be found
in the limitless void or at least nothing within easy reach.
20 The reality is quite the reverse. The apparent harmony of Japanese companies results from massive social
pressure, in which any nail that sticks out gets beaten down. When everybody enthusiastically sings the
same songs together (whether in a Japanese firm or at a political rally), one always needs to wonder whether
there might be some adverse consequences for those who are not so enthusiastic in their singing and one
should not just assume that the great chorus simply expresses the complete this-worldly happiness of the
Japanese salaryman.
21 Another Diver In the Buy-Out Pool: Why Tokyo Should Go Higher, Economist (April 15, 1989).
22 Charles P. Kindleberger and Robert Aliber, Manias, Panics and Crashes: A History of Financial Crises,
Fifth Edition (Wiley, 2005), 126.
23 Under this analysis, the singular obsession with subprime mortgages in the U.S. misses the larger real
estate bubble entirely.
24 Long-Term Capital Managements quantitative models indicated that this sort of 20-standard deviation
move would not be expected to happen in one trillion times the history of the universe. Roger Lowenstein,
When Genius Failed (Random House, 2000), 6079. LTCM went bankrupt precisely because the amplitude
of the move was far greater than anything that had been seen before, or even thought possible.
25 Because there is only one history of the world, there is no direct way to measure this probability of
successful globalization once again, our thought experiment does not quite rise to the level of a more
conventional science experiment.
26 In practice, the following set of alternatives seems most likely: 1) There are no major catastrophes, and
one retains the entire premium: It is a very profitable year. 2) There is a major catastrophe (such as 9/11),
but the losses are more than offset by increases in future premiums: Insurance equities perversely rallied in
the aftermath of 9/11.3) There is an even larger catastrophe (such as a surprise nuclear bomb): There are
significant losses, but they are likely to be mitigated by some kind of government bailout or abrogation of
the policies. 4) The catastrophe is so large that no functioning market or government remains: This is the
only case where one would incur catastrophic losses, although nobody might be left to collect them.
27 If Chinese consumers increase oil consumption to one-fourth the per capita rate of the U.S., then global
oil demand would rise by almost 20 million barrels a day. CIA World Fact Book. Given the inelasticity of
supply, this easily could result in an oil price in excess of $ 200 per barrel.
In recent speeches, both Bernanke and Greenspan have made the striking suggestion that globalization may
no longer be a net deflationary force, but instead may prove inflationary for the world economy. Remarks by
Chairman Ben S. Bernanke at the Fourth Economic Summit, Stanford Institute for Economic Policy
Research (March 2, 2007); Greg Ip, Greenspan Transcript Offers Clarity on His Actual Remarks, Wall
Street Journal (March 5, 2007). Because energy is the major constrained resource on our planet, an
inflationary account of globalization functionally equates to Peak Oil a theory which no leading central
banker openly supports or endorses.
28 Even if the 20-year growth story is true, there is still no pressing need to invest in China immediately.
Presumably, one would still capture most of the upside gains if one were to wait for just one year. Much the
same proved to be the case with the internet in early 2000: Precisely because there was a lot of truth to the
20-year growth story, there was no immediate urgency to invest at the very peak of the frenzy.
29 Internet businesses are essentially global, and for this reason successful internet businesses involve a
winner-take-all dynamic that is extreme even by the standards of the technology industry. As an investor or
entrepreneur, one could do worse than to remember the motivational advice from Glengarry Glen Ross: As

