Some principles from the Black Swan

Some thoughts about the Taleb article:

Ten principles for a Black Swan-proofworld

By Nassim Nicholas Taleb
Published: April 8 2009 03:00 | Last updated: April 8 2009 03:00 From the Financial Times.
JLB: This is long, but I hopefully worthwhile. Namely discussing the critical issues that are involved in achieving a markedly improved system of finance and values: America 2.0/Capitalism 2.0. Since some (most) of you may not reach the end, may I suggest focusing on Paragraph 4 and my conclusions that I have placed both up front and at the end:

So where do I come out—if anyone cares, that is? LOL We clearly do need an America 2.0/Capitalism 2.0. I certainly don’t profess to have all of the answers. However, in discussion with a small group of friends with divergent viewpoints, we intend to identify what we believe are the key issues, prioritize how they should be addressed and then examine each in detail to determine how we believe that they should be handled. Our group is only eight to ten people. We don’t and won’t have all of the answers. However, our discussions will produce some constructive ideas that we can then present to others in the private sector, government and abroad. I would encourage everyone to follow the same path. Set aside time to discuss these issues with good friends and recognize that multiple sessions will be required. There is too much at stake for us personally and for our families to let others “find the solution”. Thanks for listening. I’d welcome any responses and thoughts. Happy Easter/Happy Passover. Jeff

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.

JLB: In my opinion, this is a sophism. It sounds great—but it’s not clear how this would work in practice. Certain organizations may be too big to become manageable (e.g., Citigroup) or poorly managed (e.g. GM). What should be done to prevent this? A Government mandated break up or change in management? Not in a capitalist society. For the financial sector, the Government can institute stronger capital ratios with less leverage as it has done with the banks and also demand better transparency and realistic valuations—but mark to market when there is no market doesn’t get the job done either. Ditto with insurers. But what about hedge funds? Not clear. Should we say that once a hedge fund reaches a certain size (so that its failure could potentially be harmful) that it must adhere to defined ratios? It’s a very delicate balance. Markets basically work and we shouldn’t discard the information that they provide. Bubbles will always occur. I don’t have a clear answer here.

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.

JLB: once again a catchy phrase, but what does this mean? To me, if Government support is required, the Government/taxpayers should appropriately share in the upside—and the mandate should be to privatize the institution as soon as possible.

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.

JLB: I heartily agree. However, how does one find an entire new management team for Citigroup, GM, etc? Maybe the answer is “never let the ‘perfect’ overcome the ‘good’”. That is if the perfect solution isn’t there, go the with the “next best”—which is installing a new CEO, who’s mandate is to field a new team of senior managers and directors and produce a new business plan with appropriately revised strategies.

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.

JLB: In total agreement. I believe that this is the over arching lesson. If there were clawbacks, the potential for personal bankruptcy if certain schemes didn’t work (i) lenders wouldn’t lend unduly, (ii) managers wouldn’t over leverage and understand what the products actually were (or if they didn’t, not launch the products until they did) and manage for the long term rather than trying to game the system for their own short term benefit, (iii) this would also tend to limit the concerns Taleb expresses in Paragraph 1: Managers will be very cautious about growing a business to where it becomes too large to manage and unsustainable and unwieldy.

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.

JLB: Debt is indeed much more dangerous because of the impact of leverage on the downside, which can eat through equity quickly. However, why then does the market continue to lend and companies continue to borrow? See Paragraph 4.

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.

JLB: Let’s be careful here and not throw out the baby with the bath water. Derivatives can be very effective at transferring risk, which will improve the stability of interest. However, the CDS market became far larger than the notional debt market. CDS is insurance. And in other situations, you can’t purchase insurance unless you have an “insurable interest”. So if a party isn’t a lender to a company, it shouldn’t be able to purchase CDS. An a writer of CDS is an insurer de facto and should come under the control of insurance regulators. Another point for care: these “new rules” can’t be instituted only on a national basis. Otherwise, in a global financial market, the participants will take their business to other countries without these constraints, so that the G-20 needs to agree on what these rules are. “Forum shopping” would still occur. But would you want to purchase a CDS where the legal forum is a court of a nation with historic commercial legal system or a chaotic one? Let’s select Iraq as an example. Global financial organizations could write CDS (and other instruments) for purchase there or in Kuwait, etc. But would the seller and buyer really want to take a chance on the enforcement of this contract in a country with little commercial legal experience or sophistication?

