nassim taleb

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Bread & Circuses & Antiprosperity

If I was a mathematical economist — and I have very, very good reason not to be — I would try to create a formal model for what I call antiprosperity.

What is antiprosperity? It is a strange effect. I hypothesise thus: as nations (and to a lesser extent, people) become more prosperous, they tend toward greater fragility. In other words, fat times create weakness. This is not a universal law, because there are some exceptions. It is more of a tendency. The children of the strong, the hard-working or the wealthy often grow up lazy and stupid and conceited. People who keep winning don’t learn about their weaknesses, and without being aware of their weaknesses their weaknesses can fester and develop into glaring cracks.

An example of antiprosperity is the global system of derivatives. By creating a system of side bets, market participants could “hedge” against any undesired eventualities (for example, shopping chains dependent upon high consumer turnout could create an option on weather — if the weather was poor, and thus their sales were down, the option would payoff, mitigating their losses). By 2008, over $1 quadrillion of derivatives had been created to hedge against inflation, rate spikes, weather, price changes, defaults on debt, climate change, and almost anything imaginable. The problem was that if a counter-party with a large amount of derivatives on their balance sheet fails, then those “assets” become worthless. Any liabilities go unpaid, and so other companies who have agreed to contracts with the bust counter-party may themselves become illiquid due to their losses with the bust counter-party. This can quickly cascade into systemic meltdown. So, to recap, a system designed to “stabilise” global markets — and, let us not forget, was once prophesied as the end to systemic risk — ends up destroying them through unprecedented systemic risk..

I am still trying to understand what causes this mechanism. I think human life tends to be characterised by a steady process of building and breaking. As we learn skills we face setbacks, and failures, we learn from our mistakes and we fix our weaknesses. Humans once had no choice but to work for their food.  Taking away this gradual process — say, by creating a system that guarantees a constant and steady stream of food that requires no work to fulfil — creates a weakness, because the skills necessary to fulfil the pre-existing need become rusty. Western civilisation has become so good at feeding itself that it creates huge surpluses of goods and food. People don’t need to learn to feed themselves. Many people — who take the welfare route to “prosperity” (left-wing readers — yes, this includes bankers, defence contractors, and other corporate welfare recipients) — don’t even need to learn to work. They just suck up the handout and go on their merry way.

This tidal wave of prosperity hides a sickness inside, and we are seeing the first symptoms: overflowing bellies. Why learn the skills necessary to survive in the wilderness when it is easier to sit on your ass, stuffing your face with junk food? After, all the global resource infrastructure that pulls oil out of the ground in the middle east, refines it, ships it in oil tankers to America, and creates petrochemical-based fertilisers that are used to grow crops, produce (what can loosely be described as) food and transport that food to the consumer will always exist, won’t it? Readers are advised to know where their next meal is coming from — and their next meal for six months or a year — if the global system of trade were to break down.

To become stronger we must seek volatility, and to some extent, failure. When I was learning to play the guitar, I didn’t get better by playing pieces I could already play. I got better by seeking out failure by trying to play pieces and measures that were too difficult for me. Failure is beneficial and useful, because we can learn from it. Weakness is beneficial and useful, because we can learn from it.

How can governments and businesses learn the lesson of antiprosperity? Well, Steve Jobs seemed to know a thing or two about it. He was famed for his management style, whereby he lashed employed with vicious criticism to keep them on their toes. Failure and weakness built strength.

Governments should learn to keep welfare nets — both corporate and social — to a minimum. While the vulnerable (e.g. children, the aged, and the severely disabled) should under no circumstances be abandoned, welfare should never become a gold-plated ticket for an easy life. Governments should also peel back barriers to entry and overregulation so that the poor and unemployed can easily become self-employed without having to pass futile certifications, and pay thousands of dollars for licensing.

If we humans cannot avoid the excesses of prosperity, nature is a cruel mistress. What is the punishment for gluttonous obesity? It can become difficult or impossible to find a mate, thus making it difficult or impossible to pass our genes onto the next generation. The obese die younger, and thus turn back into dust sooner than their thinner counterparts.

