Taleb: Debt reduction, not stimulus

Can't believe I missed this one from back in July.

OK, so I admit I like Taleb a lot, and he's against bailouts and stimulus packages. I can agree on the former. But in the absence of aggressive, systematic conversion of debt to equity like he prescribes, then we are left with an economy that still depends on massive amounts of debt to make it go; and in this recession, few want or have the means to lend. I wonder what Taleb would prescribe then, understanding the real world in which we live?

If we follow his advice and eliminate debt, it seems to me we would have a much smaller economy than the world has today, at least at first. Maybe that's not a bad thing though.

Time to tackle the real evil: too much debt

By Nassim Nicholas Taleb and Mark Spitznagel

July 13, 2009 | Financial Times

The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.

Our analysis is as follows. First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets.

Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.

Our ability to forecast suffers due to this complexity and the occurrence of the occasional extreme event, or "black swan". Such degradation in predictability should have made companies more conservative in their capital structure, not more aggressive – yet private equity, homeowners and others have been recklessly amassing debt. Such non-linearity makes the mathematics used by economists rather useless. Our research shows that economic papers that rely on mathematics are not scientifically valid. Not only do they underestimate the possibility of "black swans" but they are unaware that we do not have any ability to deal with the mathematics of extreme events. The same flaw found in risk models that helped cause the financial meltdown is present in economic models invoked by "experts". Anyone relying on these models for conclusions is deluded.

Third, debt has a nasty property: it is highly treacherous. A loan hides volatility as it does not vary outside of default, while an equity investment has volatility but its risks are visible. Yet both have similar risks. Thus debt is the province of both the overconfident borrower who underestimates large deviations, and of the investor who wants to be deluded by hiding risks. Then there are products such as complex derivatives, which in the name of "modern finance" make the system even more fragile.

Against this background, we have two options. The first is to deflate debt, the other is to inflate assets (or counter their deflation with a collection of stimulus packages.)

We believe that stimulus packages, in all their forms, make the same mistakes that got us here. They will lead to extreme overshooting or extreme undershooting. They lead to more borrowing, by socialising private debt. But running a government deficit is dangerous, as it is vulnerable to errors in projections of economic growth. These errors will be larger in the future, so central bank money creation will lead not to inflation but to hyper-inflation, as the system is set for bigger deviations than ever before.

Relying on standard models to build policies makes us all fragile and overconfident. Asking the economics establishment for guidance (particularly after its failure to see the risk in the economy) is akin to asking to be led by the blind – instead we need to rebuild the world to make it resistant to the economist's mystifications.

Invoking the pre-internet Great Depression as guidance for current events is irresponsible: errors in fiscal policy will be magnified by this kind of thinking. Monetary policy has always been dangerous. Alan Greenspan, former Federal Reserve chairman, tried playing with the business cycle to iron out bubbles, but it eventually got completely out of control. Bubbles and fads are part of cultural life. We need to do the opposite to what Mr Greenspan did: make the economy's structure more robust to bubbles.

The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming "binary" – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from "hopers", hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers.

It is sad to see that those who failed to spot the problem (or helped to cause it) are now in charge of the remedy. Just as the impending crisis was obvious to those of us who specialise in complexity and extreme deviations, the solution is plain to see. We need an aggressive, systematic debt-for-equity conversion. We cannot afford to wait a day.

The writers are with Universa Investments; Prof Taleb is author of 'The Black Swan: The Impact of the Highly Improbable'

Taleb: Principles of a new, robust economy

10 principles for a Black Swan-proof world

By Nassim Nicholas Taleb

April 7, 2009  | Financial Times

 

1. What is fragile should break early while it is still small.  Nothing should ever become too big to fail.  Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

 

2. No socialisation of losses and privatisation of gains.  Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing.  We have managed to combine the worst of capitalism and socialism.  In France in the 1980s, the socialists took over the banks.  In the US in the 2000s, the banks took over the government.  This is surreal.

