Taleb Plays Mr. Fixit

Here is an article by Marion Maneker that looks at Nicholas Taleb, one of the few people who predicted the economic catastrophe. I've pulled out the key bits where Taleb prescribes the necessary fix:

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."

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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 21st 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.