And so too do societies enamoured with bread, circuses and free lunches. Rome was sacked, and its empire crumbled. Ming China collapsed under the weight of its traditionalism and technophobia. We here in the West — fed fat by the free lunch of petrodollar supremacy, the beauty of globalisation, the power and simplicity of a carbon-driven economy, and the largesse of the state — should heed those warnings. It is estimated that 99.9% of all species that have ever existed are now extinct

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The Economics of the War on Terror

The cost of the global war on terror since the attacks of 9/11? Almost $4 trillion.

That’s almost half of what the U.S. has added in debt since 2001:


Without the war on terror, America’s national balance sheet would look much healthier.

So has it been worth it?

America’s free spending national security hawks, frothy at the mouth, might say yes.

But the deeper reality seems to be that terrorism is a relatively small — and some would say negligible — threat:

The chronic exaggeration of U.S. national security threats also extends to the security of individual Americans. Since 9/11, a total of 238 American citizens have died from terrorist attacks, or an average of 29 per year. To put that in some perspective, according to the Consumer Product Safety Commission, the average American is as likely to be crushed to death by televisions or furniture as they are to be killed by a terrorist. A recent study from Duke University found that, since 9/11, eleven Muslim Americans were involved in active terrorist plots in the United States, which killed thirty-three Americans. Over that same time period, there have been nearly 150,000 murders and over 300,000 suicides.

So should we declare war on people being crushed to death by televisions and furniture?

Most tellingly, from 1980 to 2005 only 6% of all terrorist events in the U.S. was Islamist in nature:

The spectacular imagery of 9/11 blinded American policymakers. Whether it was a case of guilt as a result of their failure in spite of the warnings to protect America, or whether it was that the events of 9/11 became an excuse to exercise preconceived (and in my view ill-conceived) foreign policy objectives, policymakers matched the spectacular image of 9/11 with an equally spectacular spending spree.

And yes — America has not been hit by a spectacular terrorist attack since. But it hadn’t really been hit by a spectacular terrorist attack before. 9/11 was  — whatever your wider view of the incident — a black swan event: high impact, and unprecedented. And the problem with black swan events is that very often they are not repeated, and so spending money to prevent future occurrences is more or less a waste of money.

America faces a whole swathe of real risks far far bigger than international terrorism including derivatives contagion, global trade fragility, climate instability, and electromagnetic pulses. We don’t know what the next calamitous black swan event will be. But I’m pretty sure that a whole boatload of money will be spent on preventing it after it has happened, just as trillions have been wasted on preventing jihadist terrorism after it has already done the damage.

And the biggest problem here is the spending. $4 trillion of productivity was wasted. Keynesian multipliers are irrelevant — the money would surely otherwise have still been spent, and on more productive and useful endeavours. That’s a pretty big opportunity cost.

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Nassim Taleb’s Big Idea: Transforming Debt Into Equity

I have mentioned, in passing, the possibility of transforming debt into equity as a solution for many of the troubles in the global financial system.

I borrowed the idea from Nassim Taleb and Mark Spitznagel, who floated it in 2009. It is unfortunate that the idea has not yet been taken very seriously. There are probably two reasons for this: firstly Taleb and Spitznagel never fully fleshed it out, and secondly because the political and media punditry don’t really recognise the graveness of the present situation. Largely it is hoped that we can muddle through; radical solutions tend to get left on the shelf.

It is my view that it is much better to fix the system in a fundamental way, rather than clobber together solutions piecemeal. The latter approach has been the norm — from the bailouts of Greece and euro austerity, to the bailout of AIG and the wider financial system, to quantitative easing and LTRO, to Obama’s stimulus package — the focus has been on keeping a system that is falling apart at the seams from crumbling completely into dust.

So what is the problem that governments fear so hugely?

As we learned a long time ago, big defaults on the order of billions don’t just panic markets. They congest the system, because the system is predicated around the idea that everyone owes things to everyone else. The $18 billion that Greece owes to the banks are in turn owed on to other banks and other institutions. Failure to meet that payment doesn’t just mean one default, it could mean many more. The great cyclical wheel of international debt is only as strong as its weakest link. This kind of breakdown is known as a default cascade. In an international financial system which is ever-more interconnected, we will soon see how far the cascade might travel.

