Ten principles for a Black Swan-proof world

Published: Financial Times, April 7 2009

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.

Nassim Nicholas Taleb

The deregulation before deregulation

We are where we are, don't like it so some soul searching is in order. Thomas Geoghegan, a Chicago (labor) lawyer, takes a historical detour to search for the root causes of today's situation beyond the deregulation of the last decade or so. In a recent Harper's article “Infinite Debt: How Unlimited Interest Rates Destroyed the Economy,” Geoghehan is looking at:

1. Interest rates deregulation--worth mentioning is that both Adams Smith and JM Keynes were in favor of capping interest rates, for otherwise, in addition to hurting the masses, capital flees from production to banking due to higher rates of return;
2. Weakening of labor unions, which in turn led to lower negotiating power for skilled labor--as the author puts it, the side effect was that union cards were replaced by credit cards;
3. The ability of corporations to eliminate contractual employee-liabilities (read pensions and health-care obligations) through Chapter 11 reorganization.

Following is a Democracy Now! interview where the main points in the article and suggestions for the future are provided:

Obama - Gorbachev

Due either to the vagaries of the body-politik in Washington DC, or to his own temperament and biases, Obama is taking the Japanese way out of the current problems--read, long.

On the other hand, at times, it's hard to resist a growing sense of déjà vu: Obama as the Financial Capitalism's Gorbachev.

Click here to read what the LinkedIn professionals think of this subject.

(Photo Source: President Barack Obama drops by VP Joe Biden's meeting with former Soviet Union President Mikhail Gorbachev in the Vice President's Office, West Wing 3/20/09. Official White House Photo by Pete Souza)

Home to Roost or the banker as chicken

The chickens

are circling and
blotting out the
day. The sun is
bright, but the
chickens are in
the way. Yes,
the sky is dark
with chickens,
dense with them.
They turn and
then they turn
again. These
are the chickens
you let loose
one at a time
and small—
various breeds.
Now they have
come home
to roost—all
the same kind
at the same speed.

...and now click here to hear it in the voice of the author, Kay Ryan

The following YouTube Kay Ryan insert illustrates how interestingly beautiful life can turn amidst language commons.

On Obama's tax Plan

Paying taxes is a suckers' game for many. Too often, big money is being spent on tax avoidance schemes, which in turn distort behavior. Apparently, some individuals cannot think of what it takes to run modern states, while corporations have become states within states.

Our presidential hopefuls make all kinds of tax-related promises that are either unrealistic or incompletely specified. Even if McCain were to win, he could only raise taxes. Obama has come out as favoring tax-increases for those families making more than $250,000/year. Since Obama appears to have better chances to win, I will quote a couple of tax-related comments pertaining to his tax plan:

1) I'm a Democrat and an Obama supporter -- a volunteer, in fact. I am also a salaried professional, married to Joe the construction manager. Together, we earn about $250,000 a year, after deductions, and therefore will be paying higher taxes under Obama's tax plan. This even though we live in the NYC metro area, where the cost of living is 2.5 times the national average. That means that our income has the purchasing power of $100,000 in Podunk. We ain't starving, but neither are we Mr. & Mrs. Richie the Hedge Fund Manager.

My point is that Obama's plan will in fact impact the urban, professional middle class. Most of us are voting for him, but let's be honest; we are paying high taxes already here in Westchester County, plus high energy costs, plus high health care costs, and the extra $3,000 or so per year that Obama's plan will cost a family in my income bracket will not come easily.

I wish that Obama would include a "cost of living" adjustment in his tax plan, so that middle-class professionals in big cities wouldn't take a hit. On the other hand, if I have to sacrifice so that Richie finally pays his share, then I'll bite the bullet.

— KT, Chappaqua, NY

2) My husband and I have worked hard over the course of our careers. Now that we are in our late 50s, we are mature in our professions and in our earning capacities. After many years of post-graduate education, we each attained the credentials necessary for our respective professions, and we have each subsequently put in countless hours (and immeasurable passion) to serve, in his case, patients, and, in my case, clients. We net more than $250,000 annually. Although we are now worried about the value of our investments, we are still looking forward to a comfortable retirement in the next decade.

