Avoiding Financial Black Swans - Or Not

If you're familiar with the book "The Black Swan", you will be familiar with the thinking of its author Nassim Taleb. His understanding of the inter-relationships among financial instruments and with the environment in which they operate has made him financially successful, and sought after as a commentator in these difficult times. In this Financial Times article he puts forward 10 steps to avoid future black swans in the world's financial system.

As others are pointing out, it is unlikely that they would be implemented; the plan is not in the interests of those wielding power, despite how they may protest the opposite. It is nevertheless interesting to look at his prescription for some insights to understanding the system. I am adding my own commentary to the points that interest me. Refer to the FT article for his full text, from which I am only quoting extracts.

As you'll read, I suspect that his 10 steps are unimplementable, either in whole or in part.

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.

This is a call for a form of negative feedback like you can find in electronic amplifiers: a comparator feeds an error signal back into the amplifier's input to cancel the distortion due to the amplifier. The bigger the error, the bigger the correction. In the financial system, the problem is quite a bit more difficult since determining the nature and amplitude of a reliable and predictable error signal can be difficult without imposing a large regulatory cost.

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.

This is a simple prescription: those who create losses should not be permitted to shift those losses to others, and those with gains, even if it's the public in the form of government, should not shift those gains into others' hands. The problem is that if step 1 is not followed we find ourselves in this ludicrous situation of the public taking on private sector losses to keep the system functional. When the situation stabilizes, government (the people) should not transfer any gains from distressed assets to the private sector. It's ours! Political ideology of those with power tends to ideals (naturally) rather than pragmatic solutions.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus. ... 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.

The problem is: whose hands are clean? Not only that, those with the dirtiest hands possess the bulk of the knowledge of the system and how to manipulate it to recover from the crisis. There is no time for others to be scrutinized, put in charge, learn what's what and then implement effective solutions.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. ... No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

Hidden in this is the essential difference between labour and capital. Bottom-tier workers are uninvolved with making critical corporate decisions and are therefore compensated as labourers, primarily with salary. Owners (stockholders) get no salary but profit from wealth creation (company valuation) and operating income (dividends). The problem is with senior management who must be compensated for their labour and, because of their key role in directing the company, share to some extent the same risks and benefits of the owners so that their interests are aligned. The concept is good, but subject to abuse by both managers and directors (directors have private interests that may not be representative of all the owners). Even when they fail, managers keep their salaries and can earn lucrative termination payouts, which the boards are happy to agree with to recruit the talent they want in management.

I once read a novel (the name isn't important since it is otherwise unremarkable) where there was a society that recruited their leadership by election, but without the consent of the candidates. If elected (they cannot refuse to serve!) all their assets are assigned to the treasury. At the end of their term, if the treasury is increased they get their proportional share of that increase. They suffer a proportional loss for any decrease. That way they share the fate of the society's institutions. It's an interesting fable but it is just a fable. Just try to recruit a CEO in the real world who would agree to this particular deal: it won't happen.

5. Counter-balance complexity with simplicity...

The problem isn't complexity, but rather transparency. We live in a complex world and it is reasonable to expect complexity in its mechanisms. Do we expect the innards of our favourite electronic toys to be simple? No, but we do expect them to be transparent to those with domain knowledge, or at least comprehensible manuals. It should be possible for those giving us financial advice to understand the products they are recommending. With transparency, clients can make them accountable for when they give bad advice (incompetency) or defraud us (criminality).

6. Do not give children sticks of dynamite, even if they come with a warning. Complex derivatives need to be banned...

This sounds like the war on drugs: just say no! Who gets to say when a thing is too complex for us to understand and accept the risks? We don't need nannies: there should be scope for personal responsibility and failure. See my comment in point 5 regarding advisors.

7. Only Ponzi schemes should depend on confidence. ...we need to be in a position to shrug off rumours, be robust in the face of them.

Fiat currencies are largely supported by confidence, both in the currencies' intrinsic value and the market transactions based on those currencies. They are inseparable from governments and politics since all are in the public domain. Many of our social programs are Ponzi schemes, where so-called contributions by citizens go into the general treasury, not the named programs, and payouts come from current accounts. This is very similar to Madoff's fraudulent scheme, except since he had no taxation power the scheme could not be sustained.

8. ...Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is ... a structural one...

This is where regulation can help, by making leverage visible and then prohibiting critical institutions, both public and private, from becoming too leveraged. This is one reason Canadian banks have done well in this crisis. Instead, $2 trillion of assets got leveraged into $62 trillion, in part by multi-stage leverage schemes that made a mockery of traditional, and conservative, banking practices.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. ... markets ... do not harbour the certainties that normal citizens require...

There is no certainty: it is a mirage. Conservative investors were equally burned in this crisis. Remove the foundation and the entire edifice comes down, no matter how well-cared for any one room is kept by its occupants. Cash hasn't proved to be safe, and neither has real estate nor businesses focussed on the necessities of life, like food. Get over it. Yes, find good advisors, but realize that every form of wealth placement entails risk.

10. ...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.

While we're at it let's eliminate poverty, hunger, wars and mosquitoes. We can't, and we should not deceive ourselves that we can somehow create a utopia. Human nature does not allow for it. Let's focus on creating and sustaining strong institutions with enough checks and balances, and with transparency at all stages, to reduce the likelihood of catastrophic failures in future. Many people in powerful positions, both in government and in business, saw value in being willfully blind and in deliberately hobbling those with the ability to intervene. This must be prevented. Unfortunately we must move incrementally since, unlike a car mechanic, we have to keep the engine running while we rebuild it.

We live in the real world, with real people, where overly-simplistic solutions don't work. Let's not deceive ourselves. I would like to think that Taleb's prescription could be followed, but I am not that optimistic. It will be partially implemented, however it will be an imperfect and temporary solution. Vigilence must be a permanent feature since ways will be found to game the new rules, no matter what those rules may be.