The concept of too big to fail — and thus the justification for all the bailouts — comes out of these default cascades; if a default were to trigger such a cascade, the cycle of payments would break down. Thus, the logic goes, if a bankruptcy would break the system, then the government should step in and prevent that bankruptcy. Thus, the system can continue operating. Alas, this is the road to a zombie economy. If bad companies can succeed just as easily as well-run ones, then the market mechanism is rendered meaningless. Why innovate and create when instead you can run on government largesse? Why seek efficiency when inefficiency gets you cash just as easily? Furthermore, this government largesse starves new businesses of opportunities and cash. Every dollar taxed to pay for bailouts is a dollar that could have instead been invested in a startup. And every juggernaut that is saved is a hole in the marketplace that could instead have been filled by a new and better company.

The problem then, is the huge overhanging cyclical structure of debt and interest. In a free market — without bailouts and largesse — it would have collapsed into the sand long ago. That would have been painful and contractionary, but after the storm there would have been aggressive new growth; without the debt overhang, new lending would have been easier. There would be holes in the market to fill. But governments have determined that it must be saved, that there is no alternative to this strange mess.

It is not good enough to imagine a new beginning, either. For we already have this mess, and we have to get out of it. A route out — toward a place where the system is no longer so fragile. If we ignore the mess, our route out of it will be messy — systemic collapse, currency crises, trade breakdown, war or worse.

Now, I believe that the most significant factors in robustifying society are economic, as opposed to financial. The West’s greatest fragilities stem not from its weak financial system, but from its energy dependency and susceptibility to energy costs (for example, the financial crisis in 2008 might never have been so severe had there been such a huge spike in energy costs), its deteriorating infrastructure, and its imperial largesse (the cost, the blowback, the shortage of manpower). Simply, if America and the West were fuelled by decentralised domestic energy production (e.g. solar), and decentralised local production and resource extraction, the ululations of the global financial system would be irrelevant to the common people.

But, in reality, we live in a globalised and interdependent system. So anything that might robustify the financial system would be welcome.

Here’s what Taleb and Spitznagel originally wrote:

The core of the problem, the unavoidable truth, is that our economic system is laden with debt, about triple the amount relative to gross domestic product that we had in the 1980s. This does not sit well with globalisation. Our view is that government policies worldwide are causing more instability rather than curing the trouble in the system. The only solution is the immediate, forcible and systematic conversion of debt to equity. There is no other option.

Our analysis is as follows. First, debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets.

Second, the complexity created by globalisation and the internet causes economic and business values (such as company revenues, commodity prices or unemployment) to experience more extreme variations than ever before. Add to that the proliferation of systems that run more smoothly than before, but experience rare, but violent blow-ups.

The only solution is to transform debt into equity across all sectors, in an organised and systematic way. Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers. 

The strongest advantage, though, goes unmentioned. Systematically transforming debt into equity would end the problem of financial entities being too big to fail, as failure would no longer lead to a breakdown in the debt cycle. This is because insolvent positions would simply default to a majority-minority equity position, and — if the debtor’s equity position were high enough, say about 33% — liquidation could be avoided.

A huge philosophical problem is that such a complete transformation would alter (violate?) a huge number of existing contracts. It would be a top-down and coercive solution, and that is always open to legal challenge. Furthermore, curtailing the issuance of debt means curtailing the freedom of society and individuals to enter into any contract seen fit.

But the larger picture is rather intriguing — in a world where all debt has become equity, there is no such thing as a default, because an equity position is one of ownership, and thus a claim on future earnings.

Simply, lending would be done through lenders buying a share in a person or company’s or government’s future earnings, rather than through creating debt. Loan contracts could still be structured precisely the way they are today. But, as Taleb and Spitznagel insinuate in saying that “banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity”, lenders would have much more of an incentive to assist in the development of their equity position, as this would surely be the best way to get back their initial investment. And — as an equity position, rather than a cast-in-stone lending contract — terms could be far more easily renegotiated.