you all know, first prize is a Cadillac El Dorado. Anybody want to see second prize? Second prize is a set of
steak knives. Third prize is you re fired.
30The conventional account ascribes the failures of LTCM, Soros, or Tiger to tactical blunders and
inadequate risk controls. By contrast, our account would suggest that the failures should be attributed to the
fact that these funds were not macro enough.
LTCMs collapse in 1998 was triggered by the Russian default: A country with thousands of nuclear
weapons and immense oil resources going bankrupt was an unimaginable apocalyptic scenario that was not
supposed to happen or be allowed to happen. But in the endgame of the Asian financial crisis of 199798,
with stretched lenders and oil prices cut in half, this unimagined scenario became real. The failure of the
imagination then swung to the other extreme as the panicked, coordinated rate cuts of central banks kicked
off the final stage of the 1990s technology bubble, with even so-called macro funds (like Soros or Tiger)
failing to grasp the extent to which the marshaling of liquidity forces would overwhelm the micro facts of
poor business models, incompetent management, and expensive valuations.
THE EDUCATION OF A LIBERTARIAN
by PETER THIEL
REACTION ESSAY
April 13th, 2009
I remain committed to the faith of my teenage years: to authentic human freedom as a precondition for the
highest good. I stand against confiscatory taxes, totalitarian collectives, and the ideology of the inevitability
of the death of every individual. For all these reasons, I still call myself libertarian.
But I must confess that over the last two decades, I have changed radically on the question of how to
achieve these goals. Most importantly, I no longer believe that freedom and democracy are compatible. By
tracing out the development of my thinking, I hope to frame some of the challenges faced by all classical
liberals today.
As a Stanford undergraduate studying philosophy in the late 1980s, I naturally was drawn to the give-andtake of debate and the desire to bring about freedom through political means. I started a student newspaper
to challenge the prevailing campus orthodoxies; we scored some limited victories, most notably in undoing
speech codes instituted by the university. But in a broader sense we did not achieve all that much for all the
effort expended. Much of it felt like trench warfare on the Western Front in World War I; there was a lot of
carnage, but we did not move the center of the debate. In hindsight, we were preaching mainly to the choir
even if this had the important side benefit of convincing the choirs members to continue singing for the
rest of their lives.
As a young lawyer and trader in Manhattan in the 1990s, I began to understand why so many become
disillusioned after college. The world appears too big a place. Rather than fight the relentless indifference of
the universe, many of my saner peers retreated to tending their small gardens. The higher ones IQ, the more
pessimistic one became about free-market politics capitalism simply is not that popular with the crowd.
Among the smartest conservatives, this pessimism often manifested in heroic drinking; the smartest
libertarians, by contrast, had fewer hang-ups about positive law and escaped not only to alcohol but beyond
it.
As one fast-forwards to 2009, the prospects for a libertarian politics appear grim indeed. Exhibit A is a
financial crisis caused by too much debt and leverage, facilitated by a government that insured against all
sorts of moral hazards and we know that the response to this crisis involves way more debt and leverage,

and way more government. Those who have argued for free markets have been screaming into a hurricane.
The events of recent months shatter any remaining hopes of politically minded libertarians. For those of us
who are libertarian in 2009, our education culminates with the knowledge that the broader education of the
body politic has become a fools errand.
Indeed, even more pessimistically, the trend has been going the wrong way for a long time. To return to
finance, the last economic depression in the United States that did not result in massive government
intervention was the collapse of 192021. It was sharp but short, and entailed the sort of Schumpeterian
creative destruction that could lead to a real boom. The decade that followed the roaring 1920s was
so strong that historians have forgotten the depression that started it. The 1920s were the last decade in
American history during which one could be genuinely optimistic about politics. Since 1920, the vast
increase in welfare beneficiaries and the extension of the franchise to women two constituencies that are
notoriously tough for libertarians have rendered the notion of capitalist democracy into an oxymoron.
In the face of these realities, one would despair if one limited ones horizon to the world of politics. I do not
despair because I no longer believe that politics encompasses all possible futures of our world. In our time,
the great task for libertarians is to find an escape from politics in all its forms from the totalitarian and
fundamentalist catastrophes to the unthinking demos that guides so-called social democracy.
The critical question then becomes one of means, of how to escape not via politics but beyond it. Because
there are no truly free places left in our world, I suspect that the mode for escape must involve some sort of
new and hitherto untried process that leads us to some undiscovered country; and for this reason I have
focused my efforts on new technologies that may create a new space for freedom. Let me briefly speak to
three such technological frontiers:
(1)
Cyberspace. As an entrepreneur and investor, I have focused my efforts on the Internet. In the late
1990s, the founding vision of PayPal centered on the creation of a new world currency, free from all
government control and dilution the end of monetary sovereignty, as it were. In the 2000s, companies
like Facebook create the space for new modes of dissent and new ways to form communities not bounded
by historical nation-states. By starting a new Internet business, an entrepreneur may create a new world. The
hope of the Internet is that these new worlds will impact and force change on the existing social and
political order. The limitation of the Internet is that these new worlds are virtual and that any escape may be
more imaginary than real. The open question, which will not be resolved for many years, centers on which
of these accounts of the Internet proves true.
(2)
Outer space. Because the vast reaches of outer space represent a limitless frontier, they also represent
a limitless possibility for escape from world politics. But the final frontier still has a barrier to entry: Rocket
technologies have seen only modest advances since the 1960s, so that outer space still remains almost
impossibly far away. We must redouble the efforts to commercialize space, but we also must be realistic
about the time horizons involved. The libertarian future of classic science fiction, la Heinlein, will not
happen before the second half of the 21st century.
(3)
Seasteading. Between cyberspace and outer space lies the possibility of settling the oceans. To my
mind, the questions about whether people will live there (answer: enough will) are secondary to the
questions about whether seasteading technology is imminent. From my vantage point, the technology
involved is more tentative than the Internet, but much more realistic than space travel. We may have reached
the stage at which it is economically feasible, or where it soon will be feasible. It is a realistic risk, and for
this reason I eagerly support this initiative.

