Black Swan Free World (5)
On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…
5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.
Complexity gets away from us very, very quickly. And at the same time, we may spend so much time worrying about the complexity, building very complex models to deal with the complexity, that we lose sight of the basics. So Complexity can hurt us both coming and going.
So why do we insist on Complexity? That at least is simple. Most complexity exists to provide differentiation between financial products that otherwise would be pure commodities. The excuse is that the Complex products are needed to match up with the risks of a complex world. Another, even less admirable reason for the complexity is to create something that sounds like a simple risk relief product but that costs the seller much less to provide, by carving out the parts of the risk relief that are more expensive but less desirable or less well understood by the customer.
Generally, customers who are buying risk relief products like insurance or hedges have a simple objective. If they have a loss they want something that will make a payment that will offset the loss. Complexity comes in when the risk relief products are customized to potentially better meet customer needs. (according to the sales literature).
Taleb suggests that complexity also hides leverage. That is ver definitely the case. For example, a CDS can be replicated by a long position in a credit and a short position in a treasury. A short position in a treasury is finance speak for a loan at a better rate than you can actually get. And a loan is leverage. THe amount of the leverage is the full notional amount of the CDS. Fans of derivatives will scoff at the idea that the notional amount if of any interest to anyone, but in this case at least, anyone who wants to know how much leverage the buyer of a CDS has, needs to add in the full notional amount of all of the CDS.
Debt bubbles are vicious because of the feedback loop in debt. If one borrows money to purchase an asset and the asset increases in value, then you can use that increased value as collateral to increase the debt and purchase more of the asset. The increase in demand for the asset causes prices to rise and so it goes.
But ultimately the reason that may economists have a hard time identifying bubbles (other than they do not believe that bubbles really ever exist) is that they do not know the capacity of any asset market to absorb additional investment. Clearly in the example above, if there is a fixed amount of the asset that becomes subject to a debt bubble, it will very, very quickly run into a bubble situation. But if the asset is a business or more likely a sector, it is not so easy to know exactly when the capacity of that sector to efficiently use additional capital is reached.
Explore posts in the same categories: Black Swan, Correlation, Debt, Equity Risk, Financial Crisis, Hedging, Leverage, Profits, Risk, Risk Management, Uncertainty, Unknown RisksTags: Risk
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