Sytem Crisis; Not Just Systemic

Yesterday I made the (radical) argument that what this crisis is really about is a system crisis, mainly that our currency regime is a fiat based credit system that is wholly unsustainable. Slowly, this message is coming to light from more widely recognized figures including Peter Schiff, Steve Keen, Ron Paul, Mike Shedlock and even a few commentators on CNBC (surprisingly, there are intelligent conversations on occassion). Now add to that list Mr. Black Swann, Nassim Taleb, where he discusses precisely this issue when Mr. Taleb Goes To Washington:

Now that the catastrophe is here, Taleb's anger at the economic establishment that drove us over this cliff—and populates the Journal's conference—makes him a representative figure of ordinary people. Like most Americans, Taleb is seething with rage about the financial establishment's role in bringing the about credit crash. "Nobody saw the crisis coming," he says. "Bernanke, all these guys, I want them out. They proved incompetent, they crashed the plane."

THANK YOU! It puzzles me that after all this time the majority of pundits still believe that the same figures who DID NOT see the crisis coming believe that they can guide us out. The reality is Bernanke & Co. were the chief orchestrators of this crisis through interest rate intervention and massive government spending.

In private, Taleb takes a specific kind of glee in the wreckage of modern finance. He has been arguing for years that the "adult supervision" in the financial system—the worthy academics, regulators, and heads of the large banking institutions—has been deluding itself with talk of a great moderation. To Taleb, the supposed stability brought about by complex financial derivatives, global banking connections, and accelerated flows of capital was a mirage masking the accumulation of massive amounts of hidden risk.

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First, he says, we have to unmask the charlatans of risk like Myron Scholes. To Taleb, Scholes is the Great Oz in this Emerald City because his work on options and derivatives allowed the whole of the financial system to adopt poorly understood products-like the ones that brought AIG down-that hide risk. To Taleb, Scholes' academic work, which enabled the widespread use of complex derivatives, was like "giving children dynamite."

"This guy should be in a retirement home doing Sudoku," Taleb says. "His funds have blown up twice. He shouldn't be allowed in Washington to lecture anyone on risk."

With complex derivatives unmasked and, in Taleb's vision of the future, outlawed, the next step is to create a more robust version of capitalism. Taleb calls it Capitalism 2.0. Robustness begins with a dismantling of debt. Leverage was the gas that inflated the financial system until it was too big, too fragile, and too volatile.

Over the past 20 years, the financial system has grown ever more complex. Building on a greater computing capacity and communication speed—"Bank runs now take place at the speed of BlackBerry"—Taleb recognizes that the financial system now possesses an efficiency that creates volatility. That cannot and will not go away.

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 21^st century.

We can't erase the technology that created the planes, so we'll have to make sure we fly sober, maybe even with an onboard computer that dampens the controls. That means getting rid of the debt. It's that simple.

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.

Did the conference see things Taleb's way? Not really. Back at the office, many of the financial leaders present had teams of analysts working on the government's newly proposed plan for toxic assets. Instead of deleveraging, here was a plan to use more leverage (provided by the government) to solve the excesses created by leverage.

Although Taleb was impressed with Geithner, his anger has hardly dissipated. "The center of the problem is that they don't know the center of the problem," he says. "They have not yet entertained the idea that what we may be witnessing is a total failure of a way of doing business."

Unfortunately, Mr. Taleb's wise words will not be taken seriously in the near term. The sad truth is the government believes they can save the system and that they must DO something. Their solution is the same as the problem, more leverage. Taleb is right; financial institutions are great in number, but concentrated in power, a destabilizing factor.

We now have turned to the road towards the "great repudiation". In this a refer to a complete overhaul of the current currency regime on a global scale. While this is welcome, what worries me is that the move will be towards more of the same, just with a different controller, I.e the IMF.