Of course, this new system would surely pose a whole new universe of challenges and moral and regulatory quandaries, not least the moral and philosophical problems of government effectively banning debt-based lending.

But, if we are looking to avoid the moral hazard of bailouts, and the dangers of default cascades, the architects of the global financial system — including banks themselves, who could of their own volition choose to cease debt-based lending, and adopt equity-based lending — could do much worse. While systematically transforming debt to equity is too difficult and controversial (not least for contractual reasons), we must remember that in a purely free-market, all of those debt-based lenders would have gone bust a long time ago.

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All I Want for Christmas is…

An end to this bullshit.

Honestly, why is an inert and essentially useless metal like gold the best performing major asset class of the last ten years? It doesn’t do anything. It doesn’t create any return. It just sits. It’s a store of long-term purchasing power.

And most importantly it is a hedge against counter-party risk.

What is counter-party risk?

Counter-party risk is the external risk investments face. The counter-party risk to fiat currency is that the counter-party — in this case the government — will fail to deliver a system where that fiat money will be acceptable as payment for goods and services. The counter-party risk to a bond or a derivative or a swap is that the counter-party — in this case the debtor — will default on their obligations.

Gold — at least the physical form — has negligible counter-party risk. It’s been recognised as valuable for thousands of years.

Counter-party risk is a symptom of dependency. And the global financial system is a paradigm of inter-dependency: inter-connected leverage, soaring gross derivatives exposure, abstract securitisations.

When everyone in the system owes shedloads of money to everyone else the failure of one can often snowball into the failure of the many.

That, as much as anything else, is the real problem with all the policy that has gone into preserving at stabilising the financial system since 2008. It has preserved a system full of counter-party risk, where one big failure could snowball into the failure of the entire system.

Mark Spitznagel wrote a fantastic article for the WSJ a couple of days ago about the current shape of the global financial system:

The conifer’s secret to longevity lies in a paradox: Their conquest has been largely the result of episodes of massive forest destruction. When virtually all else is gone, conifers show their strength and prowess as nature’s opportunists. How? They have adapted to evade competitors by out-surviving them and then occupying their real estate after catastrophic fires.

First, the conifer takes root where no one else will go (think cold, short growing seasons and rocky, nutrient-poor soil). Here, they find the time, space and much-needed sunlight to thrive early on and build their defenses (such as height, canopy and thick bark). When fire hits, those hardy few conifers that survive can throw their seeds onto newly cleared, sunlit and nutrient-released space. For them, fire is not foe but friend. In fact, the seed-loaded cones of many conifers open only in extreme heat.

This is nature’s model: overgrowth, followed by destruction of the overgrowth, and then the subsequent new growth of the healthiest and most robust, which ultimately leaves the forest and the entire ecosystem better off than they were before.

Pondering these trees, it is not too much of a stretch to consider the financial forests of our own making, where excess credit and malinvestment thrive for a time, only to be destroyed—and then the releasing of capital into markets where competition has been wiped out. The Austrian school economists understood this well, basing a whole theory around this investment cycle.

Let’s hope that policy makers can grasp this reality and allow nature to do what she does best: change, renew and revitalise.

Merry Christmas, everyone.

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The United Kingdom of Massive Debt

Perhaps it is unpatriotic of me to ask, but are France’s shrill politicians right? Is the United Kingdom the weak link?

From the Guardian:

The entente is no longer so cordiale. As the big credit rating firms assess whether to strip France of its prized AAA status, Bank of France chief Christian Noyer this week produced a long list of reasons why he believes the agencies should turn their fire on Britain before his own country.

France’s finance minister François Baroin put things even more bluntly: “We’d rather be French than British in economic terms.”

But is the outlook across the Channel really better than in Britain? Taking Noyer’s reasons to downgrade Britain – it “has more deficits, as much debt, more inflation, less growth than us” – he is certainly right on some counts.

