The Presumption of a Financier
September 15, 2015 | by Sergio Alberich
Mr. Taleb is fooled by the Sin of the Intellectual Arrogance he so much claims to despise
Every year, mainstream magazine “The Economist” publishes an interesting issue about the upcoming calendar year. It covers hot topics from many corners of the World, ranging from small countries to the biggest economies, from Politics to Culture, touching on Science and Technology, analyzing Businesses and Sectors and commenting on Financial matters. This special issue stays on sale for months and months, and seems like a big time entrepreneurial accomplishment.
Business wise, the Magazine is a success, surfing the new media and profiting like no other traditional publisher. Unfortunately, the understanding of the market so well mastered in its business practices is utterly ignored in the vast majority of its writings. The current issue, entitled “The World in 2013”, is no different and the words of financier Nassim N. Taleb displayed on its pages should not be ignored.
On previous books and articles, Mr. Taleb’s attacks on Mathematical Economics have been harsh and very well placed 1, and that is how he opens his lines in “The Economist”. Unfortunately, this good start is quickly smashed and followed by normative solutions he thinks should be imposed over the financial market and its participants. He never directly says that the Government should be the one imposing such rules, but once he employs terms such as “to oblige”, “let’s ban” or “should force”, the coercive hand of the state becomes the only alternative.
Before outlining his normative suggestions, he says they are practical and solid, and that he selected them because they are both uncomplicated and highly effective. Well, it seems like Mr. Taleb was fooled by the same Pretense of Knowledge 2 that affects the mathematical financiers he so frequently criticizes.
His initial idea states that “A company that is classified as a candidate for a taxpayer bail-out if it fails should not then be able to pay any of its staff more than a corresponding civil servant”. Clearly it is not practical, not uncomplicated nor highly effective. Who would classify such companies as candidates for bail-outs? The FED? Anti-Trust Agencies? How would such companies be rated? How the corresponding civil servants would be chosen?
First of all, the simple, practical, uncomplicated and highly effective solution would be not to bail-out any company. That is the only way the money of the taxpayers would not be used to the benefit of bureaucrats and bonus-earners, but it doesn’t seem like an alternative to Mr. Taleb.
The expectation of bail-outs creates moral hazards no other set of regulations can undo. It does not matter how strict and restrictive such new coercive norms are, at the end they will never be able to act as efficiently as the natural market checks of the free society. Suppliers, creditors, customers, employees and any other firm stakeholder have their risk assessments affected by the illusion of the safe haven of bail-out assurances. Structures that usually would not bring those stakeholders the security they demand, will give a false sense certainty that in reality does not exist.
Employees seeking long-term job security will not be worried with the risks taken by the firm; after all, if it fails they can always count on the government to save their jobs and the firm. Suppliers, like the employees will not do their proper diligence and will calmly engage in risky commercial agreements they usually wouldn’t. Customers, creditors and anyone else involved with the firm will, also, have their choices affected by their cloudy view of reality and by the false assurances brought by the possibility of bail-outs. Therefore, if things are already terrible and disastrous in a reality where no official lists of potential candidates for bail-out exist; can you imagine the exponential rise of Moral Hazard with an official list out there?
I’ll give it to Mr. Taleb that having executives of companies that currently belong to the government earning bonuses at the expense of taxpayers is outrageous, ridiculous and simply wrong. But going as far as he goes and deciding to list companies as candidates for bail-outs and depriving them of paying their employees the way they want is even worse.
As a result of such a rule, he complicates everything, deeply increases the Moral Hazard already inflicted on the market by the existence of bail-outs, gives enormous power to the bureaucrats in charge of listing the candidates and strongly hurts liberty. Instead of presenting a highly effective solution, Nassim Nicholas Taleb gives us with something highly destructive.
The second of his recommendations is the one that hits individual freedom the most. He wants “to oblige those who start in public office to pledge never subsequently to earn from the private sector more than a set amount; the rest should go to the tax payer”, and says that it “will ensure sincerity in service – where employees are supposedly underpaid because emotional reward from serving society”. Reading those lines, one might get the impression of being going through the manifesto of a Despot. For someone who recognizes the limits of econometrics, placing no boundaries in his capacity of telling how people should live their own lives seems contradictory.
Can’t he see that he is basically restricting people from leaving their jobs, or at least their employer? Can he see that he is strongly and voraciously hitting people’s freedom? How can he think he has the right of setting a ceiling on someone’s earnings?
This atrocious recommendation not only destroys personal liberty, but it is also very complicated to be implemented and extremely inefficient. Who would keep track of such regulation? How many people would be necessary to keep an eye on it? Which sectors and industries would be vetoed? What about if the former public servant decides to start a firm, would that be legal? Any position in public service would be subject to such rules?
With one practical, solid, uncomplicated and highly effective rule (according to his own words), Mr. Taleb knockouts liberty, decides (for all of us) that working for the government is morally superior to working in the free market, establishes immovable social classes and lays the table for a bigger and expanding government.
I share Mr. Taleb’s worries regarding the close relationship between big firms in highly regulated industries and the regulatory agencies themselves. Executives are always switching sides, whether it is in the financial sector, the healthcare segment, the energy industry or any other well regulated market, it happens a lot – from agencies to industry or from industry to agencies. Yes, it is sad, and creates a lot of trouble to the economy, but the problem is not that some individuals play the game that way. The problem is that regulatory agencies exist and force people to act that way. Contrary to the argument that such agencies are out there to foster competition and prevent abuse over consumers, they exist to help big companies maintain their positions, fight the upcoming competition and prevent new entrants 3.
