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.
Critics like the Occupy Wall Street demonstrators decry the bonus system for its lack of fairness and its contribution to widening inequality. But the greater problem is that it provides an incentive to take risks. The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accumulate in the financial system and become a catalyst for disaster. This violates the fundamental rules of capitalism; Adam Smith himself was wary of the effect of limiting liability, a bedrock principle of the modern corporation.
Tagblack swans
Nassim Taleb “lowers” himself to doing journalism and writes at the Huffington Post:
The story is as follows. Last year, in Davos, during a private coffee conversation that I thought aimed at saving the world from, among other things, moral hazard, I was interrupted by Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States, who tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and Prof. Blinder’s company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.
I blurted out: “isn’t this unethical?” I was told in response, “We have plenty of former regulators on the staff,” implying that what was legal was ethical.
He goes on to note:
The more complex the regulation, the more bureaucratic the network, the more a regulator who knows the loops and glitches would benefit from it later, as his regulator edge would be a convex function of his differential knowledge. This is a franchise. (Note that this franchise is not limited to finance; the car company Toyota hired former U.S. regulators and used their “expertise” to handle investigations of its car defects). […]
The more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.
He doesn’t offer any remedy, but it does make more clear something I’ve been wondering about since I started following him: on the one hand, he calls himself a libertarian and skewers regulators, and on the other he says stuff like this:
Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.
I’ve always wanted to ask him about this apparent contradiction: who exactly is supposed to do this banning of derivatives and why should they be trusted? This article gives some clarity: he thinks there should be rules, but they shouldn’t be overly complex, because that breed corruption.
The idea that we should have hard and fast, clear rules as opposed to “regulation” is supported by the failure of the SEC’s revision of certain firms’ debt-ratio requirements. From Reason:
In 2004, the international Committee on Banking Supervision issued Basel II, an accord on banking regulation. In its wake, the SEC revised its regulations to allow five broker-dealer firms with more than $5 billion in capital—Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley—to participate in a voluntary program that changed the way their debt was calculated. The existing net-capital rules required firms to keep their debt-to-net capital ratios below 12-1 and to issue warnings if they started to get close to that. Under the new rules, broker dealers increased these ratios significantly. Merrill Lynch, for instance, hit 40-1. This was possible because the rule changed the formula for risk calculations and instituted more subjective, labor-intensive SEC oversight in place of hard and fast guidelines. “They constructed a mechanism that simply didn’t work,” former SEC official Lee Pickard told The New York Sun on September 18. “The SEC modification in 2004 is the primary reason for all of the losses that have occurred.”
So I’m guessing Taleb draws a line between banning a practice and “regulating” it – and between having rules that banks must follow and “regulating” them. It’s an interesting distinction and I wonder what other self-styled libertarians would think about it.
Taleb also notes how the debate over government and regulation goes back to Ancient Greece at least – which is a discouraging reminder that almost any modern debate we have on almost any subject goes back for centuries. It’s enough to make you want to live in a bathtub and nourish yourself onions.
Worst-case thinking means generally bad decision making for several reasons. First, it’s only half of the cost-benefit equation. Every decision has costs and benefits, risks and rewards. By speculating about what can possibly go wrong, and then acting as if that is likely to happen, worst-case thinking focuses only on the extreme but improbable risks and does a poor job at assessing outcomes.
Second, it’s based on flawed logic. It begs the question by assuming that a proponent of an action must prove that the nightmare scenario is impossible.
Third, it can be used to support any position or its opposite. If we build a nuclear power plant, it could melt down. If we don’t build it, we will run short of power and society will collapse into anarchy. If we allow flights near Iceland’s volcanic ash, planes will crash and people will die. If we don’t, organs won’t arrive in time for transplant operations and people will die. If we don’t invade Iraq, Saddam Hussein might use the nuclear weapons he might have. If we do, we might destabilize the Middle East, leading to widespread violence and death.
Of course, not all fears are equal. Those that we tend to exaggerate are more easily justified by worst-case thinking. So terrorism fears trump privacy fears, and almost everything else; technology is hard to understand and therefore scary; nuclear weapons are worse than conventional weapons; our children need to be protected at all costs; and annihilating the planet is bad. Basically, any fear that would make a good movie plot is amenable to worst-case thinking.
The other extreme is militant positive thinking. The modern condition seems to be a constant fluctuation between these two extremes: irrational fear and irrational optimism.
Barbara Ehrenreich, author of Nickeled and Dimed, has a new book out called Bright-sided: How the Relentless Promotion of Positive Thinking Has Undermined America. It sounds fascinating. She was on Democracy Now this morning:
BARBARA EHRENREICH: OK. This book could be called, you know, “What I Learned from Breast Cancer to Help Me Understand the Financial Meltdown.”
