Taleb and Tavakoli

[kent nickell]

I will admit to being a pretty strong Talebite, a term used somewhat derisively by Janet Tavakoli in her new book "Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street" The term descibes followers of the Black Swan author Nassim Taleb. Her book is quite amazing as she candidly outlines the financial incompetency and fraud of the last several years. I will also admit to being a big fan of Tavakoli and think she would actually agree with Taleb on many issues. She does not see the current economic crisis as a Black Swan as she saw many warning signs but I think Taleb would agree. The amazing global ramifications though seem to have some Black Swan attributes.....

http://www.washingtonpost.com/wp-dy.../AR2009031202181.html?wprss=rss_print/outlook

Interview
Sunday, March 15, 2009; Page B02

Options trader Nassim Nicholas Taleb made his name and career anticipating the powerful historic events he calls "Black Swans,"which include World War I, the rise of the Internet and the stock market crash of 1987. In two books published in 2001 and 2007, he urges readers to concentrate more on what they don't know than on what they do.

More recently, Taleb has blasted bankers and economists who issued reassuring forecasts right up to the brink of the current global financial crisis. He spoke recently with Washington Post reporter Peter Whoriskey.

Excerpts:
You're a fierce critic of the entire field of economics. Don't economists know anything?

You have close to a million people out there in economic life. How many people saw the extent of what could happen in this financial crisis? Some people said we'd have a problem of too much leverage, but very few saw the potential total impact that could come out of it. They didn't see the cascading effects that can be produced by a complex system.

Years ago, I noticed one thing about economics, and that is that economists didn't get anything right. I wanted to find out the reason. They would say their models are not perfect. But data show that you do much worse using their models than you would without them. It's a bull [expletive] science.
Can you give a specific example?

Every time I saw [Federal Reserve Chairman Ben] Bernanke [on television], I would have a fit of rage. He claimed that we were in a period of "great moderation." He did not understand that Black Swans are preceded by low volatility and the buildup of hidden risks. He mistook absence of volatility for the absence of risk. It was like someone sitting on dynamite and saying "It's okay, we're safe because nothing has happened."

In a complex system, things that are fragile should be allowed to fail very fast. [Former Fed Chairman Alan] Greenspan and Bernanke let something fragile, like the banks, survive very long. The longer it takes to break, the worse the outcome.

That's why I think Obama needs to start with a new economic team -- Treasury Secretary Tim Geithner and Lawrence Summers were among those who didn't see this coming in the first place. He needs new people who understand complex systems.

What about economist Nouriel Roubini? Wasn't he calling attention to the potential danger?

Yes, Roubini got it right. But Roubini wasn't right because he's an academic economist. He was right because he is a very insightful fellow. He is so good he managed to surmount his education in economics.

Other than you, who would be the right choice for the Obama administration?

I know who should not be on his team -- anyone who did not understand that the world financial system included more risks than it showed. This leaves plenty of individuals outside the administration and outside the economics profession who warned about it. Aside from Roubini, the closest thing in the economics profession would be Ken Rogoff. I would also require that the person be a business person -- someone who did not make a career writing papers to impress fellow economists.

So what's your prescription for the economy?

The first thing we need to do is to get rid of the vicious bonus system at banks that encourages you to take these huge hidden risks. When it all blows up, they still have their bonuses, because the Black Swans happen only every so often. You see a lot of people walking around who are massively wealthy who never made a penny for their investors.

Look at [former Treasury secretary Robert] Rubin at Citigroup. He made and kept a $115 million bonus while the taxpayer has to bail them out. We should not be paying the Bob Rubins anymore. We have to have clawback provisions to make sure that we punish people for their bad bets.

I am in favor of partially nationalizing the banks for this reason and banning complex derivatives. Nobody understands them. I would also start indicting the vendors of these financial risk management systems that everyone relied upon to tell them everything was okay when it wasn't.

How do you define a Black Swan? If they're so unexpected, how can we prepare for them?

A Black Swan is an exception, like the bird. It is an event with massive consequences that is unexpected. My idea is not simply to say that these things happen. My idea has been to identify the vulnerabilities, the spots where people are driving the school bus blindfolded. In banking, I identified a huge amount of risk taking on the part of banks that were using bogus models to estimate their risks.

It was so painful to watch the banking system become so fragile to the Black Swans. Now there is wealth turning into air as we speak.

What do you see ahead? What do you make of the mainstream economists who predict that the economy will turn around later this year or next?

Look, globalization has created this interlocking fragility. At no time in the history of the universe has the cancellation of a Christmas order in New York meant layoffs in China. So for a while it created the illusion of stability, but it has created this devastating Black Swan.

Complex systems do not like debt. So it will proceed to destroy tens of trillions in debt until society rebuilds itself in an ultraconservative manner. We are in for a worse ride than people think.