The future of technology is not pre-determined, and we must resist the temptation of technological
utopianism the notion that technology has a momentum or will of its own, that it will guarantee a more
free future, and therefore that we can ignore the terrible arc of the political in our world.
A better metaphor is that we are in a deadly race between politics and technology. The future will be much
better or much worse, but the question of the future remains very open indeed. We do not know exactly how
close this race is, but I suspect that it may be very close, even down to the wire. Unlike the world of politics,
in the world of technology the choices of individuals may still be paramount. The fate of our world may
depend on the effort of a single person who builds or propagates the machinery of freedom that makes the
world safe for capitalism.
For this reason, all of us must wish Patri Friedman the very best in his extraordinary experiment.
Utopian Pessimist Calls on Radical Tech to Save Economy
By Gary Wolf Email Author January 25, 2010 | 12:00 pm | Wired Feb 2010
Photo: Andreas Laszlo Konrath
Considering his wealth and good fortune, you wouldnt peg Peter Thiel as a prophet of doom. He cofounded
PayPal at age 31 and sold it to eBay four years later for $1.5 billion. Two years after that, he became the first
investor in Facebook a wager that earned him another fortune. Today, at 42, he runs a San Francisco
venture capital firm and a hedge fund, Clarium Capital. But the past year has not been easy on Thiel. As
bailouts and government stimulus policies revived financial markets, the staunch libertarian bet against the
rally and lost big. Investors have been pulling their money out of his fund: Clarium has shrunk from $7
billion in assets to about $1.5 billion. Even as he was laying odds against the economy as a fund manager,
though, Thiel was pouring money into audacious, futuristic projects as a VC and philanthropist: private
space flight, ocean colonies for human habitation, indefinite life extension. Contradiction? He sees none.
Behind both his economic skepticism and his radical utopianism is a conviction that the only way to escape
a looming social crisis is to revive the science fiction dreams of yesterday.
Wired: What do you do? How do you actually spend your days?
Peter Thiel: I spend a lot of my time thinking about the future. I run a hedge fund and a venture capital fund,
and a lot of that is just trying to learn whats going on in the world, trying to understand the world better.
Wired: You say that we have big problems in the US economy and that investors have unrealistic
expectations. Weve certainly been through a major crisis, but over the long term the stock market seems to
grow fairly reliably.
Thiel: People take it for granted that their retirement funds can earn 8.5 percent a year. Thats what their
financial planners tell them. And sure, you look back over the past 100 years, the stock market has generally
gone up 6 to 8 percent a year. But in a larger historical perspective, that kind of growth is exceptional. If you
had done the equivalent of investing in the stock market from, say, 1000 to 1100 AD, you would not have
made 8 percent a year. During the fall of the Roman Empire, youd have been lucky to get zero. Weve been
living in a unique period of accelerating technological progress. Weve gone from horses to cars to planes to
rockets to computers to the Internet in a very short time. Its not automatic that that continues.
Wired: What happens if we dont get the growth everyone expects?

Thiel: If it doesnt happen, people will go bankrupt in retirement. There are systemic consequences, too. If
we dont have enough growth, we will see a powerful shift away from capitalism. There are good things and
bad things about capitalism, but inequality becomes completely intolerable to society when everythings
static.
Wired: Youre worried about economic stagnation, but youre optimistic about artificial intelligence and
space?
Thiel: I think we have to make those things happen. We should be looking at technologies that might lead to
really big breakthroughs. As a starting point, lets just go back to the science fiction novels of the 1950s and
60s and try to run the past 40 years again.
Wired: We need underwater cities and flying cars, otherwise were going bankrupt?
Thiel: We go bankrupt if radical progress doesnt happen and we dont realize its not happening. Thats a
dangerous combination.
Wired: Weve had tremendous growth in the Internet, which is how you made your fortune. Why not look
there?
Thiel: Obviously weve done well online. But how much more progress is there going to be? How many big
new Internet companies are there? In the 90s we had Netscape, Yahoo, eBay, Amazon. In the past eight
years there have been only two: Google and Facebook.
Wired: Twitter?
Thiel: Possibly. Still, the numbers suggest a maturing industry. The Internet may be culturally important,
just as the automobile was culturally more important in the 50s than the 20s, as we got suburbia and built
the Interstate Highway System. But the last successful car company started in the US was Jeep in 1941.
Wired: Youve had a rough year. The stock market rallied strongly, and Clarium Capital bet the wrong way.
Thiel: I think were back to a zone of irrational exuberance.
Wired: Like before the Internet bubble burst?
Thiel: I think its maybe even more irrational because theres no story about the future. At least in 99 there
was a story.
Wired: Do you have another year in you, in this posture of skepticism? What if you continue to lose money?
Thiel: Am I right and early, or am I just wrong? You always have to wonder. But the things that I think Im
right about, other people are in some sense not even wrong about, because theyre not thinking about them.

The Public and Its Problems


Raghuram Rajan
CHICAGO On a recent visit to Europe, I found economists, journalists, and business people thoroughly frustrated
with their politicians. Why, they ask, cant politicians see the abyss that yawns before them, and come together to
resolve the euro crisis once and for all?

