Ethics @ Work: It's not just Madoff

Western financial system is a Ponzi scheme, says Nassim Taleb.

December 25, 2008 21:39
4 minute read.
Ethics @ Work: It's not just Madoff

Business ethics 88. (photo credit: )

Nassim Taleb has a view on the financial markets which raises some challenging questions relating to both economic and ethical aspects of modern capitalism. Taleb, a finance expert and trader himself, has a skeptical critique of the financial market system, which he described in his book The Black Swan (as per Juvenal who considered a perfect wife to be "an extremely rare bird, and very like a black swan"). Taleb's view, expounded in a recent article in The Marker, is on the one hand highly technical yet at the same time highly ethical, and certainly very timely, so it is appropriate that we discuss it here. The technical aspect of Taleb's view is as follows: Financial institutions, including banks, hedge funds and even regulators, base their risk management strategies on sophisticated risk models. They create estimates of basic statistical properties of asset returns. Based on these estimates, they tell you how safe your money is; they also use them to second-guess asset prices for trading gains. Taleb has been saying for many years that these risk models are of limited value. The problem is that statistical relationships are estimated for a period of a few years or at most decades, but the whole nature of markets is that the relationships change completely every so often. So these risk models "protect" against tiny, well-understood risks that aren't much of a danger in the first place, but actually increase exposure to truly dangerous risks. Black swans are actually much more common than people think (probably perfect wives are too). A good analogy would be waterfront property. Imagine buying a waterfront property in the Florida Keys. Your insurance agent tells you, "We've done a thorough thirty-year statistical study of householder risks. The main risks are petty burglaries and accidents." So you get ordinary household insurance and feel safe. What the agent forgot to mention is that besides the occasional loss of a few thousand dollars from theft and the rare chance of a serious accident, the house is almost certain to be totally washed away in the next thirty years. Furthermore, his expert-sounding reassurances stimulate a huge buildup of new supposedly "safe" beachfront properties. By the same token, your "hedge" fund is hedged against all the normal everyday risks and even profits from them. But these funds are not hedged against a market crisis; often they are far more exposed to crisis than regular stocks, since to manage risk they need lots of liquidity - which dries up exactly when a crisis occurs. It's like deciding you'll wait to buy flood insurance until the hurricane is right offshore - when no one in their right mind would sell you any. So far we have a strictly technical description of the market. But the ethical implications are obvious, and Taleb does not take pains to hide them. In the Marker interview, which was given before the Madoff affair but published after it, Taleb describes the entire financial system as a "Ponzi scheme." Based on the above critique, we can see the likeness. In a Ponzi scheme, you claim to have profits but really it is only new investor money coming in. Your "income" is really eating up principal. Taleb thinks something similar happens in your investment fund. Its income is obtained by assuming risk - much like selling flood insurance. But it didn't put the premiums into a fund as a good insurer must; instead, it distributed them as bonuses. Now the flood comes and you are left with nothing. At the same time, Taleb states that lately he has adopted a more forgiving attitude towards investment advisors. "In the past I was very critical of investment advisors, after it became unambiguously clear to me that they give worse results than a totally random portfolio. Today I think one can forgive them. They're just telling a story. They're not much different than astrologers, and in my opinion no one really believes them, just like you don't really believe your astrologer." My brief critique is that Taleb has many important points but he exaggerates them somewhat. Market players definitely use myopic risk models; a couple of years ago one manager described a quite ordinary market downturn as a "six sigma" event (suggesting that it had a probability of approximately one in 300,000), while it was recently revealed that the risk models used at finance titans AIG and Citibank had glaring deficiencies. However, everyday insurance has value too, and flood insurance is hard to provide since floods tend to hit everyone at the same time. Taleb himself has an extreme event fund which has done spectacularly in the last few months, but the last time I looked he hasn't totally made up for the steady losses he showed in the good years. Hedge funds have actually done better than the stock market in the recent downturn. Taleb's ethical message remains important. Certainly a lot of supposed "experts" have been humbled in recent months, and Taleb is performing a valuable service with his favorite pastime, which he describes on his Web site as "teasing people who take themselves and the quality of their knowledge too seriously, and those who don't have the courage to sometimes say: I don't know."

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