 

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.  The economics establishment (universities, regulators, central bankers, government officials, various organisations staffed with economists) lost its legitimacy with the failure of the system.  It is irresponsible and foolish to put our trust in the ability of such experts to get us out of this mess.  Instead, find the smart people whose hands are clean.

 

4. Do not let someone making an "incentive" bonus manage a nuclear plant – or your financial risks.  Odds are he would cut every corner on safety to show "profits" while claiming to be "conservative".  Bonuses do not accommodate the hidden risks of blow-ups.  It is the asymmetry of the bonus system that got us here.  No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

 

5. Counter-balance complexity with simplicity.  Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products.  The complex economy is already a form of leverage: the leverage of efficiency.  Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error.  Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

 

6. Do not give children sticks of dynamite, even if they come with a warning .  Complex derivatives need to be banned because nobody understands them and few are rational enough to know it.  Citizens must be protected from themselves, from bankers selling them "hedging" products, and from gullible regulators who listen to economic theorists.

 

7. Only Ponzi schemes should depend on confidence. Governments should never need to "restore confidence".  Cascading rumours are a product of complex systems.  Governments cannot stop the rumours.  Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

 

8. Do not give an addict more drugs if he has withdrawal pains.  Using leverage to cure the problems of too much leverage is not homeopathy, it is denial.  The debt crisis is not a temporary problem, it is a structural one.  We need rehab.

 

9. Citizens should not depend on financial assets or fallible "expert" advice for their retirement.  Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require.  Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

 

10. Make an omelette with the broken eggs.  Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches.  We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself.  Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the "Nobel" in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

 

Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage.  A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.

 

In other words, a place more resistant to black swans.

 

The writer is a veteran trader, a distinguished professor at New York University's Polytechnic Institute and the author of The Black Swan: The Impact of the Highly Improbable

Sirota: 'Too big to fail' means too big to be private

Or, as Nassim Taleb said, if it might have to be bailed out tomorrow, nationalize it today.  As Sirota explains, there is free-market thinking behind this prescription.  It's about keeping a clean separation between what is government's, and what is the private sector's, without all this quasi-national bailout baloney and airs of "protecting capitalism" with no-strings government financing.

If It's 'Too Big To Fail,' Then It's Too Big To Be Private

By David Sirota

March 3, 2009

 

I appeared yesterday at the top of Neil Cavuto's Fox News show to discuss the potential for financial industry nationalization. You can watch the clip here. I tried to use the opportunity to float a fairly simple - and old-fashioned - concept: If something is "too big to fail," then it's too big to be in private hands.

The term "too big to fail" is a euphemism for any institution that is so important to the entire nation's most basic well being, that society cannot let that institution fail. This is why one of the foundational principles of civilized society has always been nationalization - ie. government control - of the institutions that are "too big to fail": institutions like the military, whose failure would mean a basic loss of national security; law enforcement, whose failure would mean a basic loss of civil order; and infrastructure construction, whose failure would mean the crumbling of commerce. The government, as the most powerful representative of society as a whole, runs these institutions/services because they are too important to be allowed to fail.

 

Unfortunately, the hard-right and center-right ideologues who ran the government for the last 30 years gutted the basic laws and enforcement mechanisms (financial regulations, anti-trust prosecutions, etc.) that prevented a myriad of financial institutions from becoming "too big to fail."

 

The American Insurance Group is the best example of this - a company that, as the New York Times notes, essentially based its business on a risky scheme to sell insurance to other corporations against colossal housing market failure. This allowed huge banks and investment houses to effectively offload their own absurdly risky housing investments by "insuring" those investments against loss with AIG - a shuffling of paper and deep-frying of books that let those banks leverage themselves even more, sans regulation. When the housing bubble burst and the banks called in their insurance, AIG was asked to pay up, and it couldn't, because it never expected to have to back up its insurance policies. But because AIG was so big - because it had so singularly cornered the market on such insurance and had essentially become the insurer of last resort - it couldn't eventually pay up, its failure would result in a cataclysmic ripple effect of defaults.