Even if there is no consensus on what a solution might be, cant they meet and thrash out a plan that goes
beyond their repeated half-measures? It is only because of the European Central Banks bold decision to lend long
term to banks that we have seen some respite recently, or so their argument goes. Politicians, in contrast, are
failing Europe by being forever behind the curve. Why do they find it so hard to lead?
One answer that can be easily dismissed is that politicians simply dont understand the gravity of the situation.
Political leaders need not be economic geniuses to understand the advice that they hear, and many are both
intelligent and well-read.
A second answer that politicians have short time horizons, owing to electoral cycles may contain a kernel of
truth, but it is inadequate, because the adverse consequences of timid action often become apparent well before
they are up for re-election.
The best answer that I have heard comes from Axel Weber, the former president of Germanys Bundesbank and an
astute political observer. In Webers view, policymakers simply do not have the public mandate to get ahead of
problems, especially novel ones that seem small initially, but, if unresolved, imply potentially large costs.
If the problem has not been experienced before, the public is not convinced of the potential costs of inaction. And,
if action prevents the problem, the public never experiences the averted calamity, and voters therefore penalize
political leaders for the immediate costs that the action entails. Even if politicians have perfect foresight of the
disaster that awaits if nothing is done, they may have little ability to persuade voters, or less insightful party
members, that the short-term costs must be paid.
Talk is cheap, and, in the absence of evidence to the contrary, the status quousually appears comfortable enough.
So leaders ability to take corrective action increases only with time, as some of the costs of inaction are
experienced.
Calamity can still be averted if the costs of inaction escalate steadily. The worst problems, however, are those with
inaction costs that remain invisible for a long time, but increase suddenly and explosively. By the time the leader
has the mandate to act, it may be too late.
A classic example was Winston Churchills warnings against Adolf Hitlers ambitions. Hitlers plans were outlined
in Mein Kampf for all to read and he did not disguise them in his speeches. Yet few in Britain wanted to give
them credence, and many thought that communism was the greater threat, especially in the bleak years of the
Great Depression.
The Nazis dismembering of Czechoslovakia in 1938 made the sincerity of Hitlers ambitions all too clear. But it was
only after the invasion of Poland the following year that Churchill was appointed First Lord of the Admiralty, and he
became Prime Minister only after the invasion of France in 1940, when Britain stood alone.
Britain might well have been better off had Churchill held power earlier, but that would have meant costly
rearmament, which was unacceptable so long as there was a chance that Hitler proved to be a paper tiger. And, of
course, it would also have meant entrusting Britains fate to a politician who, though now regarded as an
indomitable leader, was widely distrusted at the time.
Non-linear costs of inaction are most obvious in the financial sector. At the same time, financial-sector problems
may be particularly difficult to address: if politicians emphasize the need for action too strongly in order to get a
mandate, they might precipitate the very turmoil that they seek to contain.
Between the Bear Stearns crisis and the failure of Lehman Brothers, the United States government could do little
to get ahead of the growing problem (though, of course, the government-backed mortgage underwriters Fannie
Mae and Freddie Mac were placed under conservatorship in the interim). It took the post-Lehman panic for
Congress to authorize the Troubled Asset Relief Program, which threw a financial lifeline to banks and the auto
industry, among others. And only frenetic action by the Federal Reserve and Treasury (with authorities around the
world joining) prevented a systemic meltdown. A subprime-mortgage problem that was initially estimated to imply
losses of a few hundred billion dollars imposed far higher costs on the entire world.
Similarly, eurozone politicians have obtained a mandate to take bolder action only as the markets have made the
costs of inaction more salient. Even setting aside Germanys understandable attempt to limit how much it would
have to pay, it is difficult to see how politicians could have gotten ahead of the problem.
While the ECB has bought the eurozone some time, the calming effect on markets may be a mixed blessing. Have
Europeans seen enough of the abyss to tolerate stronger action by their leaders? If not, markets might have to
deteriorate further to make possible a comprehensive resolution to the eurozone crisis.

Similarly, with government bond yields as low as they are in the US, the public has little sense of urgency about
its fiscal problems, though some doomsayers, like Peter Peterson of the Blackstone Group, have been trying their
best to awaken it. One hopes that the coming US presidential election will lead to a more enlightened public
debate about tax and entitlement reform. Otherwise, a rapid escalation of yields in the bond market might be
necessary for the public to accept that there is a problem, and for politicians to have the room to resolve it.
Dont blame the leaders for appearing short-sighted and indecisive; the fault may lie with us, the public, for not
listening to the worrywarts.