While we don't particularly enjoy paying taxes, we do enjoy being citizens of the United States. We do expect to contribute to the education, infrastructure, public health, social welfare, safety, and culture of the country we live in. We do want to do our part to insure its future. So, while we may sigh when we write checks to the IRS, we also take some satisfaction in the belief that we are integral to the success of our country. Moreover, because we can afford to pay a larger share of our income than others can, we expect to do so.

Regardless of our professional success, however, we still are limited in our income potential by our relying principally on reimbursement for our labor. There are many others in the over $250,000/year category with incomes much greater than ours. There are many whose earnings come from their investments or their executive positions enabling them to partake of large shares of corporate earnings. Fairness requires that these individuals pay even greater amounts/percentages of their income than those of us who are essentially high-earning workers do. The tax rate needs to continue to slide upward, for top incomes go way, way, way above $250,000 annually. Those corporate executives who take millions in cash, bonuses, and stocks do not even breathe the same air as my husband and I. Their tax rate has to be greater than ours. In the tax realm, that's all I ask of Obama when he takes over the reins of this country, which he will do, and not a moment too soon.

— Shelley, Santa Barbara

For the middle of the road family of professionals, I would say, expect to pay about 10 - 15 percentage points more in taxes. In other words, a 30% rate will go to about +40%. And, judging by the way Democrats on Capitol Hill voted for all financial issues, I would not hold my breath on the points raised in the above two comments, unless one really believed in transformational presidencies.

Andrew Lahde's Farewell Letter

October 17, 2008

Today I write not to gloat. Given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say good-bye.

Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted as saying, “What I have learned about the hedge fund business is that I hate it.” I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

There are far too many people for me to sincerely thank for my success. However, I do not want to sound like a Hollywood actor accepting an award. The money was reward enough. Furthermore, the endless list of those deserving thanks know who they are.

I will no longer manage money for other people or institutions. I have enough of my own wealth to manage. Some people, who think they have arrived at a reasonable estimate of my net worth, might be surprised that I would call it quits with such a small war chest. That is fine; I am content with my rewards. Moreover, I will let others try to amass nine, ten or eleven figure net worths. Meanwhile, their lives suck. Appointments back to back, booked solid for the next three months, they look forward to their two week vacation in January during which they will likely be glued to their Blackberries or other such devices. What is the point? They will all be forgotten in fifty years anyway. Steve Balmer, Steven Cohen, and Larry Ellison will all be forgotten. I do not understand the legacy thing. Nearly everyone will be forgotten. Give up on leaving your mark. Throw the Blackberry away and enjoy life.

So this is it. With all due respect, I am dropping out. Please do not expect any type of reply to emails or voicemails within normal time frames or at all. Andy Springer and his company will be handling the dissolution of the fund. And don’t worry about my employees, they were always employed by Mr. Springer’s company and only one (who has been well-rewarded) will lose his job.

I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years. I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle. I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life – where I had to compete for spaces in universities and graduate schools, jobs and assets under management – with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.

On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it. Since Thomas Jefferson and Adam Smith passed, I would argue that there has been a dearth of worthy philosophers in this country, at least ones focused on improving government. Capitalism worked for two hundred years, but times change, and systems become corrupt. George Soros, a man of staggering wealth, has stated that he would like to be remembered as a philosopher. My suggestion is that this great man start and sponsor a forum for great minds to come together to create a new system of government that truly represents the common man’s interest, while at the same time creating rewards great enough to attract the best and brightest minds to serve in government roles without having to rely on corruption to further their interests or lifestyles. This forum could be similar to the one used to create the operating system, Linux, which competes with Microsoft’s near monopoly. I believe there is an answer, but for now the system is clearly broken.