 

So now everyone is focused on the short-term question: Should we temporarily nationalize AIG and the biggest banks, or should we keep forcing taxpayers to get all the downsides of nationalization (ie. throwing money at the companies) without any of the upsides (i.e. ownership of the companies, power to throw out management, etc.)? Obviously, I'd say the former, but I'd go a step further: When it comes to an AIG - a company that is effectively ensuring the rest of the economy against loss - we shouldn't temporarily nationalize it, we should permanently nationalize it, or at least its core functions.

 

As I wrote in an earlier post, we shouldn't be afraid of permanent nationalization, because it is - thankfully - already all around us. Indeed, in some sectors of the economy, we have embraced nationalization thanks to an era where our government at least considered the possibility that if a function or service or entity is too big to fail, it is too big to be private.

 

That era's government believed a minimum retirement benefit and health insurance for the elderly is a "too big to fail" kind of function - too important to be subjected to the whims of the private marketplace. So we now have government-run Social Security and Medicare. That era's government also created the Pension Benefit Guaranty Corporation, which nationalized the catastrophic insurance of pension plans. It forces corporations to pay premiums that underwrite a fund that pays out the pensions of companies that go bankrupt. The government deemed that function - catastrophic pension insurance - as a "too big to fail" kind of function, understanding that if the service was in private for-profit hands, there would be a risk of that private venture overleveraging itself, and then failing when it needed to pay out retirement benefits to millions of Americans.

 

Now, clearly, it's time to resurrect the principle that if something is too big to fail, it's too big to be private. We can resurrect that principle both through far tougher regulation that prevents individual private institutions from ever becoming so singularly important to our nation,* and by nationalizing the few core functions and services that are probably best left to the government as insurer of last resort. In the former category, that means much stronger financial regulation, and in the latter category it means some kind of nationalization of basic market insurance (and, I might add, health insurance).

 

If ever there was a time that the country was ready for this kind of back-to-what-made-us-great argument, that time is now.

 

* A key point here is the word singular: There is some safety in diversification and numbers - for instance, if a crucial function of the economy is handled by multiple businesses, then the failure of one of those businesses should (theoretically) pose much less danger to the overall economy than if that business was so singularly or monopolistically crucial as in the case of AIG.

Roubini & Taleb bitch slap CNBC cheerleaders

It's pathetic how hard CNBC tries to spin Roubini and Taleb's statements, and how hard they look for "glimmerings of hope."

One of the bubbly newsbabes even posited that since people are finally desperate enough to listen to Roubini and Taleb, that the market must have finally hit bottom.  (Meaning, it's going to start going up).  Taleb would have nothing of it.  He said the system needs to be completely changed, change our culture, and live with less debt.  And most important, Taleb said banks need to change their incentive systems, which encourage bankers to take on hidden risk in pursuit of short-term bonuses:  "Wall Street can no longer operate like before."  And: "Those who one day may need to be bailed out need to be nationalized now."  The CNBC panel, which is used to kissing Wall Street's behind, was going nuts.

Roubini also favors government nationalizing the insolvent banks and then re-selling them.  He said, "Cash is king," and he's not invested in the market.  "We need more sustainable [economic] growth based on real investment in human and physical capital," not an economy based on unproductive housing or dot-com bubbles.


Nouriel Roubini and Nassim Taleb Spreading Doom & Gloom on CNBC
February 9, 2009 | CNBC

URL: http://www.cnbc.com/id/15840232?video=1027496846&play=1.

Re: Political perspectives on economy, bailouts

I'm not sure how coherent your argument below is.  Let's suppose we could trust the other guy to do the "right thing."  Would it then be morally OK for us to relax, knowing he'd pick up our slack?  No, of course not.  If you believe there is a "right thing" to do, then it's the right thing because you're supposed to do it no matter what, even if you're the only good person left on Earth.

If by "doing our individual best," you mean taking care of yourself when times get tough and forgetting about others, well.... No.  I disagree.  Charity and safety nets matter the most when times are really tough.

Indeed, government has a role to play now.  You lament that you can't count on the "other guy" anymore.  Well, that's precisely why government's needs to make the other guy ante up (especially the top 5% who have enjoyed so much increase in wealth over the past 30 years), so that we all can count on each other.  I'm not convinced we should spend $1 trillion on stimulus, but government is going to have to spend a lot of money, no doubt. 

