Reintroducing a margin of safety into capitalism
Posted on March 27, 2009 by Richard Beddard
Filed Under Investing, Ramblings |
No more flying by the seat of the pants
First, I’m sorry about the lack of posts this week. I’m working on bringing you the Thrifty 30 and the next few weeks might be a bit light too.
The concept of ‘Margin of safety’ is well known to value investors who try to pay less for companies than they judge the companies are worth in case they are wrong or the stockmarket tanks. The lower the price, the bigger the margin of safety, and the more likely the investor is to get a good return.
In this interview Nassim Taleb, a maverick professor of finance and options trader, seems to be saying that there was not enough margin of safety in Capitalism. Complexity (complex derivatives) plus efficiency (transactions happen very fast) plus leverage equals danger. He’d ban the complex derivatives and reduce debt:
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.
Capitalism 2.0 should include a margin of safety. He calls it redundancy. You might also call it ‘room for error’:
A deleveraged financial system is a stable one, especially if we increase the redundancy within the system. That’s an idea Taleb has taken from biology. But in finance, redundancy means two things: not having players in the game who are “too big to fail” and not allowing anyone—from the individual to the institution—to play with too much money. Redundancy means have cash on the side, not risking it all, and not becoming dependent upon financial assets for your economic well-being.
Smaller banks, less debt, cash on the side, working for a living. It all sounds a bit like I imagine capitalism was in the good old days, Capitalism 0.0, maybe.
It contrasts with Robert Shiller, less of a maverick but still radical for an economist, who’d enable the widespread use of derivatives to protect people from the vicissitudes of the market. According to this view, derivatives and debt are like a gun, only dangerous in the wrong hands.
Comments
6 Responses to “Reintroducing a margin of safety into capitalism”
Leave a Reply
Hi Richard,
Thanks for that excellent summary of the interview with Nassim Taleb. That must be the first time where Taleb actually made sense and offered a good solution.
Now he just needs to back this up with a bit of math (and not vague talk) to demonstrate how adding slack to the system will actually make things more stable. He could even write a paper with a catchy name like:
“The Fractal Geometry of Badly Behaved Markets”
Or
“The Resonant Frequency of Financial Systems”
(Apologies if these names are already in use
)
Anyway it does not surprise me that the bankers are not interested because any system like this would give them far less profits to cream off. Even now, those bankers are so unbelievably greedy, creaming off all that government money in the form of ‘margins’, giving them record profits in 2009 and saying they need even more money (although they cannot seem to lend out the last lot).
It is important to target the correct debt with any new control system and also any financial rescue package. As I mentioned to you recently, I think that consumer debt is far more destructive to company profits than company debt.
This is demonstrated by the relationship between ‘turnover’ and ‘operating profits’. If turnover is 100M and operating profits is 10M then you only need consumers to stop spending by 10% (directly impacting turnover) to completely wipe out your profits.
I suspect that government debt will be far more destructive than consumer debt ultimately. And the combination of government debt and consumer debt might prove fatal (Gordon Brown and Barak Obama beware!).
Therefore I personally feel that a government policy to directly buy up (and write off) consumer debt would be far more effective than trying to simultaneously increase consumer debt and government debt through the banks.
I would rather that happened than the current, utterly insane, methods which are needlessly enriching the banks and the super-rich, and do not seem to be working in any case.
Reintroducing a margin of safety into capitalism : Interactive Investor Blog…
Nassim Taleb says that volatility resulting from both debt leverage and a hyper-efficient system is just too great….
Hi Robin,
I’m wondering if I’ve been wrong about Taleb (well not wrong exactly, but just unable to get past his imperious tone - perhaps I shall just have to force myself).
I think the title of your proposed book is The (Mis)Behaviour of Markets but it was written by Benoit Mandelbrot
If the Government buys consumer debt, where does it get the money from? Ultimately aren’t government debt and consumer debt the same? We pay the former off with higher taxes or higher inflation or both. We pay the latter off with interest.
Hi Richard,
The problem with debt is that it tends to get pigeon holed (using various legal frameworks) and then resold as something else.
So, if we say that the government has debt G and tax payer has debt C, then the total debt liability to the tax payer is actually C + G as they will ultimately pay for G (through taxes and increased interest rates).
Now suppose the government take on new debt T, which they want to give to their buddies, the banks, to try to make them increase lending.
So now the tax payer is not just liable for C + G + T but if the banks do finally lend out the money then the debt liability is C + G + T + T! Even worse, the banks may try to leverage up the money so you will eventually give the tax payer a burden like
C + G + T + 10T.
This level of ‘perceived’ debt is bound to make the tax payer want to reduce C (the only thing they control) and not spend anymore. The problem is that it is hopeless because C is just too big. It will take years at current salary levels. During this time, people will be less productive and the world growth will stall.
However, if you can reduce C directly and permanently then you will effectively be trying to restore things to a level playing field again for everyone, where the amount of debt and the price of houses reflect people’s actual salaries.
One way to reduce C is to give the banks the money T in exchange that they permanently write off their loans by some significant amount X (where X is much bigger than T). The size of X will be whatever is needed to allow a sustainable recovery.
Now peoples perceived debt liability is
(C – X) + G + T
X is big e.g. 1 / 2 of C.
This is a lot smaller than
C + G + T + 10T
And cost the same.
The key is to get consumers confident and spending again so that company turnover can be restored.
Finally, it is utterly wrong that the banks own mortgages that are far bigger than a vast number of people can afford to pay back (especially as they have taken their deposit and their interest payments already). It is time to acknowledge that mistakes were made and a clean slate is needed. You cannot, on the one hand, say the banks were wrong but still try to help them out of their mess and on the other hand, say that it was the tax payers own stupid fault for taking out debt they could not handle. Leveraged debt (in all its many forms) ultimately caused this problem and now we need to use another form of leverage (in the form X/T) to set it right again.
A final footnote; the US government have just allowed the banks to drop their ‘mark-to-market’ rules.
This means that they can now price their assets based on the ‘expected’ future cash flows (where some cash flows will need to continue for 50 years to actually pay back the loan).
In other words, they can now say that their assets are no longer based on the 200K house but on the 400K mortgage that was taken out by the ’stupid’ tax payer on the 200K house.
Now, if only they can keep unemployment below 8% they should be okay…
[...] Philosopher trader Nassim Nicholas Taleb publishes his ten principles for a black swan proof world, aka Capitalism 2.0. [...]