Why Companies Fail


GMs stock price has sunk by a third since its IPO. Why is corporate turnaround so difficult and rare? The answer is
often culturethe hardest thing of all to change.
By MEGAN MCARDLE

THE AMERICAN AUTO industryan industry thats been the proud symbol of Americas manufacturing might for a
century, an industry that helped to build our middle classis once again on the rise. Thats what President Barack
Obama told assembled reporters and officials on November 18, 2010, the day after the new General Motors went
public, with the largest IPO in American history.
GM sold 478 million common shares at $33 each, as well as a sizable chunk of preferred stock, raising $20.1 billion.
While the IPO itself didnt fully recover the federal governments post-crash investment in GM (some $50 billion), a
complete payoff seemed possible if the stock price rose enough, allowing the government to sell off its remaining stake
at a better price. More important, said sober analysts, the stripped-down cost structure, looser union contracts, and
management shake-up that preceded the IPO would allow GM to finally shed its decades-old legacy of divisive labor
battles and mediocre, gas-guzzling cars. (As I reported in these pages in 2010, I, too, saw inklings of hope.)
In November 2011, roughly a year later, Treasury revised its estimate of the governments likely loss upward from
$14.3 billion to $23.6 billion. As of this writing, GMs stock was hovering around $20 a share. The company was beset
by reports that the batteries in its splashy new hybrid-electric car had an unfortunate tendency to catch fire.
Meanwhile, sales of the Chevy Cruze, which was supposed to be the Corolla-killer, were slipping after a strong initial
showing.
This despite the fact that the companys major Japanese competitors had been crippled by a tsunami and a nuclear
meltdown. Business journalists often joke that some struggling firm could be saved only by an act of God, but in the
case of GMs stock price, even that hasnt been enough.
Which has to raise the question: Was the company really saved? Did it finally have its Come to Jesus moment? Or
was this just one more temporary detour in the companys erratic amble toward perdition?
Historical precedent offers strong reasons to worry that GM might continue to backslide. Though casual glosses
usually present the companys history as a steady decline from the mighty 1960s to the debacle of 2008, in fact, there
were quite a few moments when GMand Detroit more generallyappeared to have mended its ways. In 1994, during
one of those moments, the reporter Paul Ingrassia published a book called Comeback: The Fall and Rise of the
American Automobile Industry. In his 2010 book, Crash Course, he sounds older and wiser:
Throughout the 1980s and 1990s, every time the Big Three and the UAW returned to prosperity, they would succumb
to hubris and lapse back into their old bad habits. It was like a Biblical cycle of repentance, reform, and going astray,
again and again, as Detroit was repeatedly lured by the golden calves of corporate excess and union overreach.

The cycle reached its peak at the beginning of the new millennium, when the Big Three plunged from record profits to
breathtaking losses in just five years.
Over the past few decades, GMs ability to resist change has proved almost uncanny. Why did the company wait so
long and do so littlenot once, but time and againbefore finally falling into bankruptcy? And what, if anything, does
that portend for its future? The questions go beyond GM, a company thats hardly unique. Why did Blockbuster idly
watch Netflix destroy its business? Why did Kodak let digital cameras drive a once-mighty industrial giant into pennystock territory?
Ask Jeff Stibel, and hell tell you: because thats what troubled companies do. Stibel, once an aspiring cognitive
scientist in Browns graduate program, is now a serial entrepreneur who has led turnarounds at Web.com and Dun &
Bradstreet Credibility Corp. Once the human mind has set out to do something, or has gotten in the habit of doing
something, he told me, changing it is very hard. When you add group dynamics, its even harder. You dont need to
be a brain scientist, of course, to know that people resist change and yet, even knowing that, youd be surprised at
how many firms keep driving toward inevitable disaster at top speed. GMs record is very much the norm, not the
exception.
Years ago, I listened to an earnings call with the head of a biotech firm that had sold off the income streams from all its
patents, had nothing in its pipeline, and was rapidly burning through its cash. Nonetheless, the CEO kept talking
about our future as if the company had one, other than liquidation. The equity analysts on the call didnt seem fazed;
apparently, thats how companies in these situations usually behave. Management and workers seem oblivious to their
failures. They wait too long before they act, and even when they do take action, its often inadequate.
This dynamic has given rise to a booming industry of turnaround specialists. They range from serial CEOs, like Stibel,
who may walk in with an entire senior management team, to more-traditional management consultants. The industry
is big enough to support considerable specializationby company size, by industry, even by technique (cost cutter,
brand builder). All seem to agree on one thing: most companies wait far too long to even recognize that they have a
problem.
Typically, a company doesnt pull someone in until theyre on the brink of disaster, says Thomas Kim, a Denver-based turnaround specialist and an officer of the Turnaround Management Association. They cant make payroll,
cant make a loan payment, or cant pay off their loan thats coming due. Obviously, if everyone waits until the checks
get rubbery, the chances of avoiding the onrushing debacle are slim. But the flip side of the problem, says Michael
Buenzow, a senior managing director in the corporate finance and restructuring practice at FTI Consulting, is that
unless the crisis is acute, its hard to make anything happen. If youre brought in too early, he says, the employees in
the organization wont have that same sense of urgency.
And yet, the argument that people continue down dead ends merely because they hate change seems inadequate. After
all, people also hate losing their jobs and their money. As economists like to say, most people are risk-averseits why
unions accept wage cuts to keep pensions and health-care benefits, and why extended warranties are big business for
Best Buy. Firms are full of these mostly risk-averse people. So why do they so commonly refuse to swerve?
One possibility is that firms dont change because inertia is in their DNAindeed, its a gene that once made many of
them successful. In their 1989 book, Organizational Ecology, Michael Hannan and John Freeman argue that
organizations are actually selected for inertia by their environment, and rarely change their fundamental structural
features. Change is risky, after all, since it definitionally involves doing something that isnt already workingand
even product lines that have grown lackluster still have some customers. Firms that are prone to frequent large

