NOTE: This article appears on Zero Hedge, and is also posted on doc stock. There is a misunderstanding, mostly self-inflicted, that I disagree with Mr. Taleb’s brilliant book. Nothing could be further from the truth; I view his work and message with the greatest respect, his command of mathematics heroic. At the same time, I am very disappointed at the media’s sound bite version of his work; that the financial crisis was a terrible and unpredictable occurrence hidden in the obscurity of a statistical long tail. That is very much not the point, which I try to articulate in the following article.

Bureaucracy and complexity

In the May/June 2011 issue of Foreign Affairs, Mr. Taleb and Mr. Blyth write an article titled The Black Swan of Cairo. The thrust of the piece is that complex systems must be allowed variability. Suppressing it in the pursuit of stability inevitably leads to larger variability later, often in catastrophic form.

We have applauded Mr. Taleb for some time now for pushing the issues of control midst complexity through the media clutter. Theoretically, there is little to disagree with the article. Picture an anthill artificially fed by a kind picnicker for several months; when she leaves, the colony’s artificially bloated size alone will force a hardship unbecoming, not to mention the outsized pain of adjustment and relocation that otherwise would have occurred earlier and more often.

As EU leaders attempt to delay the contractions of nation restructuring, the article is receiving renewed attention. Bail-outs and money printing only exacerbate the ferocity of the inevitable societal adjustments to come. Ultimately there is no monetary answer to avoid the glacier of unfunded liabilities which approaches western governments.

In fact, Mr. Taleb and Mr. Blyth are being too kind when it comes to the financial crises besetting western civilizations in the last several years. For no matter how one looks at the evidence, the Fed, IMF and other institutions must accept serious blame both for failing to predict its inevitability and severity, and standing flat footed as the failures occur.

We are not watching complexity at work; we are watching bureaucracy crumble that long ago successfully destroyed complexity. Complex systems are self-organizing and robust; they are duplicative and competitive. Our governments represent the antithesis of complexity, and they are causing this mess.

Let us begin with the macro view and inch towards the relative microcosm of the financial crisis of 2008.

The debt glacier

Most fundamentally, there is the problem of long term unfunded liabilities. It is well known, and has been for some decades, that Western Europe’s societal structure is unsustainable. While a media bent on sound bites might be forgiven for such oversight, economists and experts tasked with the fiduciary duty of overseeing fiscal health and currency management do not have that luxury.

We are not wandering into a surprise or horrified by the dark specter of a Black Swan rearing its long tailed head; this macro crisis appeared on the horizon long ago, easily calculated by any actuary armed with the knowledge that governments were not investing tax streams, but stealing them for current consumption. We may not have got the timing right, but we are within the 20 year window of the largest reformation of governments in history.

But it is not the result of complexity. It is the result of monopoly in place of complexity. These are not a complex, robust system of retirement funds drowning societies, but a monopolistic government built on redistribution without investment.

One might even take a step further back and stipulate that when Nixon finally closed the gold window, the Fed took on a frightening fiduciary duty for the world as the caretaker of a global currency with virtually no backing by any basket of commodities. Any economist or historian knows that no fiat currency has ever survived.

Figure 1. France and Germany debt forecasts

And over the decades, surely the long run danger and destructive effects of denigrating the world’s currency was clear to everyone. Contrary to the Left’s simplistic argument that it was sociopathic corporations that befouled undeveloped countries, it is the inexorable drip of fiat currency decline that both funds western deficit profligacy and transfers wealth from the domestic and international poor to institutions controlling and benefiting from currency manipulation. This is simple two-dimensional monetary theory, requiring no understanding of percolation or complexity theory. How did anyone holding those fiduciary reins believe this would all turn out? We are determinedly and immorally sucking the world dry.

Our monetary policies do not defend inflation; they fund deficit spending and protect banking institutions. That is their empirical purpose, and that is what technocrats are now struggling to accomplish in the EU. Further, the monetary system as constructed is not modeled after complexity; it is an artificial hierarchical oligopoly with all the single process failure points that entails, pasted on top of complex economies and kept alive by increasing leverage and bailed out by equally non-robust, frail self-serving governments without the will or common sense to reform. We are not watching complexity at work; we are watching unsustainable bureaucracies self-destruct while they force complex economies to foot the bill.

But let us return to the more concrete and foreseeable issue of long term debt. If there was one scenario that politicians and economists and currency manipulators must avoid at all cost, it is currency and debt collapse. This is not one of a possible list of long tail events; it is the big enchilada. Like the Ford motto, this is job 1 for them. This is the ‘do anything at all, but never trash civilization under a mountain of debt,’ thing.

