Monday, April 20, 2009

SIMPLE IDEAS TO SIMPLIFY A COMPLICATED MESS

Nasim Taleb, author of The Black Swan, has a short article in the Financial Times (you may need to register -- for free -- to view the article if you've already hit their link a few times lately) listing ten principles that will leave us less susceptible to unexpected phenomena that have the ability to mess up the economy. Or as he says, to create a "world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news. "

As is often the case with something worth reading, there's nothing terribly profound here, and nothing that we haven't seen over-and-over the past few months. But that doesn't change the fact that it's good to see it spelled out succinctly and clearly. The article in full (H/T Ritholtz):

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.

I'm going to jump in very quickly here. This last point is very important. In the wake of the mess, we hear endless prattling about the need for "more regulation." We don't need "more regulation." We need consistently-applied, correctly-implemented regulation. Simple, easy-to-understand, very limited rules that everyone has to live by. And a complete elimination of all the institutionalized favors and incentives that a very small cadre of banks & bankers receive at everyone else's expense. I know I'm being idealistic, but this whole post is about how things should be, as opposed to business-as-usual. Anyhow, back to Taleb:

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.

As always, I don't necessarily agree with all his suggestions, most notably No. 6 and a few of his other ideas about "banning" certain investment vehicles. I still believe that in a world where the system ceased to be rigged in favor of those who peddle these exotic securitizations -- in other words, where they fully bear the risk of their financial ambitions -- we would all be ok, wild ideas or not.

But overall, there's an awful lot of sense in these 10 simple ideas.

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2 Comments:

Blogger DED said...

No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

A point that seems to be lost throughout this mess.

This last point is very important. In the wake of the mess, we hear endless prattling about the need for "more regulation." We don't need "more regulation." We need consistently-applied, correctly-implemented regulation. Simple, easy-to-understand, very limited rules that everyone has to live by. And a complete elimination of all the institutionalized favors and incentives that a very small cadre of banks & bankers receive at everyone else's expense. I know I'm being idealistic, but this whole post is about how things should be, as opposed to business-as-usual.

I certainly agree, but I don't see this message getting through to Congress, except for Ron Paul and a few others. But then we get a knee jerk reactionary argument about deregulation being what W did, when that isn't the case at all.

But overall, there's an awful lot of sense in these 10 simple ideas.

Yes indeed.

3:16 PM  
Blogger Mr Furious said...

For the last thirty years capitalism has equaled rewards and profits and that's it.

All upside and no downside. And all obstacles need to be pushed aside.

12:06 AM  

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