changes will probably have more opportunities to kill themselves off with bad choices than firms that resist big
changes.
Moreover, the need for accountability and reliability in the modern economy selects against constant radical
experimentationpeople like knowing that their bank has cumbersome and invariable procedures for keeping track of
deposits, for instance. Think of McDonalds, where a core premise is that no matter where you go, the food and decor
will be reliably, exactly the same. Or consider what happened to Coke after it tried to change the recipe of its iconic
product, even though taste tests showed that most people actually liked the new version better. The larger and older
the firm is, the heavier the selection for stability.
This is a powerfully attractive model for explaining why innovation so often seems to be driven by newcomers, rather
than by profitable incumbents with huge R&D budgets. It also helps explain why so many companies in turnaround
situations are gripped by inertia.
Blockbuster, for instance, promisedand for a long time deliveredreliability and ubiquity. Most customers were
never more than a few minutes from a bright, clean, spacious store with an ample selection of the latest videos. But
eventually that commitment to ubiquity and sameness killed the company. Blockbuster did see the possibilities of
streaming, and explored some partnerships to exploit them, but was slow to roll out changes to its core business (as
late as August 1999, only 1,000 Blockbuster stores even carried DVDs). Meanwhile, the commitment to ubiquity had
caused the firm to take on a mountain of debt to lease all that pricey real estate. At some point, the company needed to
leap into the unknown. But by the time its managers all held hands and took the plunge, the clock had run out.
Blockbusters streaming service, launched in 2004, was far too little, and far, far too late.
Thomas Kim sums up the problem of corporate inflexibility pungently. There are companies that perform reasonably
well, and are completely dysfunctional. But then the market changes. In the companies that we see that hit the wall,
that dysfunctional corporate culture really becomes a problem.
Detroit labor relations have been a disaster ever since the early unionization drives, which were acrimonious and at
times violent (at the infamous Battle of the Overpass, in 1937, a claque of Ford security guards attacked union
agitators in front of an assembled press delegation). The result was a poisonous relationship; in many ways, GM
workers were more a part of the United Auto Workers than of GM. Eventually, the union became a sort of shadow
management that had to sign off on every production decision the company made, if it had any effect at all on workers.
This system actually worked during the boom years. Because GMs competitors were unionized too, the UAWs power
kept wages more or less equal across the Big Three, and helped contain cost competition that might have led to price
wars, undercutting margins. The UAW, meanwhile, never had to worry that an excessively rich compensation package
would put the Big Three in jeopardy.
Conditions changed, but the thinking didnt. The union frequently behaved like a parasite that didnt care whether it
killed its hostcalling strikes just as the company was trying to launch a pathbreaking small car; demanding that GM
keep paying surplus workers nearly full salary indefinitely, even as market share declined. Rather than trying to
change this dynamic, management caved, again and againpossibly, Ingrassia suggests, because any increase in
wages would trickle up, as GM strove to maintain a pay differential between management and the hourly workers.
GMs strategy, which focused first and foremost on sheer scale, also became ineffective over time, yet the company
never moved substantially beyond it. Competitors built well-understood brands based on super-reliability, or style and
performance, picking off customers year after year. But GM never settled on what it wanted to be, beyond gigantic.