Figure 2. UK and USA long term debt forecasts

Western governments are defying every law of jurisprudence, basic investment principle and financial modeling. They have done so for decades. The numbers are catastrophic. Forget interest rate servicing or monetary policy; debt rollover will soon consume huge swaths of world GDP. That this specter has been on the horizon for so long is a terrible indictment of bureaucracy and political doublespeak.

More immediate debt

The Figure 3 US total debt from Morgan Stanley is enlightening but misleading in at least two respects. First, a more accurate calculation of government debt is as a percentage of tax revenue since it represents the payment stream. Public debt as a percentage of GDP either minimizes the extent of the debt or implies that bankrupt bureaucracies can nationalize the economy to service it. You choose.

Figure 3 US total debt from Morgan Stanley 2

Second, it is the rollover that will kill us. In a total fit of denial, all western governments are shortening their bond offerings as long term rates rise in response to jittery investors. That rollover will engulf world GDP within 20-40 years depending on inputs; sooner if world GDP slides.

From the Black Swan article:

The policy implications are identical: to make systems robust, all risks must be visible and out in the open— fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying.

This quotation almost goes without saying; we must measure what we propose to observe, much less manage. And that is the point; we did measure our debt, and in excruciating detail.

In fact the rise of government, commercial and private debt in the past three decades has been so astounding that it broke into the shallow hard membrane of public consciousness on more than one occasion. That it occurred at all is a wonder given the moral arrogance of New Deal redistribution in preference to real investment and the osmotic effect of simplistic and disproven Marxian tautologies flooding every media and educational membrane.

In addition to the “Avoid debt collapse at all cost” Rule, the increasing ineffectiveness of marginal debt sounded its own metronomic train whistle as it rolled around the bend, its negative slope morphing the economy into a kind of permanently declining debtor’s prison. Maybe the worst part is that unlike Johnny Cash, we did not even shoot our guns; we are in Folsom economic Prison because the economists and policy makers shot theirs. Someone is on that train rolling on down to San Antone. It just isn’t going to be any of the citizenry. Keynes isn’t on that train either, but he is rolling over in his grave.

Figure 4 Declining marginal utility of debt

Now we have benighted politicians telling us that confiscating billions from the rich will substitute for the investment required to pay off the tens of trillions in debt we owe. That may be a good motivating speech for train robbers or inarticulate thugs wronged by the Man, but one has to well and truly jump the mathematical shark to believe it will work for a whole population. Worse, the sound bites clutter the airwaves and distract from adult conversation.

Contrary to the implications of the Black Swan article, the story of the last two decades has been of bureaucracies increasingly ignoring the ever louder chorus of objections coming from its citizenry as it barreled and tooted on into inconceivable territory. In a stupendous example of crowd wisdom, there is very real evidence that the American citizenry has been voting for a more constrained government since Jimmy Carter, and throwing out every party since that disappointed them.

The issue is not that the financial crisis was not foreseeable; lurking in some Power law tail, but that the enormity of the path we were on was allowed to continue. Even barring the benefit of hindsight, there is no rational argument to be made for accumulating these debts without drastic Fed increases in interest rates and screaming from the roof tops.

We can only surmise the thoughts of some of our experts lying in bed at night, wondering how this nightmarish scenario could keep going on without collapse or staggering inflation. We imagine a succession of mad Fed economists and academics thinking, “I know, we’ll replace long term investment with currency devaluation, leverage the hell out of it, and then recompense the poor we are ripping off by supporting all manner of tax redistribution schemes. Yeah. Yeah. That’ll do it.” What a load of malarkey. When Mr. Greenspan, perhaps the biggest market manipulating wolf in free market (i.e., read complex system) sheep’s clothing in history, announced that the business cycle had finally been tamed, was he making a statement or asking a nightmare induced question midst a reality he no longer recognized as sane?

Consider the landscape. With a dedication only Asians could muster, Japan has been putting the lie to Keynes for decades. How deeply entrenched in a Kubler-Ross induced denial does one need to be to argue Japan did not provide enough stimulus; their infrastructure alone is now a structural income stream for the Yakuza. Meanwhile, marginal debt utility was tanking even while over-leveraged firms required more subsidy. Especially in an artificially induced oligopoly, does any of that sound top-heavy to you?

Did the best economists and bankers in the world really believe we had reached a new nirvana, as the long glacier of debt insolvency approached? After all, insolvency is the harrowing and inevitable end of the two-dimensional financial structure we built; always has. Oligopoly is anything but robust, or duplicative or complex. We all know that.

