Taleb on Overstabilisation

It’s nice to know that Taleb is preaching more or less the same gospel that I am.

Via the NYT:

Stabilization, of course, has long been the economic playbook of the United States government; it has kept interest rates low, shored up banks, purchased bad debts and printed money. But the effect is akin to treating metastatic cancer with painkillers. It has not only let deeper problems fester, but also aggravated inequality. Bankers have continued to get rich using taxpayer dollars as both fuel and backstop. And printing money tends to disproportionately benefit a certain class. The rise in asset prices made the superrich even richer, while the median family income has dropped.

Overstabilization also corrects problems that ought not to be corrected and renders the economy more fragile; and in a fragile economy, even small errors can lead to crises and plunge the entire system into chaos. That’s what happened in 2008. More than four years after that financial crisis began, nothing has been done to address its root causes.

Our goal instead should be an antifragile system — one in which mistakes don’t ricochet throughout the economy, but can instead be used to fuel growth. The key elements to such a system are decentralization of decision making and ensuring that all economic and political actors have some “skin in the game.”

Two of the biggest policy mistakes of the past decade resulted from centralized decision making. First, the Iraq war, in addition to its tragic outcomes, cost between 40 and 100 times the original estimates. The second was the 2008 crisis, which I believe resulted from an all-too-powerful Federal Reserve providing cheap money to stifle economic volatility; this, in turn, led to the accumulation of hidden risks in the economic system, which cascaded into a major blowup.

Just as we didn’t forecast these two mistakes and their impact, we’ll miss the next ones unless we confront our error-prone system. Fortunately, the solution can be bipartisan, pleasing both those who decry a large federal government and those who distrust the market.

First, in a decentralized system, errors are by nature smaller. Switzerland is one of the world’s wealthiest and most stable countries. It is also highly decentralized — with 26 cantons that are self-governing and make most of their own budgetary decisions. The absence of a central monopoly on taxation makes them compete for tax and bureaucratic efficiency. And if the Jura canton goes bankrupt, it will not destabilize the entire Swiss economy.

In decentralized systems, problems can be solved early and when they are small; stakeholders are also generally more willing to pay to solve local challenges (like fixing a bridge), which often affect them in a direct way. And when there are terrible failures in economic management — a bankrupt county, a state ill-prepared for its pension obligations — these do not necessarily bring the national economy to its knees. In fact, states and municipalities will learn from the mistakes of others, ultimately making the economy stronger.

It’s a myth that centralization and size bring “efficiency.” Centralized states are deficit-prone precisely because they tend to be gamed by lobbyists and large corporations, which increase their size in order to get the protection of bailouts. No large company should ever be bailed out; it creates a moral hazard.

Consider the difference between Silicon Valley entrepreneurs, who are taught to “fail early and often,” and large corporations that leech off governments and demand bailouts when they’re in trouble on the pretext that they are too big to fail. Entrepreneurs don’t ask for bailouts, and their failures do not destabilize the economy as a whole.

Second, there must be skin in the game across the board, so that nobody can inflict harm on others without first harming himself. Bankers got rich — and are still rich — from transferring risk to taxpayers (and we still haven’t seen clawbacks of executive pay at companies that were bailed out). Likewise, Washington bureaucrats haven’t been exposed to punishment for their errors, whereas officials at the municipal level often have to face the wrath of voters (and neighbors) who are affected by their mistakes.

If we want our economy not to be merely resilient, but to flourish, we must strive for antifragility. It is the difference between something that breaks severely after a policy error, and something that thrives from such mistakes. Since we cannot stop making mistakes and prediction errors, let us make sure their impact is limited and localized, and can in the long term help ensure our prosperity and growth.

The Problem With Centralisation

Nassim Taleb slams the European project. Perfect timing to counteract the Nobel Peace Prize nonsense.

Via Foreign Policy:

The European Union is a horrible, stupid project. The idea that unification would create an economy that could compete with China and be more like the United States is pure garbage. What ruined China, throughout history, is the top-down state. What made Europe great was the diversity: political and economic. Having the same currency, the euro, was a terrible idea. It encouraged everyone to borrow to the hilt.