Even a dysfunctional culture, once well established, is astonishingly efficient at reproducing itself. The UCLA
sociologist Gabriel Rossman told me, If new entrants assimilate to whatever is the majority at the time they enter,
and if new entrants trickle in slowly, then the founding culture can persist over time, even if over the long run they
make up a tiny minority. This is why Americans speak English even though more of us are ethnically German or
Yoruba. In linguistics and sociology, its known as the founder effect. In corporations, its known as how weve
always done things.
Corporate culture, like any other culture, can change, of course. Edward Niedermeyer, of TheTruthAboutCars.com,
who has been a pretty tough critic of GM, thinks that this time may really be different. Finally, he says, folks over
there seem well aware of the old bad habits and are trying extremely hard to avoid them. (Although he is quick to
point out that new bad habits could easily emerge.)
David Cole, of the Center for Automotive Research, agrees. For one thing, its clear that the UAW has come to understand that it needs to actively work to keep the auto industry healthy. With membership a quarter of what it used to
be, the union is now in worse shape than the Big Three. So it is focused on providing a more flexible, better-skilled
workforce. It has also allowed workers pay to be tied to the fate of GM.
One of the things that the UAW never wanted, says Cole, was to have an equity position in the company, because
they didnt want the membership to think like investors. Now with the bonus scheme, theyve essentially got an equity
position.
But then, some questions linger the scattered complaints that the company is channel stuffing (upping its
reported sales by getting dealers to take cars they dont want), the continued reliance on incentives like zero percent
financing, and of course, those exploding batteries. Unfortunately, corporate culture is a sort of black box; from the
outside, you cant see whats going on. You have to wait to see what emerges.
What we can say is that this time, were actually going to find out. GM has fixed basically every other problem that
anyone could name: Instead of a $2,000-a-car cost disadvantage due in large part to legacy costs such as wages and
retiree benefits, it now has a cost advantage. The eight marques that multiplied the overhead and muddied the value
propositions of its brands have been streamlined to four. The excess dealerships have been closed.
Whats left is culture. After everything, if GM begins losing market share again, well know that its beyond saving. To
paraphrase the old joke: How many experts does it take to turn around a big company? Only onebut the company
has to really want to change.

The mathematical equation that caused the banks to crash


The Black-Scholes equation was the mathematical justification for the trading that plunged
the world's banks into catastrophe
It was the holy grail of investors. The Black-Scholes equation, brainchild of economists Fischer Black and Myron
Scholes, provided a rational way to price a financial contract when it still had time to run. It was like buying or
selling a bet on a horse, halfway through the race. It opened up a new world of ever more complex investments,
blossoming into a gigantic global industry. But when the sub-prime mortgage market turned sour, the darling of
the financial markets became the Black Hole equation, sucking money out of the universe in an unending
stream.
Anyone who has followed the crisis will understand that the real economy of businesses and commodities is
being upstaged by complicated financial instruments known as derivatives. These are not money or goods. They

are investments in investments, bets about bets. Derivatives created a booming global economy, but they also
led to turbulent markets, the credit crunch, the near collapse of the banking system and the economic slump.
And it was the Black-Scholes equation that opened up the world of derivatives.
The equation itself wasn't the real problem. It was useful, it was precise, and its limitations were clearly stated. It
provided an industry-standard method to assess the likely value of a financial derivative. So derivatives could be
traded before they matured. The formula was fine if you used it sensibly and abandoned it when market
conditions weren't appropriate. The trouble was its potential for abuse. It allowed derivatives to become
commodities that could be traded in their own right. The financial sector called it the Midas Formula and saw it
as a recipe for making everything turn to gold. But the markets forgot how the story of King Midas ended.
Black-Scholes underpinned massive economic growth. By 2007, the international financial system was trading
derivatives valued at one quadrillion dollars per year. This is 10 times the total worth, adjusted for inflation, of all
products made by the world's manufacturing industries over the last century. The downside was the invention of
ever-more complex financial instruments whose value and risk were increasingly opaque. So companies hired
mathematically talented analysts to develop similar formulas, telling them how much those new instruments
were worth and how risky they were. Then, disastrously, they forgot to ask how reliable the answers would be if
market conditions changed.
Black and Scholes invented their equation in 1973; Robert Merton supplied extra justification soon after. It
applies to the simplest and oldest derivatives: options. There are two main kinds. A put option gives its buyer the
right to sell a commodity at a specified time for an agreed price. A call option is similar, but it confers the right to
buy instead of sell. The equation provides a systematic way to calculate the value of an option before it matures.
Then the option can be sold at any time. The equation was so effective that it won Merton and Scholes the 1997
Nobel prize in economics. (Black had died by then, so he was ineligible.)
If everyone knows the correct value of a derivative and they all agree, how can anyone make money? The
formula requires the user to estimate several numerical quantities. But the main way to make money on
derivatives is to win your bet to buy a derivative that can later be sold at a higher price, or matures with a
higher value than predicted. The winners get their profit from the losers. In any given year, between 75% and
90% of all options traders lose money. The world's banks lost hundreds of billions when the sub-prime mortgage
bubble burst. In the ensuing panic, taxpayers were forced to pick up the bill, but that was politics, not
mathematical economics.
The Black-Scholes equation relates the recommended price of the option to four other quantities. Three can be
measured directly: time, the price of the asset upon which the option is secured and the risk-free interest rate.
This is the theoretical interest that could be earned by an investment with zero risk, such as government bonds.
The fourth quantity is the volatility of the asset. This is a measure of how erratically its market value changes.
The equation assumes that the asset's volatility remains the same for the lifetime of the option, which need not
be correct. Volatility can be estimated by statistical analysis of price movements but it can't be measured in a
precise, foolproof way, and estimates may not match reality.
The idea behind many financial models goes back to Louis Bachelier in 1900, who suggested that fluctuations of
the stock market can be modelled by a random process known as Brownian motion. At each instant, the price of
a stock either increases or decreases, and the model assumes fixed probabilities for these events. They may be
equally likely, or one may be more probable than the other. It's like someone standing on a street and repeatedly
tossing a coin to decide whether to move a small step forwards or backwards, so they zigzag back and forth
erratically. Their position corresponds to the price of the stock, moving up or down at random. The most
important statistical features of Brownian motion are its mean and its standard deviation. The mean is the shortterm average price, which typically drifts in a specific direction, up or down depending on where the market
thinks the stock is going. The standard deviation can be thought of as the average amount by which the price
differs from the mean, calculated using a standard statistical formula. For stock prices this is called volatility, and
it measures how erratically the price fluctuates. On a graph of price against time, volatility corresponds to how
jagged the zigzag movements look.