When house prices exploded out of all historical precedent while unaudited GSEs bought up half the mortgage market and off-Balance sheet entries made financial statements unreadable (remember the quotation), where was the gnashing of teeth in our institutions? Anyone with even a passing regard for market efficiency knows those ideas are silly. Don’t we? Here on Main St. the teeth chattering was loud and clear and sustained and frustrated.

When Basil increasingly allowed both higher bank leverage and incestuous backstops to increase risk and interdependence, where were the legislators and financiers and auditors? Large bank assets have grown from single digit percentages to over 200% of GDP in less than 50 years. When capital requirements are waived on bonds that prop up unfunded liabilities in preference to a pyramid scheme of tax flows, citizens might well ask who is watching the store. Did our leaders suppose we could ignore CAPM just because we decreed it? Sounds like something Nero would do. If our institutions are bent on aiding and abetting a banking system that would be inoperable or illegal in any other industry, we do not have a problem with complexity; we have a problem with bureaucracy and special interest.

Perhaps it should not be surprising that in a fit of sympathetic pique, our professional institutions followed the baby and the bathwater out the window by allowing auditing and legal regulation to devolve into nothing but ‘Get out of Jail Free’ cards. It is becoming very difficult to argue that those hard won degrees represent anything but a tax on society. Lehman, Dexia, MF Global, Madoff, Enron; choose your favorite example. The list is long and as the mess gets deeper, it will get longer faster. There is no effort to change the circumstances that prevent it.

Lessons learned

More than 3 years and trillions of monetary and fiscal injection later, our decidedly non-complex legislature produced regulation which solves neither linear nor complex issues. We also have:

• a significantly poorer generation,
• private debt load that has moved hardly an inch,
• trillions in assets stagnating the economy and prolonging unemployment because it prevents market clearing,
• transferred billions of fixed income from retirees and investors to banks,
• skyrocketing public spending in the face of a negative multiplier.

None of this activity principally aids a complex market recovery, including jobs. All of this activity saves oligopolistic banks and prevents their haircuts and failure. The toll on the complex economic system will be felt for decades. That is the cost of TARP. When symbiotic, artificial institutions cannot imagine a world without them, you know we are in trouble.

When it comes to the financial collapse, the real lesson has less to do with complexity than bureaucracy. Did we really need an historic collapse to learn that institutions and bureaus almost immediately find their first priority is self-preservation (that may be the understatement of the decade)?

And the lessons of Milgram on inactivity and compliance in hierarchies are frightening ones. We are watching bureaucracies across western civilization race to the bottom; the party system is just the puppet show out front. Even now, on the eve of terrible and excruciating reformation, the discussion is firmly centered on saving the monopolized system rather than saving nations.

There is no Superman of bureaucracy. There are no rules or regulations that will prevent failure or negate investment on our road to prosperity that we do not already know. Our institutions have just consistently rejected them. After all, leverage and redistribution is much easier than successful investment. In a complex system, these bureaus would have died and been replaced by their betters long ago.

Complex societies and economies have given up some of their complexity in return for monopolistic bureaucracies that promise added stability. They have responded by injecting unsafe and unsound monopolies into every facet of our lives. They have over-promised and under-delivered in virtually every succeeding invasion of society’s complex fabric. They have caused every recession in the last hundred years. They are destroying our civilizations with debt pyramids. We need to rebuild our institutions from the ground up, with simpler, more conservative rules we can follow with clarity.

Lately, many folks have begun to consider Option ‘B’: functionally dismantle those institutions altogether and rebuild them within smaller communities where their bureaucratic over-reach can be more effectively squashed. As currently comprised those bureaus are adding little or no net value whatsoever. And the people know it; the foundational issues of the OWS movement were the same as for the Tea Party. How OWS concluded the answer to oligopolistic bungling was even more bureaucratic control and less complexity is a dismaying argument for dismantling public education altogether and allowing market complexity to handle it. All of which brings us back to the beginning; in agreement with Mr. Taleb and Mr. Blyth.

The Black Swan: Second Edition: The Impact of the Highly Improbable: With a new section: “On Robustness and Fragility”by Nassim Nicholas Taleb

[1] Stephen Cecchetii, Madhusudan Mohanty, and Fabrizio Zampolli, The future of public debt: prospects and implications(Bank for International Settlements, March 2010), http://www.bis.org/publ/work300.htm.

[2] Morgan Stanley Research, The statistical history of the United States.

