Dienstag, Juli 14, 2009

Economics, Debt, Taleb and Black Swans...

In today's FT there's an OpEd by Nassim Nicolas Taleb and Mark Spitznagel which is both right and wrong.

And as an aside: this is the last post for ca 3 weeks, as I'll be out looking at universities with my oldest daughter.

There's quite a bit good in this, but there's just one or two points of disagreement...

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.

Bingo, bunk and bingo.

First of all: debt relative to GDP is the right thing to measure for sustainability of economic growth (too little or too much means growth is strangled or drowned, but the "right" amount isn't that simple to determine).

Second of all: this has nothing to do with globalization. Zilch. Why? Because globalization has everything to do with comparative advantages and trade, not the financial difficulties created by market manipulation and the ensuing market reactions.

Third of all: absolutely correct. Government policies and actions are making things worse, substantially so, and is setting the system up for the next bubble in the name of getting re-elected. The solution applied is most definitely an eminently implementable and doable one, but there are other options. It's just that no one really wants to face them.

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.

The problem with equity is how it is accounted for when viewing financial statements under mark-to-market rules (and there appears no movement to change this, despite it having caused ruin): equity is valued at market rates, and thus this works pro-cyclically. If mark-to-market is removed, then by all means is this a solution. With it in place, all we have is more of the same.

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.

Again, the problem is pro-cyclical behavior patterns and a lack of anti-cyclical tools. But this has nothing to do with globalization, it has only to do with the fast and easy availability of information.

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.

As someone who has spent most of his professional career as a forecaster, the man has it right. It is, of course, based on a faulty understanding of forecasting: the "black swan" events rarely, if ever, appear in a forecast because they are so unlikely. Blaming the forecaster for not presenting this is an error: the error lies in not understanding the complexity of economic systems and their interdependencies, which, given the fact that the traditional business economist has virtually disappeared from the corporate world, replaced by bean-counters and legal beagles, should come as no surprise. The failure of economics is not so much the failure of the economists, but much more the discounting of them by those who think they know better, but have most eminently proved that they do not.

Could the economists have done their job better? Here an unqualified and loudly proclaimed Yes. But given how businesses usually treat their economists - as suppliers of data, not as judges of development and dangers - and how accountants and lawyers act in ignorance of economics, deluded by their beliefs that they are the ones in control, it should come as no surprise that so many companies were broadsided by events. I recently gave a presentation of the dangers of economic developments in the next several years and received criticism that my presentation was far too opinionated and that one could interpret the data rather differently. My response was that it was time for people to perhaps listen to economists, those actually out there in the business world, and that they were paying me for my opinions in any case. It was just that I explicitly stated them rather than simply putting them into the forecast.

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.

Again, absolutely correct. Debt is treacherous since it is there regardless of events: you cannot avoid it. The disaster of a loan default is different from equity: you can tell the problems with equity instruments, while a loan cannot be read this way. Debt is indeed the province of not merely the overconfident borrower, but also the unreflected one, someone going through the rote without thinking about what they are doing actually means.

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.)

The third option is to hunker down and pay off the debt, accepting stagnation in the wake of exuberance. But no one wants to do this, as it implies not merely a few years, but rather, literally, several decades.

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.

Here the man knows what he is talking about, but has ignored the greatest danger, the long reach of long-dead economists. The danger to the system right now is that governments truly believe that they can, via stimuli, actually affect the changes they want. This is so wrong as to be painfully obvious to anyone outside of academia and government, but those working there are blind to the idea that they cannot change the world and that there will be a terrible day of reckoning when the markets judge.

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.

Absolutely correct. Here his critique of the economics profession and its vast failure over the last 10 years (at least) is spot-on.

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.

Again, absolutely correct. As much as I admire Greenspan, his attempt to control bubbles simply led to the next bubble, constantly expanding and on thinner and thinner basis as the economy overheated and overexpanded.

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.

Unfortunately, this is where Taleb and Spitznagel fail. How can banks, for properties which are in debt over their value, swap interest for equity? There isn't any equity left in the property to be capitalized: jingle mail will be the answer to any attempt to work out a deal that doesn't replace the fantasy of future eternal equity improvements for those homeowners. Banks may recognize their reality - that they own the homes that they financed - and become landlords, renting to their former mortgage customers, but you cannot extend equity when the equity is negative.

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.

Well, it's not just those who failed to spot the problem: it's the even sadder fact that those who demanded that the markets be systematically distorted are now those in charge of what they call a remedy, but in reality is nothing less than the "Democratic Party Re-Election Act", aka the stimulus package.

We don't have another day. We are already sliding into a decade of slump and stagnation, where the socialization of debt will mean punishingly high tax rates and an increasing burden of that parasitical activity known as government.

We are already too late. It happened when the Democrats achieved their majorities and President Obama was elected.


Ed hat gesagt…


Great post, but I'm in two minds about the mark-to-market accounting issue. (Please note that neither of these minds is an expert in economics or accounting!). I can appreciate the problems with mark-to-market, i.e. that it is pro-cyclical and that if the market for the asset in question become illiquid, it can be difficult to determine any meaningful market price.

However, I worry that the managers and accountants will want the benefits of mark-to-market in the boom years, but want it suspended in times of trouble. One shouldn't have it both ways. If I understand correctly, if a company is relying upon this equity value (either it's own share price or investments it has made in other assets) for the operation of its business, the absolute value of the equity may limit its ambitions, but it is a sudden collapse in the asset value (under mark-to-market) that will kill them. I see this pro-cyclical behaviour as an advantage actually, as it should make said managers and accountants more fearful of an unwarranted/speculative increase in the value of the equity they hold, as that will make them more vulnerable to a subsequent collapse when the bubble bursts. In other words it should introduce more fear into the greed years.

Of course, I am probably naive to think that the managers will notice this, or care even if they do. Still, one could argue that the damage done by mark-to-market deserves to be done, as it shows up those with flawed business models.

John F. Opie hat gesagt…

Hi Ed -

Excellent point, one that I hadn't even thought of: of course managers and accountants will want to apply mark-to-market when it benefits them and not so when it doesn't. If anything, the upswing dangers are even worse than the downswing dangers, since you could leverage your increasing equity to acquire huge amounts of capital.

If anything, it'd be enormously tempting to acquire huge amounts of debt during an upswing and then stash enough of aside before a downswing, blaming the collapse of the company then on having acquired too much debt, and what's a few tens of millions lost in the chaos?

And your point on making flawed business models apparent is also right on: of course, this happens with any and all business models that rely on heavy leveraging of cash flow in order for the company to survive. When you do that, you're betting the future of the company on the vagaries of the market and that company's ability to actually follow the business plan. Ever seen one that survives the first year?