Britain’s deficit will stand at 7% of GDP next year, while France’s will be 4.6%, according to International Monetary Fund forecasts. But Britain’s net debt is put at 76.9% of GDP in 2012 and France’s at 83.5%. UK inflation has been way above the government-set target of 2% this year and the IMF forecasts it will be 2.4% in 2012. In France the rate is expected to be 1.4%.

On growth, neither country can claim a stellar performance. France’s economy grew 0.4% in the third quarter and Britain’s 0.5%. Nor has either a particularly rosy outlook. In Britain the economy is expected to grow by 1.6% in 2012. But in the near term there is a 1-in-3 chance of a recession, according to the independent Office for Budget Responsibility. In France, the IMF predicts slightly slower 2012 growth of 1.4%. But in the near term France’s national statistics office predicts a technical, albeit short, recession.

There is one significant factor everyone is overlooking.

Total debt:

From Zero Hedge:

While we sympathize with England, and are stunned by the immature petulant response from France and its head banker Christian Noyer to the threat of an imminent S&P downgrade of its overblown AAA rating, the truth is that France is actually 100% correct in telling the world to shift its attention from France and to Britain.

France should quietly and happily accept a downgrade, because the worst that could happen would be a few big French banks collapsing, and that’s it. If, on the other hand, the UK becomes the center of attention then this island, which far more so than the US is the true center of the global banking ponzi scheme, will suddenly find itself at the mercy of the market.

And why is the debt so high? Well, the superficial answer is that the UK is a “world financial centre”. The deeper answer is that the UK allows unlimited re-hypothecation of assets. Re-hypothecation is when a bank or broker re-uses collateral posted by clients, such as hedge funds, to back the broker’s own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal. It is justified by brokers on the basis that it is a capital efficient way of financing their operations. In the US brokers can re-hypothecate assets up to 140% of their book value.

In the UK, there is absolutely no statutory limit on the amount that can be re-hypothecated. Brokers are free to re-hypothecate all and even more than the assets deposited by clients. That is the kind of thing that creates huge interlinked webs of debt. And much of Britain’s huge debt load — particularly in the financial industry — is one giant web of endless re-hypothecation. Even firms (e.g. hedge funds) that do not internally re-hypothecate collateral are at risk, because their assets may have been re-hypothecated by a broker, or they may be owed money by a firm that re-hypothecates to high heaven. The problem here is the systemic fragility.

Simply, the UK financial sector has been attracting a lot of global capital because some British regulations are extremely lax. While it is pleasing to see the Vickers report, that recommends a British Glass-Steagall separation of investment and retail banking, becoming government policy, and while such a system might have insulated the real economy from the madness of unlimited re-hypothecation, the damage is already done. The debt already exists, and some day that debt web will have to be unwound.

Now Britain does have one clear advantage in over France. It can print its own money to recapitalise banks. But with inflation already prohibitively high, any such action is risky. If short sellers turn their fire on Britain, we could be in for a bumpy ride to hell and back.

UPDATE: Readers wanting to understand the true extent of economic degradation in some parts of the UK ought look no further than a recent post…

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Skin in the Game…

From Nassim Taleb:



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Central Banker to the World

If there’s one guy in the entire financial world who is not only useless, but also extremely dangerous, it’s Nobel Prize-winning schmuck Myron Scholes. Scholes won the Nobel for his contribution to the Black-Scholes-Merton derivatives pricing model. In theory, that equation allowed financial actors to more easily calculate their risk and reward positions, and hedge accordingly. This led to the development of a variety of complex hedging and arbitrage strategies that have spawned the complex web of interconnected debt and derivatives that we see today, where huge parts of the global economy have become too interconnected to fail. And as we are slowly learning, being too interconnected to fail doesn’t prevent failure — it just makes its effects more poisonous.

Myron Scholes’ own ventures were very unsuccessful. He was the “brains” behind Long Term Capital Management, the ill-fated hedge fund that blew up in 1998:

Nassim Taleb put it better than I ever could:

This guy should be in a retirement home doing Sudoku. His funds have blown up twice. He shouldn’t be allowed in Washington to lecture anyone on risk.

