Taleb reveals unsettling truths; Western economy is overcentralised, creating extra risk

October 13, 2013 2:25 pm

Commonsense ideas behind Taleb’s rhetorical flourishes

By John Authers

Western economy is overcentralised, creating extra risk

How fragile we are. Five years on from the Lehman Brothers collapse, political and regulatory errors have made the world’s financial system even more fragile. This alarming line of thought comes from Nassim Nicholas Taleb, best known for The Black Swan, which explained markets’ difficulties in pricing extreme events for which they had no precedent. Mr Taleb, who spoke to me in London last week, divides opinion. For some he is a genius, for others a charlatan. What seems clear, however, is that his gloriously charismatic act and polymath choice of imagery, drawn from philosophy, mathematics and the Classics, can get in the way of underlying ideas which are not in fact far-fetched. Indeed they contain a hard kernel of commonsense truth.Here, then, is an attempt to render Mr Taleb’s poetic arguments in prose. Those wishing to see the man in action can watch the videos on FT.com.

He argues first that natural systems work by allowing things that do not work to break. This did not happen after the Lehman bankruptcy. True, letting Lehman fail was an attempt to instil discipline in the banking system, but it came too late. Moral hazard – the risky behaviour that people indulge in when they are insured against the worst – had steadily been allowed to take root ever since the rescue of Continental-Illinois in 1983, which gave the world the phrase “too big to fail”.

A policy aimed at making it easy for financial institutions and their managers to survive – which has been in force since Lehman – shows that politicians and regulators do not understand the properties of a healthy system, which would allow for errors to occur without “socialising” them – or inflicting the cost of an error on everyone.

Many would agree. But starting from where we are now, how do we move to a healthy system? Taleb repeats, ad infinitum, the concept of “skin in the game”. Those making decisions in the market have to stand to suffer from the consequences of any mistakes. This was not true, for example, of lenders who could immediately sell the risks carried by subprime mortgages to someone else via the securitisation market.

For Taleb, this implies that hedge funds should now become the dominant model. One of the few disasters that did not happen in the dark days of late 2008 was the collapse of a systemically important hedge fund. Why not? Because they were diversified, and their managers know that hedge funds can, and do, fail all the time. Generally, by the time they fail they are not big enough to have a systemic impact.

Taleb says that a hedge fund manager typically has between 20 and 50 times the exposure to the fund of his next biggest customer. This makes them far more careful, and also makes them vulnerable to exiting the “gene pool” if they prove not to have the necessary talent.

Hedge funds have attracted much new money post-crisis, despite failing to beat the stock market, and are developing strategies that aim to disintermediate the banks, such as loan funds. So this process is already at work, albeit very slowly.

Decentralisation should not only be applied to the banking system. Companies have been allowed to get bigger. As he puts it, the S&P 500 is on its way to becoming the “S&P1” – and note that the price of the S&P has increased 480 per cent since 1990, while its market value has increased 700 per cent, thanks to takeovers that allowed big companies to take a greater share of the economy.

He also applies this notion to public debt. At the municipal level, one bankruptcy will not destroy the system – as the calm reaction in the muni bond market to Detroit’s bankruptcy this summer shows. With the discipline of default hanging over them, those running city governments need to be responsible.

At the national level, the system is more fragile. One tall tower is more likely to fall in a storm than a lawn of grass. This leads to Taleb’s contention that US federal debt is the most fragile of all, and should be decentralised, because default is unthinkable. Hence, “I’m kind of happy with what’s happening in the US now. We’d like the government periodically to come back with a plan, just like a corporation that has a debt addiction.”

Implementing this idea in practice without extreme volatility will be hard. But the Taleb arguments remain strong. Fragility, he insists, trumps growth. If a plane has an elevated chance of crashing, even if that chance is very small, we would give that priority over its speed or its price. So, governments should have a risk manager’s mindset, and not try to prod the economy into growing. Without a risk-averse mindset, risks will grow.

Stripped of the rhetorical flourishes, this is what the Taleb argument comes to. The western economy is over-centralised, and that creates extra risk. It is hard to disagree – and that should worry everyone.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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