Taleb and The Daily Capitalist

By Jeff Harding

I was blown away by this op-ed piece in the Financial Times by Nassim Taleb and Mark Spitznagel. It’s something I might have written. The significance is that Professor Taleb is a famous writer and his words actually carry some weight. Not that mine don’t … but you know what I mean. I am a big fan of Taleb and his ideas expressed in his now famous book, The Black Swan. I have sent him articles and have exchanged a few emails, but I have no clue if he reads The Daily Capitalist. I’m not flattering myself that he gets his ideas here.

This article is a page taken out of the big book of Austrian School of economics. I have often speculated that he was a follower of this school but I wasn’t sure to what extent. He says things differently, but he hits the main issues.

The one thing I disagree with is this conclusion that we need banks to convert debt into equity to bail us out. I don’t really understand this argument. He argues that deflation must occur, but he says to do it, banks should reach out to borrowers and lower interest rates in exchange for equity. How do you do that? First of all, for much of the debt there is no equity left. Recent studies have shown that about 25% of homeowners ditch their homes, not because of their inability to pay, but because of negative equity in their home. With prices still falling, it would not be practical for banks to do this. Banks need to get this debt off their books.

Also, Federal regulators are making it impossible for banks to renegotiate bad loans. They are requiring them to write down loans, come up with more equity, and tighten lending standards. By the time the politicians get around to changing the rules, the loans will be long written off. Furthermore, many of the loans are held by investment trusts, not banks. Much of the debt in this country has been securitized, and their trust structures don’t allow for such renegotiations.

Debt needs to be written down and banks need to recapitalize, not become investors with their borrowers. The quicker the better.

Time to tackle the real evil: too much debt

By Nassim Nicholas Taleb and Mark Spitznagel

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. This does not sit well with globalisation. Our view is that 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. There is no other option.

Our analysis is as follows. 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. Alan Greenspan, former Federal Reserve chairman, tried playing with the business cycle to iron out bubbles, but it eventually got completely out of control. 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.

The writers are with Universa Investments; Prof Taleb is author of The Black Swan: The Impact of the Highly Improbable