Yet lecturing the world on risk, as well as financial stability and the international financial system is exactly what Scholes is doing.

From Ambrose Evans-Pritchard:

So the question arises, should the rest of the world take over management of Europe to prevent or mitigate disaster? Specifically, should the US Federal Reserve assume leadership as a monetary superpower and impose policy on a paralyzed ECB, acting as a global lender of last resort?

In essence, the US would do for EMU what it did in military and strategic terms for the Europe in the 1990s when Washington said enough is enough after squabbling EU leaders had allowed 200,000 people to be slaughtered in the Balkans. The Pentagon settled matters swiftly with “Operation Deliberate Force”, raining Tomahawk missiles on the Serb positions. Power met greater power.

Personally, I have not made up my mind about the wisdom of a Fed rescue. It is fraught with dangers, and one might argue that resources are better deployed breaking EMU into workable halves with minimal possible damage.

However, debate is already joined – and wheels are turning in Washington policy basements – so let me throw this out for readers to chew over.

Nobel economist Myron Scholes first floated the idea over lunch at a Riksbank forum in August. “I wonder whether Bernanke might not say that we believe in a harmonised world, that the Europeans are our friends, and we know that the ECB can’t print money to buy bonds because the Germans won’t let them. And since the ECB will soon run out of money, we will step in and start buying European government bonds for them’. It is something to think about,” he said.

Now, I don’t believe that an idea is necessarily discredited because its author is stupid. But this is another very bad idea from the author of many very bad ideas.

Bernanke’s copying of the failed Japanese response to a burst bubble — print money and avoid liquidation — has already doomed the United States to over two years of zombification, lowered employment, weak lending, biflation, and a lack of new growth or creative destruction. Does Europe — and the globe — deserve to be subjected to the same horrendous zombified state? I don’t think so.

Bernanke’s approach is deeply reactionary — it puts systemic stability above everything else — and will take any measure necessary to ensure it. But is systemic stability really worth anything if the system that is stabilised — encumbered by excessive debt, malinvestment and fragility — stinks? In my view, the bad debt, bad investments, and bad companies need to liquidate. The recapitalisation comes afterwards.

The best way to “save” a bad system is to let it fail, and help rebuild it. Clearly, neither Europe, nor America, nor the globe are working. Policymakers need bolder policy — they need to start looking at allowing what is failing to fail — and then facilitating rebuilding. If stern teutonic monetarism allows for the kind of global failure that can allow the junk to liquidate, then I am all for it. Yes — it undermines the Federal Reserve’s reactionary money printing policies. But that’s the cost of a system as fragile as the one Myron Scholes has helped build, where American stability is threatened by crisis in Europe, etc.

It is my theory that the real disaster in economics in the last half century was its takeover by mathematicians like Myron Scholes. These people never seemed to care much about reality, or empiricism. They have been lost in their imagined abstractions, drunk on maths, drunk on the beautiful, idealised, linear models that they create — but which merely resemble reality. Models are not real. That was the problem at Long Term Capital Management — their statistical arbitrage models worked perfectly at a theoretical level, but crashed and burned in complex, messy reality — at cost to the taxpayer, the investor, and the financial world at large. I can’t help but think that this is the problem here too — the ideal of a highly liquid, hugely interconnected and truly global financial system is seductive to idealist mathematicians, and therefore its preservation has become central to the Fed’s policies (the FOMC is dominated, of course, by mathematical economists and econometricians). In messy, non-abstract reality, the fragility of such a system makes it absolutely unsustainable. The mathematicians will keep pumping liquidity and trying to save their paradigm. But it won’t work.

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Negative Real Interest Rates

Paul Krugman thinks negative real interest rates are a policy tool to stimulate recovery:

To preview the conclusions briefly: in a country with poor long-run growth prospects – for example, because of unfavorable demographic trends – the short-term real interest rate that would be needed to match saving and investment may well be negative; since nominal interest rates cannot be negative, the country therefore “needs” expected inflation.

