Debt hides volatility from Taleb
July 15, 2009
Nassim Nicholas Taleb and one of his colleagues are back in the FT today with an article on the "evils" of debt and why the only solution to the economic system's woes is (start the fanfare, this is scary stuff!) the "immediate, forcible and systematic conversion of debt to equity". The main points of the article are that:
- Debt and leverage lead directly to fragility in the system whereas equity is robust at absorbing extreme variations in the system.
- The economic system is experiencing more extreme events (more "Black Swans") than ever before rendering mainstream economic forecasting useless.
- Debt hides volatility as a loan does not vary outside of default whereas an equity investment has volatility but its risk is more visible and as a result more manageable.
I think the last point on debt hiding volatility is quite profound – on a personal basis I would put it into the category of one of those things that you know but it becomes clearer when expressed in a different way, usually (in my case!) by somebody else. Its implications are illustrated particularly well in the following extract from the text:
"Thus debt is the province of both the overconfident borrower who underestimates large deviations, and of the investor who wants to be deluded by hiding risks."
The article is dramatic (as is usual with Taleb, see post) and short on detail of how such a fundamental conversion of debt to equity should happen from a practical point of view. It is nonetheless thought-provoking, particular around the use of flawed economic models being used to get us out of a crisis that the underlying maths helped us to get into, and the consequent proposal that we shouldn't try to model and control the risks of the system but instead endorse equity as the defensive, stabilising shock-absorber of choice. Maybe I should call my insurance broker, I think I need to increase my cover…