People have the problem of denial. This is one of the things I learned in Lebanon. Everybody who left Beirut when the war started, including my parents, said, 'Oh, its temporary.' It lasted 17 years! People tend to underestimate the gravity of these situations. That's how they work.

Is this crisis going to last 17 years?

Unfortunately no, complex systems cascade much faster than that. However, the destruction will be deeper than people anticipate. It will bring down a lot of people.

My rosy scenario is that a better economic environment will develop, a low-debt, robust growth world, in which whatever is fragile will be allowed to break early and not late.

My nightmare scenario is that the government saves Citibank once again, as well as the other banks, and business resumes as usual. Then, the next time the system breaks, it breaks much, much bigger.

 

[kent nickell]

Re: Taleb and Tavakoli

Harvard economist Ken Rogoff was one of the few people that Taleb recommended would be useful advisors to the Obama administration.


""Aside from Roubini, the closest thing in the economics profession would be Ken Rogoff.""

http://www.project-syndicate.org/commentary/rogoff54/English

What it the Deficit Endgame
Kenneth Rogoff

REKJAVIK ? No one yet has any real idea about when the global financial crisis will end, but one thing is certain: government budget deficits are headed into the stratosphere. Investors in the coming years will need to be persuaded to hold mountains of new debt.

Although governments may try to cram public debt down the throats of local savers (by using, for example, their rising influence over banks to force them to hold a disproportionate quantity of government paper), they will eventually find themselves having to pay much higher interest rates as well. Within a couple years, interest rates on long-term US Treasury notes could easily rise 3-4%, with interest rates on other governments? paper rising as much, or more.

Interest rates will rise to compensate investors both for having to accept a larger share of government bonds in their portfolio and for an increasing risk that governments will be tempted to inflate away the value of their debts, or even default.

In research that Carmen Reinhart and I have done on the history of financial crises, we find that public debt typically doubles, even adjusting for inflation, in the three years following a crisis. Many nations, large and small, are now well on the way to meeting this projection.

China?s government has clearly indicated that it will use any means necessary to backstop growth in the face of a free fall in exports. The Chinese have $2 trillion in hard currency reserves to back up their promise. President Barack Obama?s new budget calls for a stunning $1.75 trillion deficit in the United States, a multiple of the previous record. Even those countries that are not actively engaged in a fiscal orgy are seeing their surpluses collapse and their deficits soar, mainly in the face of falling tax revenues.

Indeed, few governments have submitted remotely realistic budget projections, typically relying on overly rosy economic scenarios. Unfortunately, in 2009, the global economy will not be a bed of roses. Income in the US and euro-area both appear to have declined at an annualized rate of roughly 6% in the fourth quarter of 2008; Japan?s GDP fell at perhaps twice that rate.

China?s claim that its GDP grew at a 6% rate, during the end of last year, is suspect. Exports have collapsed throughout Asia, including Korea, Japan, and Singapore. Arguably India, and to a lesser extent Brazil, have been holding out a bit better. But few emerging markets have reached a stage at which they can withstand a sustained collapse in the developed economies, much less serve as substitute engines of global growth.

With the credit crisis still making it difficult for many small and medium-size businesses to obtain even the minimal level of financing necessary to maintain inventories and conduct trade, global GDP is on a precipice in 2009. There is a real possibility that global growth will register its first contraction since World War II.

In all likelihood, a slew of countries will see output declines of 4-5% in 2009, with some. having true depression level drops, of 10% or more. Worse yet, unless financial systems spring back, growth could disappoint for years to come, especially in ?ground zero? countries such as the United States, Britain, Ireland and Spain. US long-term growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution,

Countries with European-style growth rates could handle debt obligations of 60% of GDP when interest rates were low. But, with debts in many countries rising to 80% or 90% of GDP, and with today?s low interest rates clearly a temporary phenomenon, trouble is brewing. Many of the countries that are piling on massive quantities of debt to bail out their banks have only tepid medium term growth prospects, raising real questions of solvency and sustainability

Italy, for example with a debt-to-income ratio already exceeding 100%, has been able to manage so far thanks to falling global rates. But as debts mount, and global interest rates rise, investors will become rightly nervous about the risk of debt restructuring. Other countries, such as Ireland, Britain, and the US, started with a much stronger fiscal position, but may not be much better off when the smoke clears.

Exchange rates are another wild card. Asian central banks are still nervously clinging to the dollar. But with the US printing debt and money like it is going out of style, it would appear the euro is set to appreciate against the dollar two or three years down the road, if the euro is still around, that is.

As debt mounts and the recession lingers, we are surely going to see a number of governments trying to lighten their load through financial repression, higher inflation, partial default, or a combinations of all three. Unfortunately, the endgame to the great recession of the 2000?s will not be a pretty picture.