Black-Scholes implements Bachelier's vision. It does not give the value of the option (the price at which it should
be sold or bought) directly. It is what mathematicians call a partial differential equation, expressing the rate of
change of the price in terms of the rates at which various other quantities are changing. Fortunately, the
equation can be solved to provide a specific formula for the value of a put option, with a similar formula for call
options.
The early success of Black-Scholes encouraged the financial sector to develop a host of related equations
aimed at different financial instruments. Conventional banks could use these equations to justify loans and
trades and assess the likely profits, always keeping an eye open for potential trouble. But less conventional
businesses weren't so cautious. Soon, the banks followed them into increasingly speculative ventures.
Any mathematical model of reality relies on simplifications and assumptions. The Black-Scholes equation was
based on arbitrage pricing theory, in which both drift and volatility are constant. This assumption is common in
financial theory, but it is often false for real markets. The equation also assumes that there are no transaction
costs, no limits on short-selling and that money can always be lent and borrowed at a known, fixed, risk-free
interest rate. Again, reality is often very different.
When these assumptions are valid, risk is usually low, because large stock market fluctuations should be
extremely rare. But on 19 October 1987, Black Monday, the world's stock markets lost more than 20% of their
value within a few hours. An event this extreme is virtually impossible under the model's assumptions. In his
bestseller The Black Swan, Nassim Nicholas Taleb, an expert in mathematical finance, calls extreme events of
this kind black swans. In ancient times, all known swans were white and "black swan" was widely used in the
same way we now refer to a flying pig. But in 1697, the Dutch explorer Willem de Vlamingh found masses of
black swans on what became known as the Swan River in Australia. So the phrase now refers to an assumption
that appears to be grounded in fact, but might at any moment turn out to be wildly mistaken.
Large fluctuations in the stock market are far more common than Brownian motion predicts. The reason is
unrealistic assumptions ignoring potential black swans. But usually the model performed very well, so as time
passed and confidence grew, many bankers and traders forgot the model had limitations. They used the
equation as a kind of talisman, a bit of mathematical magic to protect them against criticism if anything went
wrong.
Banks, hedge funds, and other speculators were soon trading complicated derivatives such as credit default
swaps likened to insuring your neighbour's house against fire in eye-watering quantities. They were priced
and considered to be assets in their own right. That meant they could be used as security for other purchases.
As everything got more complicated, the models used to assess value and risk deviated ever further from reality.
Somewhere underneath it all was real property, and the markets assumed that property values would keep
rising for ever, making these investments risk-free.
The Black-Scholes equation has its roots in mathematical physics, where quantities are infinitely divisible, time
flows continuously and variables change smoothly. Such models may not be appropriate to the world of finance.
Traditional mathematical economics doesn't always match reality, either, and when it fails, it fails badly.
Physicists, mathematicians and economists are therefore looking for better models.
At the forefront of these efforts is complexity science, a new branch ofmathematics that models the market as a
collection of individuals interacting according to specified rules. These models reveal the damaging effects of the
herd instinct: market traders copy other market traders. Virtually every financial crisis in the last century has
been pushed over the edge by the herd instinct. It makes everything go belly-up at the same time. If engineers
took that attitude, and one bridge in the world fell down, so would all the others.
By studying ecological systems, it can be shown that instability is common in economic models, mainly because
of the poor design of the financial system. The facility to transfer billions at the click of a mouse may allow everquicker profits, but it also makes shocks propagate faster.

Was an equation to blame for the financial crash, then? Yes and no. Black-Scholes may have contributed to the
crash, but only because it was abused. In any case, the equation was just one ingredient in a rich stew of
financial irresponsibility, political ineptitude, perverse incentives and lax regulation.
Despite its supposed expertise, the financial sector performs no better than random guesswork. The stock
market has spent 20 years going nowhere. The system is too complex to be run on error-strewn hunches and
gut feelings, but current mathematical models don't represent reality adequately. The entire system is poorly
understood and dangerously unstable. The world economy desperately needs a radical overhaul and that
requires more mathematics, not less. It may be rocket science, but magic it's not.