The most stable country in the history of mankind, and probably the most boring, by the way, is Switzerland. It’s not even a city-state environment; it’s a municipal state. Most decisions are made at the local level, which allows for distributed errors that don’t adversely affect the wider system. Meanwhile, people want a united Europe, more alignment, and look at the problems. The solution is right in the middle of Europe — Switzerland. It’s not united! It doesn’t have a Brussels! It doesn’t need one.

The future is unpredictable. In economics some decisions will be lead to desired results and others will not. Real-world outcomes are ultimately impossible to predict, because the real world is chaotic and no simulation can ever model the real world in precise detail; the map is not the territory.

Centralisation concentrates decision-making. Centralisation acts as a transmission mechanism to transmit and amplify the effects of centralised decisions throughout a system. This means that when bad decisions are made — as inevitably happens in human behaviour — the entire system will be damaged. Under a decentralised system, there is no such problem. Under a decentralised heterogeneous system, mistakes are not so easily transmitted or amplified. Centralisation is fragile.

And central planning is mistake-prone. Central planners are uniquely ineffective as resource allocators. Free markets transmit information; the true underlying state of supply and demand. Without an open market to transmit price information, central planners cannot allocate resources according to the true state of supply and demand. Capital, time, and labour are allocated based on the central planner’s preferences, rather than the preferences of the wider society.

These two factors taken together mean that centralised systems tend to be both fragile and mistake-prone. That is a dangerous — and unsustainable — combination.

The End of European Sovereignty?

It looks like fiscal union will at least be tried in Europe.

From the BBC:

German Chancellor Angela Merkel has said Europe is working towards setting up a “fiscal union”, in a bid to resolve the eurozone’s debt crisis.

She told the Bundestag that a new EU treaty was needed to set up such a union and impose budget discipline.

On Monday she is to meet French President Nicolas Sarkozy, who has also called for EU treaty changes.

EU leaders have been under pressure to do more to tackle the debt crisis, amid concern about the survival of the euro.

In her speech, Mrs Merkel promised “concrete steps towards a fiscal union” – in effect close integration of the tax-and-spend polices of individual eurozone countries, with Brussels imposing penalties on members that break the rules.

In hindsight, perhaps this was always Germany’s favoured course.

From Reuters:

The idea [of Euro bonds] was immediately rejected by German Finance Minister Wolfgang Schaeuble, who said such bonds would undermine the basis for the single currency by weakening fiscal discipline among member states.

“I rule out euro bonds for as long as member states conduct their own financial policies, and we need differing interest rates so that there are possibilities of incentives and sanctions to force fiscal solidity,” he told Der Spiegel weekly.

“Without that kind of solidity, there is no foundation for a joint currency,” he added, according to extracts of an interview released ahead of publication.

In theory (ignoring the lack of a economic common culture, lack of labour market flexibility, lack of a common language, etc, etc)  this would have made Europe a viable monetary union. In practice, no amount of “budget discipline” can now reverse the ongoing confidence panic — essentially a run on the Euro — stemming from the mediterranean budgetary disasters. Fiscal union might have prevented this mess from developing, but once the mess has developed, it won’t do anything to contain or reverse it. The fact that policy makers seem to be making things up as they go along is not exactly inspiring confidence, either. The only hope for temporarily reversing the run on Europe (and kicking the can down the road into Euro zombification — or, as Obama calls it, “recovery”) is a massive money printing operation.

Will the cathedral of teutonic monetarism (also known as the ECB) allow for it? No — that’s why they’re trying for fiscal union as an alternative.

In any case, such a fiscal union will surely prove deeply unpopular with a Europe growing sick of top-down technocratic integrationism, and frankly seems bound to fail. Why? Because it almost certainly means stern teutonic austerity — a policy which will surely cause yet more economic contraction, more pain, and more of a mess.