Interviews with Robert Zoellick, President of the World Bank

September 9, 2009

Precis: The world is a complex place subject to various influences. For instance, China is cutting back on credit, which will have a dampening effect. Developing nations could provide help in the recovery, which although has begun, is still fragile and likely to be slow.

Lastly, the World Bank remains dedicated to hiring diversity.

July 10, 2010

Precis: Recovery is still fragile fraught with risk. Developing nations continue to be impacted. His job is to identify risks and make them public. Stimulus amounts in the USA were reasonable, but we must remember that it always takes much longer to execute these plans than people might imagine.

The dollar will remain the reserve currency. Despite countries like Russia and China lamenting their hostage situation, it is partly their choice which currencies they hold. Likewise, as the reserve currency, it is incumbent upon USA to follow prudent fiscal policy.

Commentary

It is always immensely interesting to listen to the heads of large states.  Besides the required diplomacy, it is an almost universal truism that his words are defined by the size of the institution.  Complexity inherently questions the ability of such a bureaucracy to solve grave issues.  They are by their nature anything but creative or adaptable.  They are inherently the product of immense political and special interest, bound by their mandates.

Bill Gates, with access to his own fortune, and much less bound by self-interested constituents, is much better situated to try and fail and try something new.

Lastly, complexity predicts that like ant colonies, the World Bank’s trillions of dollars would be put to much more effective use by self-organizing smaller groups trying and failing and learning from each other.  The monolithic bureaucracy is by its nature anything but adaptive or evolutionary, and any effective development solutions are bound to be the result of successive iterations built on thousands of errant attempts.  Besides, economies and markets are local.  You know, that is where the autonomous ant resides.

There will be more to say about that for readers confused about its implications to the economic crisis and banking reform.

An Age of Paradox

We live in an age of paradoxes of which we never speak:

• The best example of free market capitalism in the world today is in China, corruption notwithstanding, where the government long ago exchanged its murderous Maoist philosophy for Deng Xiaoping’s version of Adam Smith. They’ve driven the world economy ever since. Meanwhile OECD countries, espousing free markets, rely heavily on a cartelization of government and big business to manage the ‘competitive’ economy.
• Socialism has been attempted in virtually every country in the western hemisphere and in less than a hundred years is bringing every one of them to a crashing economic failure not seen in a thousand years, yet even in the USA it remains an ever tempting idea we are bound and determined to try.
• Americans take great pride in their belief in ‘free markets’ and yet think nothing of the idea that a group of bankers and economists can manage interest rates and the economy. Worse, when the economy fails, we blame the markets.
• As we stand in the trough of what is already the worst recession since the 1930s, when the Government / Fed / banking cartel has failed us the most, we are considering an even higher level of regulation and government intervention as the answer, instituted by the very people who built the cartel in the first place. The mind boggles.
• It remains beyond comprehension that believers in evolution do not condone or nurture the benefits of competition. What a strange predicament that religious espousers of intelligent design tend to be the last bastion for free markets.
• Amid these strange days, it is probably not so surprising that the triumvirate of bankers, economists, and government have brought us to our knees once again. Although we scoff at the idea that Russian central planning could never work, we still tend to think that politicians can deliver us to the promised land of economic well being and that the brilliant duo of Clinton and Greenspan were responsible for our past glory days. If our failure is due to markets, how is it possible to believe the success of the other?

The Failure of Economists

Only a very small percentage of economists predicted the collapse of the global financial markets. It is noteworthy that they are all shunned by mainstream government employed economic theorists. Notice none of them are consulted on fixing the mess.

Likewise, no one is talking institutional measurement and delivery structure failure. The Fed and government spend hundreds of millions of dollars per annum predicting economic risk yet missed the largest collapse since the Great Depression. Bernanke was minimizing the fallout even while the whole house burned. Doesn’t that mean the underlying theory is foundationally incorrect? For it is also true that despite the increasing complexity of the economy, there are relatively few variables which can plunge the economic engine into recession, and these variables remain at the heart of each and every economic collapse; monetary policy and government distortion of fractional reserve banking risk. These are the only two. No industry in a free market can cause a recession. Period.

Now we are told that adjustments to the banking engine will soon begin yielding the soft, rich earth of a vibrant economy.

We Can’t Understand the Financials

But the actual economic risk is almost impossible to estimate partly because hundreds of trillions of dollars of derivatives aren’t even on Bank Balance Sheets. The FASB has long ago abdicated its fiduciary duty. Current derivative contracts equal approximately $590 trillion (down from $690 trillion before the collapse), with a net total exposure of about $60 trillion, which equals world GDP. Goldman Sachs, JP Morgan, Bank of America and WTC hold about $200 trillion. We won’t be seeing any of those banks fail.

