May 17, 2011
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This essay is excerpted from the most recent version of The Credit Strategist (formerly the HCM Market Letter). To subscribe directly to this publication, please go here. The Credit Strategist is on Twitter - @credstrategist
“Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to ‘Black Swans’ – that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.”
Nassim Nicholas Taleb and Mark Blyth1
The dominant economic and political policy regimes followed by the United States over the last 30 years are profoundly flawed. That is the argument made in an important new article in the new issue of Foreign Affairs (“The Black Swan of Cairo,” May/June 2011) written by Nassim Nicholas Taleb and Brown University political scientist Mark Blyth. Rather than confronting sources of volatility, policymakers have sought to smooth out volatility at all costs. Unfortunately, these costs are proving to be very high and will ultimately prove prohibitive. Pressures build inside complex systems until they can no longer be suppressed. When these pressures can no longer be contained, they tend to erupt with far greater violence than had they been allowed to adjust earlier. In complex, non-linear systems such as human societies and economies, the only way to achieve stability is by tolerating some volatility. Attempting to micro-manage away recessions or regime changes is an approach that is not only damned to backfire but ends up increasing both the probability and intensity of such events.
It is a deep-seated human tendency to delay imminent pain at any cost. We see this phenomenon at every level of human life, from the relationships and partnerships in our daily lives to the larger systems that govern society at large. Ignoring or suppressing economic imbalances, political dissent or personal differences is doomed to failure because it ignores the symptoms while allowing the underlying disease to flourish. Under the current risk management paradigm, however, measures taken to prevent these events from occurring, or minimizing the damage they cause, end up perpetuating the underlying conditions that require adjustment. Human existence is prone to unexpected events. These events are “unexpected” because they occur with low statistical frequency, but they are certain to occur from time to time. Rather than avoiding these events at all costs, we must accept that they will occur and build systems that can absorb them and minimize their damage.
The global financial crisis was largely caused by efforts of the world’s dominant central bank – the United States’ Federal Reserve – to prevent recessions at all costs by maintaining artificially low interest rates for unduly long periods of time (something it is doing again right now). Mssrs. Taleb and Blyth argue similarly that revolutions in Tunisia, Egypt, Libya, Yemen and Syria were largely the result from years of Western governments – and in particular the United States – coddling tyrants rather than confronting them. While there were certainly other factors at work in the Middle East – among them the advent of the Internet that exposed young populations in Arab states to the appeal of democracy – it is now apparent that permitting autocrats like Mubarek and Khaddafi to remain in power was doomed to failure. The application of the “Black Swan” theory to politics is compelling and places American foreign policy in an important new light. While policymakers have acted at all costs to prevent short-term crises, they have failed to absorb the lesson that the long-term effect of such measures is to exacerbate crises when they inevitably occur. Rather than reducing risk, modern risk-management ends up increasing it. Put another way, too many white swans inevitably end up breeding black swans. And we all know what big birds can drop on us while flying overhead.
The economy would be far more stable and productive had Alan Greenspan been a student of Hyman Minsky rather than Ayn Rand. Mr. Greenspan tried to eliminate booms-and-busts by adjusting interest rates downward (or otherwise increasing systemic liquidity) every time the economy slowed. Or course, all he ended up doing was insuring that boom-and-busts would proliferate. The so-called “Greenspan put” (which has been perpetuated – perfected even – by the current Federal Reserve Chairman Ben Bernanke) convinced investors that the Federal Reserve would bail them out if the economy or the markets got into serious trouble. As a result, investors engaged in increasingly reckless behavior because they believed they would be protected from the worst consequences of their behavior. It was precisely this reaction to Mr. Greenspan’s repeated bailouts that increased the likelihood of their necessity. Had Mr., Greenspan acted differently and forced the system to discipline itself, investor behavior likely would have been more responsible. Rather than saving the markets, Mr. Greenspan’s philosophy and approach guaranteed their failure.