But I was diagnosed about eight years ago and started reaching out, as you would do, naturally, to find support and information on the web and all that sort of thing. What I found was very different. What I found was constant exhortations to be positive, to be cheerful, to even embrace the disease as if it were a gift. You know, if that’s your idea of a gift, take me off your Christmas list, is my feeling. And this puzzled me. But it went along with the idea that you would not get better unless you mobilized all these positive thoughts all the time, which, by the way, I’m happy to tell you, there’s nothing to that. I mean, there’s been sufficient scientific research now that we know that your mood does not, you know, dictate whether you will get better or not. But, you know, imagine the burden that is on somebody who’s already suffering from a very serious disease, and then, in addition, they have to worry about constantly working on their mood, you know, like a second illness.
AMY GOODMAN: So, talk about the research. I think that’s going to surprise people, what you just said. I mean, years ago, you were in biology. You were at Rockefeller University.
BARBARA EHRENREICH: Oh, yeah. No, I—and here it finally came in useful. I think there’s a widespread idea—it sounds so familiar that, you know, you would, you know, just let it go right by you—which is that your immune system will be boosted if you are thinking positively. Well, there’s not a whole lot to that. There’s not a whole lot to support that. And furthermore, more to the point here, it’s not clear that the immune system has anything to do with recovery from cancer or with whether you get it in the first place. Now, I had—I guess I had kind of accepted those things, too. But that is the ideology, though, that you find in so many other areas of American life, too, that if you—you can control things with your mind, if you just have the right thoughts and attitudes. There is nothing in the material world that’s causing your problem; it’s all within you.
SHARIF ABDEL KOUDDOUS: And how did this ideology, this positive thinking movement, become so pervasive in American society? You document its rise in the culture.
BARBARA EHRENREICH: Yeah, well, I go back to the nineteenth century, because I’m always interested in history. But it really began to take off in a very big way in about the ’80s and ’90s, because the corporate world got very interested in it, got interested in it during the age of downsizing, because it was a way to say to the person who was losing his or her job, just as you would say to the breast cancer patient, “This is in your mind. You know, you can overcome this. If you—if something bad has happened to you, that must mean you have a bad attitude. And now, if you want everything to be alright, just focus your thoughts in this new positive way, and you’ll be OK.”
I can’t tell you how many times I have read people who have lost their jobs in this recession in the newspaper saying, “But I’m trying so hard to be positive.” Well, maybe there’s no reason to be positive. Maybe you should be angry, you know? I mean, there is a place for that in the world.
She seems to have had a busy day: she also appeared on Talk of the Nation today. NPR has the interview, and excerpt from the book.
See also:
Think Negative! Oprah, it’s time to come clean about The Secret
How to Be Lucky and Be a Survivor
Previous posts tagged happiness and depression.
Easier said than done:
My whole idea is to lower risk in society by developing a system that can resist human error, rather than one where human error rules. The first step is to make sure that no financial institution is too big to fail. Next, make sure governments don’t favour big companies. Governments should also decrease the role of economists – they’re no more reliable than astrologers, and they do more damage. […]
My advice is that instead of investing in medium-risk securities, you should put most of your money in very low-risk securities, and a little bit in high-risk securities. Then you might get a good black swan. Also, it’s good to have more than one profession, in case your own profession goes out of style. A Wall Street trader who’s also a belly dancer will do a lot better than a trader who winds up driving a taxi.
Globe and Mail: We still have the same disease
Note: article contains error, Black Swan was published in 2007, not 2008.
Peter Schwartz of GBN suggests there’s “a high likelihood” of a global food crisis due to commodity speculation and the potential for a bad rice season.
Schwartz, however, is quick to point out that he’s not stating unequivocally that there will be a food crisis. “Our goal is to do scenarios and look at the uncertainties and the elements that could surprise us … We’re not predicting a food crisis, but (saying) that we are vulnerable to it,” he told INSEAD Knowledge following a lecture on ‘Emerging Strategic Issues and Wildcards’ at Singapore’s Civil Service College.
So how can we better prepare ourselves from unpredictable ‘black swan’ events which would have a major impact? Schwartz believes the answer is to think the unthinkable. That involves considering possibilities that are outlandish, implausible but highly consequential. The Asian tsunami, he says, is a prime example of such a black swan event whose impact could have been reduced somewhat had the right questions been asked.
Insead: Planning for the unthinkable
(via Kristin Wolff)
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