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.

JLB: Another sophism. What does this really mean? Are we going to change human nature and eliminate “fear” and “greed”. No, we simply need to be “robust”. Where is your normal thoughtful analysis here, Mr. Taleb?
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. JLB: complete agreement. If a nation’s National Debt/GDP > 1, it’s time for the emergency room and drastic cutbacks and action. The US GDP is slightly under $14 trillion. Our notional debt is about $10 trillion. However when off balance sheet liabilities of social security and Medicare are taken into account, the real debt totals somewhere between $40 and $50 trillion, or a ratio of about 3.2:1. Disaster. We simply can’t continue to pile on more debt. It’s flat out unsustainable—and especially not for pork. It’s a national disgrace that the Congress had to be enticed with $185 billion of pork to pass the greatly needed $700 billion TARP bill. And even more of a disgrace that the media didn’t crusade against this. We need to restructure both Social Security and Medicare to lower the overall burden (e.g., SS benefits kick in later and don’t accrue to people with incomes in excess of a certain amount, since they really don’t need it). Caution: these are quick ideas—but a much more in depth study is required.

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).

JLB: Further sophism. Most people don’t control their own businesses. They are employees. Even some very sophisticated and intelligent professionals are very inexperienced in financial matters (physicians, engineers, attorneys, etc.). And what about when people sell their businesses as they retire? Should they never retire? What we do need to do is to improve the financial literacy of the US population. First, this is essential for the electorate to make informed decisions about who will govern them and about how to achieve some measure of financial security. As an example of the severity of this problem, I believe that more than 50% of those Americans recently polled could not answer the following question: If an item is $300, would you prefer a 10% discount or $40 off the price?

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 buy-outs, 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.

JLB: Totally agree about the need to avoid band-aid patches. We need a thoughtful new 2.0 approach. However, what Taleb suggests is pure knee jerk and very harmful. Layering on more regulations to stifle entrepreneurship and creativity—which leads to growth and “all boats rising”. This is Taleb acting out. There’s no point to banning LBO’s, if the participants can suffer personally from the losses as well as the gains. Shuttering the “Nobel” is meant to stifle the study of issues and production of potential alternatives and solutions? Not really what I believe what we want.

Taleb: 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.

JLB:So where do I come out—if anyone cares, that is? LOL We clearly do need an America 2.0/Capitalism 2.0. I certainly don’t profess to have all of the answers. However, in discussion with a small group of friends with divergent viewpoints, we intend to identify what we believe are the key issues, prioritize how they should be addressed and then examine each in detail to determine how we believe that they should be handled. Our group is only eight to ten people. We don’t and won’t have all of the answers. However, our discussions will produce some constructive ideas that we can then present to others in the private sector, government and abroad. I would encourage everyone to follow the same path. Set aside time to discuss these issues with good friends and recognize that multiple sessions will be required. There is too much at stake for us personally and for our families to let others “find the solution”. Thanks for listening. I’d welcome any responses and thoughts. Happy Easter/Happy Passover. Jeff

Mr. Taleb a veteran trader, a professor at New York University's Polytechnic Institute and the author of "The Black Swan: The Impact of the Highly Improbable"
Copyright The Financial Times Limited 2009

Mr. Balash is involved in private capital and business strategy. He has previously been a managing director at Lehman Brothers and Drexel Burnham in Corporate Finance and M&A. He has been integral in six startups and has created over $3 billion in value during his career.

I strongly agree we need a simpler non leawvereged banking system.please look at my model on myt website www.credit-crunch.synthasite.com