There is going to be a lot of suffering over the next year or so, maybe longer.  This is uncharted territory.  And yet many seem to take some sick pleasure from the prospect of such suffering -- the same people, I suspect, who enjoy "teaching people a lesson," who relish pointing the finger and offering a holier-than-thou lecture whenever somebody falls down.  But did you ever stop and wonder why it is always the poor and middle class clock-punchers who must learn (and re-learn) all these important, stoical, "real American" lessons about life, as if they were the billion-dollar gamblers, as if they were the irresponsible louts who gamed the banking system to show huge profits and hide a mountain of piling debt, or collected seven-figure bonuses by maximizing short-term gains at the expense of long-term value?  What moral lessons have those rich, hotshot SOBs learned from all of this?

When bankers and traders engaged in legalized, unregulated gambling with derivatives and credit default swaps, practiced insider trading and cooked the books as their mortgage banks went under, devised "teaser" loans to fool ignorant borrowers, and gamed Wall Street's financial system to maximize their salary and bonuses, well... those were just the excesses of roaring capitalism.  After all, their greed fuels the machine that feeds us all.  But when a union worker asks for a wage increase to exceed inflation, plus health benefits and a pension, well... he is a lazy piece of shit who is ruining our economy.  He is a goddamn socialist.  He (and his father before him) should have known better.  His "greed" is completely out of bounds. 

Some people (ahem!) think that Wall Street was just plain dumb, they didn't know what they were doing when they were creating all those $ billions in mega-leveraged debt.  They can't be blamed, despite their high IQs and Ivy League MBAs and PhDs, for pushing the global economy over the brink.  Yet the blue-collar union worker should have known full well that he was destroying his own job, his company, and indeed America's manufacturing base by negotiating with his management for the highest wages and benefits he could get.  The union worker, despite his high school education, and the sudden confluence of global economic forces beyond his control and often his understanding, was nevertheless knowledgeable and personally culpable and therefore deserves his sudden joblessness and our collective scorn.  

Don't you see the gross double standard at work in this reasoning?  Moreover, don't you see the gross imbalance in the effect on our economy of Wall Street's greed and recklessness vs. auto unions' "greed"?   And yet you reserve a special disdain for the simple, middle-class union worker, who is probably a defender of the basic Christian "family values" that you treasure.  Don't you see that you, this kid who wrote this op-ed, and most Republicans are suckers for a class of people who don't give two shits about you, and who are laughing all the way to the mega-merger of their bank (paid for by you)? 

I'm not defending the unions all the way, but let's acknowledge that there is only one kind of greed -- the greedy kind.  If you think that a white-collar banker's greed is somehow more virtuous because he's dealing with more zeroes and taking risks with somebody else's money, then please excuse me while I vomit.  Indeed, if "greed is good," if overoptimism and risk-taking are what make capitalism go, then it's nonsensical to excoriate the losers and praise the winners alike because they were greedy, optimistic, and heedless of risk!

The book I'm reading now, The Black Swan, by Nicholas Taleb, a successful trader and self-styled philosopher, was at the forefront of my mind as I wrote the above.  Wrote Taleb: "Capitalism is, among other things, the revitalization of the world thanks to the opportunity to be lucky."  And: "As individuals we should love free markets because operators in them can be as incompetent as they wish," meaning, as incompetent, risk-taking, and overoptimistic as they wish to be without being able to hurt everybody else too badly, thanks to bankruptcy.  Unlike government incompetence, which affects us all and rarely results in the government's disintegration.  Taleb is convinced that most successful businesses and businessmen were simply lucky.  That's all.  Just being in the right place at the right time. 

On Wed, Jan 14, 2009 at 6:36 PM, < > wrote:

http://www.northstarwriters.com/pi148.htm

Choices would be more clear if we could TRUST our fellow man. It's a reminder to all of us to complete our committments and practice responsibility.

It is more true today than ever, that saving the nation and world begins with each one of us doing our individual best. We can't count on the "other guy".