The theory here is that aggregate demand is being lowered by the (unproductive) hoarding of cash and treasuries. Therefore, the best way to get the economy flowing again is to make holding assets like cash and treasuries expensive, by creating inflation. This is what creates negative real rates — when the rate of inflation exceeds the rate of interest. Under such circumstances, hoarders should — in theory — draw down their Treasury and cash holdings and invest in more productive endeavours offering higher rates of return.

Negative real rates are a blunt axe used to bludgeon creditors including China who hold shedloads of cash and Treasuries. This could be a dangerous policy, because America is not energy-independent, and nor is it manufacturing-independent: it depends upon global oil, trade routes, and global manufacturing to function. That’s why America spends more than the rest of the world put together on its military. American agriculture is dependent on imported oil. American transportation is dependent on imported oil. Bludgeoning other powers — who have the power to upset the apple cart a little — could be seen as much like a game of Russian roulette.

The calculation could well be that China’s wealth is dependent on American stability — that interconnection has made the global system “too big to fail”. It is true that China is heavily invested in America — but assuming that that means America can thumb its nose at China’s interests seems naive. There are a lot of people in China desperate for a better standard of living. It would be naive to assume the Chinese government will forever carry the bag for America’s standard of living.

Paul Krugman believes that this would be good for America — that the transfer of dollars from West to East has effectively been a program of “quantitative diseasing”, and that if China liquidates she will effectively be conducting QE on behalf of the Fed, and thereby stimulating the American economy. Let’s flip that over: America — in continuing to buy Chinese goods and ship hoards of dollars to China — has been conducting “quantitative diseasing” of the dollar for most of the last 30 years. Maybe he’s right. But maybe not.

Forcing real rates even lower as a “policy tool” could be the spark that lights a bonfire, the straw that breaks the camel’s back. This denouement — that US Treasury debt is (in real-terms) a bad investment — could lead to all kinds of ramifications in the international financial system.

Possibly rather than moderating nominal debt values, or encouraging risk the inflationary road is a road to a trade war with America’s creditors, a trade war that a highly-dependent America — who controls neither her energy-intake nor her supply chains might struggle to win, even in the context of American military supremacy. 

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Technocrats, Technocrats Everywhere!

In surely the dumbest news of the week month year, Europe is giving austerity a last throw of the dice.

From the Washington Post:

ROME — Italy’s premier-designate Mario Monti began talks on Monday to create a new government of non-political experts tasked with overhauling an ailing economy to keep market fears over the country from threatening the existence of the euro.

Investors initially cheered Monti’s appointment, following quickly on Silvio Berlusconi’s weekend resignation, though concern lingered about the sheer amount of work his new government will have to do to restore faith in the country’s battered economy and finances.

Improving market confidence in Italy is crucial to the future of the eurozone as the country would be too expensive to rescue. A default on its €1.9 trillion ($2.6 trillion) in debt would cause massive chaos in financial markets and shake the global economy.

As in Greece, where a new government of technocrats also took over last week, the hope is that administrations of experts not affiliated to parties will be more willing to make the tough but necessary decisions [i.e. slashing spending to pay off bankers] that politicians have so far balked at.

Monti appeared to have the respect of many Italians, eager to see an end to the financial crisis that threatens their own well-being.

The likelihood is that these technocrat-driven austerity programs will totally fail to reduce the debt load and suck Europe even further into the abyss. Reducing government spending in an already depressed economy tends to leave the middle class with less disposable income in the short term, which tends to turn a bad situation into a worse one. A classic example of this is the Brüning administration, which led Germany from 1930 to 1932 — and whose technocratic austerity program made the German people hungry for change, and a charismatic new leader.

From Alternet:

After just two years of “austerity” measures, Germany’s economy had completely collapsed: unemployment doubled from 15 percent in 1930 to 30 percent in 1932, protests spread, and Bruning was finally forced out. Just two years of austerity, and Germany was willing to be ruled by anyone or anything except for the kinds of democratic politicians that administered “austerity” pain. In Germany’s 1932 elections, the Nazis and the Communists came out on top — and by early 1933, with Hitler in charge, Germany’s fledgling democracy was shut down for good.

