Mr. Taleb Goes to Washington

When the Secretary of the Treasury admits that the financial system has failed, as he did in his Congressional testimony yesterday, you would assume that the country is in for a sweeping overhaul of Wall Street and the banking establishment. But that hardly seems the case with what we’ve seen proposed. Part of the problem seems to be where the Obama administration is getting its advice: from the same characters who built the over-leveraged, under-capitalized mess.

Case in point, the Wall Street Journal held its Future of Finance Intitiative in Washington, DC earlier this week to contribute principles to the reform debate. On the whole, the assembled group went for incremental adjustments over wholesale reform. The lone voice of radical reform was Nassim Taleb, but he couldn’t stay past the opening night festivities. Here’s what he would have told the conference the next day:

First, he says, we have to unmask the charlatans of risk like Myron Scholes. To Taleb, Scholes is the Great Oz in this Emerald City because his work on options and derivatives allowed the whole of the financial system to adopt poorly understood products-like the ones that brought AIG down-that hide risk. To Taleb, Scholes’ academic work, which enabled the widespread use of complex derivatives, was like “giving children dynamite.”

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

With complex derivatives unmasked and, in Taleb’s vision of the future, outlawed, the next step is to create a more robust version of capitalism. Taleb calls it Capitalism 2.0. Robustness begins with a dismantling of debt. Leverage was the gas that inflated the financial system until it was too big, too fragile, and too volatile.

Taleb’s solution? It’s fairly simple. Get rid of the leverage. That’s the problem with the PPIP, it uses leverage to try to cure the problems of over-leverage.

We cannot have both debt leverage and a hyper-efficient system—the volatility is just too great. What Taleb explains—which no one else does—is that efficiency is already a form of leverage. A highly efficient system removes slack and magnifies small changes. Think of the efficient system as a high-performance aircraft. Each minute of steering input creates a rapid and violent shift of course, speed, or altitude. The system itself is souped up even before you add the debt. Once you do, the pilot is equally jacked up and twitchy, creating an explosive combination. Now imagine that fighter jet trying to fly in a 1,000-plane formation, and you get an idea of the world financial system in the 21st century.

We can’t erase the technology that created the planes, so we’ll have to make sure we fly sober, maybe even with an onboard computer that dampens the controls. That means getting rid of the debt. It’s that simple.


Mr. Taleb Goes to Washington

A Black Swan Meets Some Ugly Ducklings
The Big Money; March 26, 2009

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