Nicholas Nassim Taleb and Mark Spitznagel have a provocative comment up at the Financial Time today, In some ways, it is isn’t surprising for those familiar with his work on risk and uncertainty. On the other hand, it is an eye opener to see what an internally consistent, reasonably comprehensive solution to our mess looks like,
Taleb and Spitznagel, unlike most others, include real economy fragility in their calculus. The dependence on sophisticated computers networks and advanced communications creates more points of failure. Integrates supply chains and interdependence due to trade also creates more complexity. For the life of me, I never understood the vogue for outsourcing and offshoring, Every study ever done says the majority of companies are disappointed with the results. It seems to represent hope over experience. And from what little I have seen in the way of hard numbers says it does not yield impressive results. One IBM project, to send some work to China, showed that the labor cost savings were substantial, something like a 75% to 80% reducution. Yet the all-in cost savings projected were a mere 15% to 20%. And most projects do not live up to expectations. The gap between the two figures says the additonal coordination costs and delays were considerable.
That is a tremendous amount of rigidity and risk to introduce into one’s operations for not much gain. Yet everyone went merrily down that path because it was what all right-minded modern companies were supposed to do.
The other big message of this piece is trying to prop up asset prices via more debt is a bad idea. He recommends restructuring via large-scale debt to equity conversions, plus arrangements that allow for partial equity conversions if borrowers go into arrears. A clever concept, but too hard to administer.
As much as Taleb and Spitznagel’s message about the dangers of debt, and the need for a surgical remedy is clear, the odds of the right sort of action are zero unless things get much worse in short order.
From the 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….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….
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…. 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.