The issue is that if a nation is to lower the government’s participation rate in the economy (usually a very good idea — the market is usually a more efficient allocator of capital than central planners), it must not do so during a time of wider crisis. That’s because switching from dependence on the state is a stressor in itself. This can compound the problem.

Now obviously the debt is unsustainable — as was the load of war reparations that Brüning sought to pay down in Germany. A deflationary austerity program is the last throw of the dice creditors have to get an intact pound of flesh. The reality is that they made bad investments in the sovereign debt of countries without a sovereign printing press — and that means they will (in the end) have to accept big losses on their investments — either via direct default, or via nations leaving the Euro and printing huge inflationary quantities of their new national currency to maintain state spending and pay down debt.

Monti — and his Greek technocrat counterpart Papademos — must be aware how the Brüning administration ended. If they are not, I am sure there are millions of furious Greeks and Italians who would be willing to show them.

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Too Fucked to Bail

From Nassim Nicholas Taleb writing for the NYT:

I have a solution for the problem of bankers who take risks that threaten the general public: Eliminate bonuses.

More than three years since the global financial crisis started, financial institutions are still blowing themselves up. The latest, MF Global, filed for bankruptcy protection last week after its chief executive, Jon S. Corzine, made risky investments in European bonds. So far, lenders and shareholders have been paying the price, not taxpayers. But it is only a matter of time before private risk-taking leads to another giant bailout like the ones the United States was forced to provide in 2008.

The promise of “no more bailouts,” enshrined in last year’s Wall Street reform law, is just that — a promise. The financiers (and their lawyers) will always stay one step ahead of the regulators. No one really knows what will happen the next time a giant bank goes bust because of its misunderstanding of risk.

Instead, it’s time for a fundamental reform: Any person who works for a company that, regardless of its current financial health, would require a taxpayer-financed bailout if it failed, should not get a bonus, ever. In fact, all pay at systemically important financial institutions — big banks, but also some insurance companies and even huge hedge funds — should be strictly regulated.

What would banking look like if bonuses were eliminated? It would not be too different from what it was like when I was a bank intern in the 1980s, before the wave of deregulation that culminated in the 1999 repeal of the Glass-Steagall Act, the Depression-era law that had separated investment and commercial banking. Before then, bankers and lenders were boring “lifers.” Banking was bland and predictable; the chairman’s income was less than that of today’s junior trader. Investment banks, which paid bonuses and weren’t allowed to lend, were partnerships with skin in the game, not gamblers playing with other people’s money.

Hedge funds, which are loosely regulated, could take on some of the risks that banks would shed under my proposal. While we tend to hear about the successful ones, the great majority fail and their failures rarely make the front page. The principal-agent problem they have isn’t a problem for taxpayers: Typically their investors manage the governance of hedge funds by ensuring that the manager is hurt more than any of his investors in the event of a blowup.

I believe that “less is more” — simple heuristics are necessary for complex problems. So instead of thousands of pages of regulation, we should enforce a basic principle: Bonuses and bailouts should never mix.

The ramifications of the last crisis was that a failing and failed system was saved, pretty much intact. Yes — changes have been made around the fringes — the end of prop trading, the promise to later implement the Volcker rule.

But the big picture is that very few lessons were learned: the leverage stayed, the algorithmic trading stayed, the casino mentality stayed, and the huge web of interconnected derivatives stayed. state-owned and bailed-out banks have continued paying bonuses far in excess of anything payed to public servants. 2010 was a record year for Wall Street pay.

Is there anything that can address systemic fragility — the core problem — in a system wracked with the greatest debt burden in history? I don’t mean to be fatalistic — and I think we need to try Taleb’s measure — but I think that even a ban on bonuses would be gamed around by the vultures and vampires and cannibals.

I am concerned that the only thing that will really regulate this new hyper-leveraged, hyper-fragile global market is its self-destruction — where “too big to fail” metastasises into “too fucked to bail”, and the entire system collapses, the residual debt is erased, and the system has to be rebuilt from scratch.