29 April 2009

for finance to work, it must be as simple and boring as water supply

Taleb makes the point. As we are now seeing with industrial scale pig farming, big systems provide temporary efficiency at the cost of stability, redundancy and robustness.

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 risk-bearing. 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.


The dude makes the point even better, money backstops the division of labour, when it is working properly it should be invisible, when it becomes significant as a profit center and in a boom, begins to dominate politics, it is a sure sign of nothing but immanent and total collapse..

Indeed, it wasn't a change in temporal standards that led to the current financial disorder. Rather, inter alia, it was, I believe, a loosening of monetary standards. If standards of time are crucial for accurate financial calculation so too, it seems, should be standards for money. These standards for money go beyond the basic decision to, for instance, set a fixed exchange rate to specie or some other method to ensure that no more money is created than there are goods and labor to buy with it. They would include restrictions on securitization and credit, and procedures for liquidation. The idea of unrestricted finance seems to me about as absurd as unrestricted time....how many seconds in a hour?...however many you prefer.

The calendar reform noted above can perhaps be seen as a lesson in compounding- error, that is. Eleven minutes is but 0.002% of a year, yet, over time such a seemingly trivial error- certainly one that went unnoticed by most people on earth- eventually pushed back the date of the vernal equinox by 10 days.

At least the error was constant. What if temporal standards had been "elastic?" Imagine the confusion that would result from days being 25 hours one year and 23 the next. Imagine, instead, the increased confusion that would result if the elasticity of temporal standards varied per individual. Tax payers might wish for years of 500 days while mortgage bond holders might wish for months of 10 days. Such mortgage bond holders, if they were able to implement this "short month" policy, would see the value of their assets, at least on paper, rise dramatically.

Of course, under such conditions, it wouldn't be long before the whole system of temporally based payments collapsed. If the desired changes in standards were less radical- call it the Fabian approach to loosened standards- the collapse would take longer to manifest. In any event, the lesson is clear, standards that vary over time and individual (or group) inevitably create confusion and discord. In the highly ordered modern world my month must be the same as everyone else's month.

Equally, in the modern world, my money must be the same as everyone else's money. There must be some standard of reference if calculations today are to have any merit tomorrow.


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