Hence, the only solution here is not the one proposed by Mr. Taleb, where he basically wants to deal with the problems that arise out of regulation with more regulation, but to reduce and ultimately put an end on regulatory agencies.
Mr Taleb continues to violate individual liberties in his third suggestion. He wants to tell people how they should run their business, and once again he is wrong. “We should force corporate managers to eat some of the losses”, is his no-brainer solution to put an end in the Principal-Agent Problem.
In short, his view is that managers having their equity at stake would be less prone to undertake very risky strategies as a result of having their upsides and downsides in sync with those of other investors. Yes, it makes sense at first glance, and to a certain extent it already happens out there in the market (managers have their equity at stake). Incredibly, we find many more Hedge Fund Managers (less regulated industry) making it an integral part of their Sales Pitch to potential investors than Banks incorporating it (more regulated industry). Yet again, where Mr. Taleb takes the wrong turn is not in identifying the problem, but in trying to impose ridiculous regulations that are neither practical nor uncomplicated.
While ignoring the fundamental differences between Equityholders and Managers 4, he blinds himself to some of the possible unfoldings of his vicious recommendation. Such enforcement could exclude the possibility, or in the best case make it much harder for those without assets to ever manage anything, and consequently ever hold assets. Many capable individuals would be simply put out of the market, locked out of some capacities and destined to either operate outside the law or in functions not shaped to their talents. What about the impact in the number of funds, in the quality of the products and in the diversity of different strategies out there, has he ever thought about them? I wonder how Mr. Taleb would deal with the unintended consequences arising from his recommendations. More regulation?
No doubt the Principal-Agent Problem is out there, but instead of trying to put an end on it through the proposed imposition, it would be much simpler to try to understand why it usually happens in clusters of very much regulated industries. Perhaps it would be smarter, less complicated and more efficient to remove regulations 5 that kill the natural market checks on such conflict of interest.
Finally, Mr. Taleb goes strong against Value-at-Risk (VaR). Regarding his technical arguments, I have to agree with the unsuitability of this risk-management tool 6. However, from there to subscribing to his idea of banning it, there is a huge gap. Again, let the firms, its managers and its entrepreneurs decide which methods they want to employ to their businesses. If they choose to pick great tools, the free market will reward them. If they pick bad ones (like VaR in our shared opinion), let them fail and be pushed into oblivion by the market forces.
The one to blame on the overspread use of VaR is not the free market, but the many regulations and government agencies that push for its use. The Basel Accords, the FED, the SEC and other regulatory agencies either demand or lobby for its use. Get rid of such draconian rules and we get rid of many bad tools. Get rid of regulations and their Moral Hazard effects will soon be vanished when the natural market checks are restored. It is that simple!
Mr. Taleb has correctly identified some problems out there, but has failed to realize that they are the consequence of excessive regulation, and not the shortcoming of the free market. He fails to understand what caused such problems, and he fails to see the unfolding of his very perilous suggestions. Those four practical, solid, uncomplicated and highly effective rules that should be coercively imposed on all of us have no power to solve any problem, but have the power to make government bigger and more powerful, restrict human action, deprive individuals of freedom and block entrepreneurship.
Should one of the issues raised by Mr. Taleb be given back to the free market to solve, then 2013 will be a great year. Should any of his ideas be imposed from top to bottom, like he suggests, then 2013 will be a very bad year.
This article was originally written and published in early 2013 by Sergio Alberich – https://www.juandemariana.org/ijm-actualidad/analisis-diario/la-presuncion-de-un-financiero-la-arrogancia-intelectual-de-nassim
- Sheehan, James, “Fools Put Faith in Data Alone” http://mises.org/daily/2056;
- That’s the title of the speech given by F.A. Hayek in his Nobel Prize acceptance Lecture http://mises.org/daily/3229;
- Suggested readings on the effects of regulation and regulatory agencies are: Rockwell, Llewllyn, “Regulatory-Industrial Complex“ http://mises.org/daily/5930/RegulatoryIndustrial-Complex; and Armentano, Dominck, Antitrust the case for repeal http://mises.org/document/6061/;
- Equityholders are the ones who bear the risk and uncertainty of the production process using their savings to advance wage payments to workers – managers included – for services that will not yield income until the future. In a sense, investors/equityholders, trade present goods (the wages in this case) for future goods (the marginal product of the worker added to the production process. Suggested readings offering a deeper explanation on the topic are: Mises, Ludwig, “Human Action” (chapters 21 and 22) http://mises.org/Books/humanaction.pdf; and Rothabard, Murray, “Man, Economy and State” (chapters 6 and 7) http://mises.org/Books/mespm.PDF;
- Both the FDIC and the possibility of Bail-Outs are good examples of government intervention weakening the natural checks of the market;
- The 1997 debate between Philippe Jorion and Nassim Taleb provides a good summary of Mr. Taleb’s arguments derivativesstrategy.com/magazine/archive/1997/0497fea2.asp; and Murray Rothbard criticism on Mathematical Economics could also be applied to the case of VaR http://mises.org/daily/3638.