The government has an unfunded liability of $65 trillion and rising. The Fed has injected $12 trillion into the economy since the crisis began. And the ARM and commercial real estate markets have yet to reset and each are larger markets than the sub-prime fiasco.

Somewhere in here we must question whether transnational standards are a good idea at all.  Surely if everyone follows the Basil Accords, its weakness (and every regulation has weakness) is transmitted across the whole G20.  It is interesting to note that Canada, which retained its own more stringent regulation in the midst of Basil, didn’t require any bail-outs.  Their banks came through the mess relatively unscathed, and somehow predominantly chose not to play in the mortgage backed securities markets.  How did they come to that conclusion?  Some American banks like BB&T (America’s ninth largest bank) also chose not to play.  Strangely, none of them were consulted on remedies; only the failing banks got in on the discussion, and some of their managers, like Paulson and Geithner, are key political appointees.

The Over Worked Engine

We know some things which are ultimately unsustainable; the government is attempting to run a $15T economy on a Ponzi scheme of taxes without saving for a rainy day even their Keynesian socialist icon postulates. And the Fed backed GSE / banking industry is inherently ignoring market risk by calculating inter-bank loans as capital on an already over leveraged deposit base. No amount of assurance by the bankrupt FDIC can make us depositors feel better about that. That the IMF considers Pigouvian taxes a ‘fix’ is absurd.

There is a growing sense that our banking and monetary policies have exacted a terrible cost on America’s and the world’s poor. Maybe the political and powerful are much more inept holding the economy’s tail than previously considered. Perhaps it is impossible to fix the engine by playing with its parts. Perhaps leveraged central planning can’t work after all, just as our Founding Fathers warned.

The American dollar has been the world’s de facto gold replacement since 1971. You can still walk down a dog track to a small village in Bolivia, Thailand or Moldova, and purchase lunch in American dollars.  And except for these foreigners holding our currency, our dollar would have crashed long ago.

It appears the world is waking up; India just purchased 200 tons of gold from the IMF, and other governments are lining up behind them. Who can blame them for being a little worried as we decimate every market we see? We know one thing; if the implosion of commercial real estate collapses the banks again in the next year or two, we’ll have 35% unemployment and looting in the streets no matter what the economists think.

References

Kling, Arnold. “The Root of the Financial Crisis.” The Hoover Institution, December 1, 2009. http://www.hoover.org/publications/policyreview/72903637.html.

Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse Thomas E. Woods Jr.

End the Fed Ron Paul

From GATA (Gold Anti-Trust Action Committee):I love this line in the article: “Poisoned food and toys for fraudulent securities” We get faulty products. They get worthless paper. What could be fairer? Here are some snippets of the article:

Politicians, regulators and financial specialists outside the United States are seeking a role in oversight of American markets, banks and rating agencies in the wake of recent problems related to sub-prime mortgages.Their argument is simple: The United States is exporting financial products, but losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks.“  We need an international approach, and the United States needs to be part of it,” said Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg. While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia have more leverage this time around. Washington might have to yield if it wants to succeed in imposing bilateral regulations on state-owned investment funds from emerging economies.“  America depends on the rest of the world to finance its debt,” Bofinger said. “If our institutions stopped buying their financial products, it would hurt.” Banks and investment funds from China to France were recently hit with heavy losses after buying mortgage-related securities and complex financial products originating from the United States.  In many cases, investors were caught by surprise because American rating agencies gave the products top ratings, leading buyers to believe there was little risk.  International investors are also asking why American banks were allowed to give mortgages to home buyers who could not repay them. The Chinese central bank said Tuesday that it was moving to standardize information disclosure of all asset-backed securities as it expands its own market for these financial instruments.  Information about loans, terms and borrowers will need to be included in any new securities that are introduced in China, it said.“  It’s not just the U.S. regulators that failed, though they did fail,” Rosner said. International banking regulators have “thrown the keys to the rating agencies,” which have been left in charge of the safety and soundness of bank capital, insurance and pension money.

Free and fair trade: Poisoned food and toys for fraudulent securities | Gold Anti-Trust Action Committee

August 31, 2007

There’s little doubt a major part of the problem has been that foreign banks and institutions have been buying these products almost mindlessly, based on rating agency risk assessments that were absolutely wrong.  The major fault with the global credit crunch between banks now is that no one knows where the default risk really lies.

Question: When you get a $20M bonus for selling CDO’s, but they all go bad and help a create a global credit morass, do you have to give your money back?

Answer: Of course not.  But governments will step in and help clean up your mess.