Monday, July 6, 2009

Betting On The Black Swan: The Mountain Or The Ocean?

In mid-May, I made a post regarding Nassim Taleb.

Bloomberg reports:
' "Policy makers have no control over the outcome of their actions,” Taleb said. “The plane they are flying will either hit the mountain, which is hyperinflation, or crash in the ocean, which is deflation. There is a chance of the pilot hitting the runway. But if he’s not skilled, it’s less than he thinks.” '

"Universa is buying options on about 20 products that move according to expectations about inflation, Taleb said."

The entire article:

The Wall Street Journal also reported on the story:
"Unlike last year's sudden market implosion, inflation isn't an unimaginable event that few currently anticipate. In fact, many fear inflation right now amid government efforts to goose the economy. Universa's bet, however, is that inflation will reach levels few expect."

"By opening the inflation fund, Universa is trying to capitalize on a wave of investor demand for its products, which when they're right can protect investors from extreme market moves.
The new strategy, designed by Mr. Spitznagel, aims to post big gains if inflation and interest rates take off as they did in the 1970s. Universa will invest in options tied to commodities such as corn, crude oil and copper, as well as options on stocks such as oil drillers and gold miners."

' "We think these things are going to see massive volatility," Mr. Taleb said in an interview.
The fund will also bet against Treasury bonds, which tend to weaken in inflationary environments. Last week, Treasury yields shot to their highest level since November as prices fell on inflation concerns. Oil topped $66 a barrel. Gold is creeping nearing $1,000 an ounce."

The entire WSJ story:

Taleb's Ten Principles For a Black Swan-Proof World
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 riskbearing.
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.

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