It is precisely because imbalances have been suppressed for so long that the global economy is now so fragile. When the suppression of imbalances collapsed in the financial crisis of 2008, policymakers doubled down on their smoothing approach rather than realizing that it was the underlying cause of the problem. While certain emergency measures were necessary to prevent a complete collapse at the height of the crisis, policymakers extended these measures far longer than necessary. In retrospect, the Federal Reserve’s interminable zero interest policy and its quantitative easing programs are likely to be seen not only as ineffective but damaging to the prospects for sustainable long-term economic growth. As noted below, a number of asset classes are beginning to exhibit bubble-like behavior, something that would be far less likely to occur were interest rates normalized. Recessions are not depressions, and there are far worse things in the world than negative economic growth when an economic slowdown is exactly what is needed to absorb overcapacity and other imbalances.2
Experienced observers understand that the longer it takes for an imbalance to be corrected, the more violent the correction is likely to be. In the financial markets, the best investors are those who incorporate this understanding into their strategy. Today the world is facing a number of severe imbalances that will ultimately have to adjust, with serious market repercussions. Two of the most important such imbalances are the build-up of unsustainable debt levels in major Western economies and the rapid exhaustion of many of the world’s key natural resources. The longer policymakers delay in confronting these imbalances, the more volatile and destructive their corrections will be. The current regime of risk management and policymaking must be changed to insure that the mistakes of the past will not be repeated.
While the economy has stabilized, growth is sluggish. The economic data has taken the form of one-step-forward and one-step-backwards, which is better than one-step-forward and two-steps-backward but still disappointing. The trillion dollar question remains what will happen when QEII ends at the end of June. The government has been the largest purchasers of Treasuries, promulgating a Ponzi scheme of unprecedented scale. In recent day, Treasury rates have dropped further with the 10-year bond dropping to the 3.25 percent range from the 3.50 percent range that many expected to be its low for the rest of the year. This price action suggests that the markets have profound doubts about U.S. economic growth for the remainder of the year.
The thesis that the United States is experiencing a self-sustaining recovery is going to be tested shortly. In particular, higher energy and food prices are likely to retard consumer spending and economic growth. The most recent unemployment report, which showed an unexpected increase in claims to 474,000 (the highest level since last August), is being chalked up to statistical anomalies. We would ask why the media and government spokesmen don’t chalk up positive reports to similar anomalies, but we already know the answer. All of the government’s numbers on employment are statistical approximations; they are most useful in showing trends, not actual numbers. Accordingly, the four week moving average has moved back up to 431,250, the highest since November. This should disturb even the most bullish among us.The April job figure mercifully showed an increase of 244,000 jobs (including 268,000 new private sector jobs and 24,000 fewer government jobs), although 175,000 of these jobs were created by the birth-death model rather than by the economy. The number of Americans who have been jobless for more than six months also declined by 283,000, although the long-term unemployed still comprise a high 43.4 percent of the jobless army. There was other disappointing news as well. The unemployment rate returned to 9.0 percent from 8.8 percent in March; the labor participation rate remained unchanged at a disappointing 64.2 percent; and the actual number of people out of work stayed at 13.7 million. U6 – the “real” unemployment rate – rose by 0.2 percent to 15.9 percent; the average workweek didn’t budge from 34.3 hours; and wages only edged up by 0.1 percent to $22.95 (and by only 1.9 percent over the past year). Finally, only 16.3 percent of people on unemployment in March found work in April, a disappointing number. While the headline looked good, the truth is that this report was nothing to write home about. At best it can give rise to relief that the jobs picture didn’t deteriorate along with other economic statistics such as housing. While the establishment is desperate to paint a positive picture on jobs, the reality remains much more troubling.
1. Nassim Nicholas Taleb and Mark Blyth, “The Black Swan of Cairo,” Foreign Affairs, May/June 2011, p. 33.
2. Japan has been in recession for twenty years and the country has not collapsed. Japan is now coming to the point (hastened by its need to rebuild after the tsunami) where it will no longer be able to sustain policies that fail to deal with its gross economic imbalances. This is what investor Kyle Bass has described as the “Keynesian end point,” when total government debt service exceeds total government revenue. Japan remains, however, a far less ethnically fractured society than the United States and is likely to manage the transition without significant social instability. The United States is unlikely to enjoy that luxury.
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