Lastly, while I still have an audience, I would like to bring attention to an alternative food and energy source. You won’t see it included in BP’s, “Feel good. We are working on sustainable solutions,” television commercials, nor is it mentioned in ADM’s similar commercials. But hemp has been used for at least 5,000 years for cloth and food, as well as just about everything that is produced from petroleum products. Hemp is not marijuana and vice versa. Hemp is the male plant and it grows like a weed, hence the slang term. The original American flag was made of hemp fiber and our Constitution was printed on paper made of hemp. It was used as recently as World War II by the U.S. Government, and then promptly made illegal after the war was won. At a time when rhetoric is flying about becoming more self-sufficient in terms of energy, why is it illegal to grow this plant in this country? Ah, the female. The evil female plant – marijuana. It gets you high, it makes you laugh, it does not produce a hangover. Unlike alcohol, it does not result in bar fights or wife beating. So, why is this innocuous plant illegal? Is it a gateway drug? No, that would be alcohol, which is so heavily advertised in this country. My only conclusion as to why it is illegal, is that Corporate America, which owns Congress, would rather sell you Paxil, Zoloft, Xanax and other addictive drugs, than allow you to grow a plant in your home without some of the profits going into their coffers. This policy is ludicrous. It has surely contributed to our dependency on foreign energy sources. Our policies have other countries literally laughing at our stupidity, most notably Canada, as well as several European nations (both Eastern and Western). You would not know this by paying attention to U.S. media sources though, as they tend not to elaborate on who is laughing at the United States this week. Please people, let’s stop the rhetoric and start thinking about how we can truly become self-sufficient.

With that I say good-bye and good luck.

All the best,
Andrew Lahde

Andrew Lahde's Farewell Letter -

Gimme the next bubble!

After a long sequence of not doing the right thing-s, our western world is headed if not down then lower. " Down" is probably too sudden relative to how history evolves and the preparedness of the Chinese, or lack thereof.

The "low," as I see it, can be described in terms of under-, and un-employment, but one can think of many other metrics.

In the US, even if the ever shifting targets of the (now) $700Bn TARP are reached, how does this address the more real problem of jobs creation? For the time being, the voices one can hear, from the House Speaker Pelosi to über-investor Buffet, sound optimistic about the financial prospects of the system and pessimistic about jobs.

So, one gets the feeling that the government has extricated itself from several of the responsibilities associated with running the state. We've come to rely on Wall Street to sort out most society decision-making needs--from pensions to child-care, from environment to efficient allocation of resources, from war to peace.

That free markets have more in common with flea markets than financial markets is a fact we painfully reckon with periodically. And, re-adjusting for such facts, read bailing the system out, is probably a tax on our beliefs (e.g. in smaller government) and hope that the next bubble will rescue ME. Somehow, the growing problem with Wall Street is that it needs more money each time it's crying for rescue.

Bush tried to privatize social security for he most probably learned about the real problem in the economy 8 years ago to these days. Failing to privatize social security, and succeeding only moderately to stimulate jobs growth with the Iraq War, he had given free hand to the bankers.

Yet, for people like us, the recession started in 2000-2001. By “us” I mean people who have not worked in: defense, real estate, healthcare (insurance, included), banking. Now, one can only wish the military Keynesianism had been applied towards national infrastructures instead of sand castles in Iraq…

Most probably, the upcoming elections will effect a kind of Keynesianism different from the one characterizing the last 8 years. If this is going to be the case, healthcare automation and alternative energy would be two areas where bubblets, if not bubbles, are likely to develop.

As a side issue, the huge size of our economic/financial actors has dealt these days' near fatal blow to our system, yet nobody seems to notice that most all solutions lead to even further size increases and fewer players.

Wall Street: How good of an approximation for market-based capitalism?

Four months ago I challenged the LinkedIn community with a topic titled "Survival of Capitalism." Last week, one of my LinkedIn connections asked the question "Is capitalism dead?"

Needless to say, within the time between these two almost identical questions, the answers have taken quite different paths. Here's what I've learned myself, or how I replied to the second question:

There is a useful distinction between capitalism and free markets as illustrated by Arrighi and others. According to Arrighi, the US form of capitalism entered its final stage in the 1970s. Moreover, capitalism does not die, it just goes to live in another country, with better/more accommodating systems.

At this point in time, increasingly, the answer to your question is in the hands of the US creditor(s). They'll have an increasing say in how the capitalism evolves from here on.

On the other hand, I raised a very similar question to yours, about 4 months ago. I was not aware at that time of the distinction between capitalism and free markets, yet I felt there was something rotten in capitalism. Worth reading are all the answers at that time--see also the implicit "socialist" cries from folks in very regulated industries....

As I've been writing about markets and their actors for some time, allow me to reference the following: Wall Street: How good of an approximation it makes? ... for market-based capitalism?