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Musings Report 2021-14 4-3-21 Taleb, Risk and Getting Punched in the Face
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Taleb, Risk and Getting Punched in the Face
How Do We Solve a Problem If the Variables Are Hidden?
We're all taught to solve for X: 9 + 9 = X and so on.
To solve for X, we need to know the function--add, subtract, multiply, divide, etc.--and the initial conditions: the data points to work with (9 and 9).
How do we solve a problem with variables that are invisible? We can't.
How do we solve a problem in which the functions are unknown? We can't.
How do we solve a problem in which the initial conditions are unknown? We can't.
How do we solve a problem in which the functions and/or initial conditions change mid-calculation? We can't.
I see the same question in forums, threads, articles and emails: what can I do to protect myself and my family from whatever lies ahead?
Given the uncertainties and extremes that are so evident, this is a well-grounded question / problem to be solved.
The general answer takes one of two paths: inflation leading to hyper-inflation or a deflationary collapse of defaults and popping asset bubbles.
It's easy to find pundits arguing for one or the other, but do we have the initial conditions, variables and functions we need to solve this problem, inflation or deflation?
Consider two variables that are rarely visible in pundits' arguments:
1) What will benefit the banks?
2) What will benefit the nation's place in the geopolitical order / global economy?
The inflationary camp holds that the soaring debt, public and private, can only be serviced if incomes inflate so households, companies and governments have enough income to make the payments on their soaring debts.
Since this is a self-reinforcing spiral--more inflation leads to more inflation--central banks will be forced to print their currencies into oblivion, i.e. hyper-inflation.
If they ever stop printing, the house of cards (soaring debt) would collapse.
This logic seems sound enough, but how will banks profit once households can pay off their once-stupendous mortgage (that required 30 years of monthly payments to pay off) with a single month's pay?
Hyper-inflation will destroy not just the currency but the entire banking sector, which is politically powerful. Will the banks just sit by passively watching their wealth and income being destroyed by accelerating inflation? I think not.
The banks would much prefer defaults that they can shift to the government (via bailouts) and deflation, where every monthly payment has greater purchasing power than the previous month.
Next, consider the consequences of hyper-inflation on the nation's currency: it loses virtually all its value in terms of buying food, oil, semiconductors, autos, etc. from other nations. Nobody will want to trade real goods for worthless dollars. Imports paid with dollars will plummet to zero in hyper-inflation.
In terms of a nation's wealth, its currency is number one, because if the currency plummets to near-zero value then everything denominated in the currency also loses value on the global stage.
A reserve currency--a national currency that is widely held globally because it will hold its value and the market for everything denominated in that currency is extremely large and liquid--is the crown jewel of the nation (or entity, in the case of the EU) that issues it.
Who would benefit from the destruction of a nation's reserve currency? Virtually no one. The nation would be impoverished. So why is hyper-inflation--the destruction of the currency--so broadly accepted as inevitable?
It's also widely assumed that the Federal Reserve and other central banks control all the variables in setting bond yields, interest rates and inflation. But what if some critical variables are outside the Fed's control? What if their claim to control all variables is mere PR?
We also don't know what function might manifest. Will it be arithmatic--1 + 1 = 2 + 1 = 3, etc.--or geometric-- 1 + 1 = 2 + 2 = 4 + 4 = 8 + 8 = 16?
This makes an enormous difference: arithmatic inflation is predictable--3% a year, for example--but geometric increases lead to hyper-inflation and complete destabilization.
Very few pundits reckon the central banks and governments will choose default and deflation because these will be painful--but what could be more painful than wiping out the value of the currency?
If the wealthy elite own gold, silver, cryptocurrencies, farmland, manufacturing, mines and government bonds, then the default of zombie households and corporations (zombies defined as entities that have to borrow more to remain among the living), would have little effect on elite wealth. Corporate bondholders and marginal lenders would be destroyed,, but again, the wealthy need only avoid owning marginal debt to avoid the debacle of default losses.
Asset bubbles popping will hurt everyone who owns the assets, but those without debt will not be endangered like those who must service debt even as their "wealth" has largely vanished.
The politically powerful elites have their ace in the hole in a deflationary collapse: they can demand politicians (who need their contributions to fund their re-election campaigns) bail out the banks, transferring the losses from defaults from private banks to the public sector, exactly what happened in 2008-09.
But one again, are the elites and government fully in control of all variables, or could they be assuming arithmatic functions when geometric functions might actually manifest? Deflationary defaults can destroy bank assets just as quickly as hyper-inflation, as once buyers vanish (i.e. markets go bidless) then the value of assets plummets to levels no one believes possible.
Entire highrise buildings are sold for the value of the elevators. Yes, it happened in the Great Depression.
A little inflation or deflation is a good thing, easily manageable by the government and elite, but geometric inflation or deflation undermines the entire financial system, including the finances of governments and elites.
How do we calculate the probability and potential intensity of social disorder? It's widely assumed that the U.S. could never experience the sort of massive, widespread social disorder that occurs in developing-world nations during crises. But humans are humans, and when put under pressure by high inflation / deflation and declining prosperity, people respond in ways that can very quickly escape the control of authorities.
(For more on this, please see my previous Musings/Patreon post on Cultural Revolutions.)
If the variables that are hidden have geometric functions, then seemingly small disorders can spread throughout the entire society--or supply chain.
Where does all this leave us? We know from studies of human psychology that humans don't feel comfortable with uncertainty and seek a haven of certainty as quickly as possible. They will cling to anchored beliefs in the face of conflicting evidence and strengthen their attachment to beliefs when challenged. We're wired for a decisive commitment to a belief structure. We don't like sustained indecision or ambiguity.
But if we can't possibly solve the problem of what happens next, we have to accept that this era's uncertainties may not be resolvable.
This is an exceedingly valuable insight, as if we embrace this uncertainty, we can avoid defaulting to a rigid, brittle false certitude that can only lead us astray if events don't follow the path we've committed to.
In other words, we all want certainty, a prediction that plays out perfectly, but this isn't possible because 1) the variables are invisible 2) the functions are unknown and 3) the "solution" (predicted path) depends entirely on the initial conditions, in which small changes completely change the outcome.
Faced with the knowledge that so-called fat tail risk (i.e. a geometric function replacing an arithmatic function, and small events triggering large consequences, i.e. non-linear dynamics) is real but unpredictable, then we're forced to think through these supposedly low-probability risks and devise a response that we can implement because we already thought it out.
This is the difference between having a pre-planned response and panic: the OODA loop (Observe, Orient, Decide, Act) is helpful, but in real time what we observe and contextualize (i.e. orient) is easily biased by our emotions and the swirl of chaotic events and inputs. The real secret is having a plan already embedded in one's mind and muscle-memory: if I observe these dynamics, then this is evidence that these variables and functions are in play, and here's my response / solution.
Martial arts is a useful analogy. Martial arts training is less about learning how to hurt people and more about self-discipline, starting with the rule that one will only use one's skills for self-defense, never for aggression. The disciplined repetition of training embeds muscle-memory which informs an automatic self-defense response. As Bruce Lee said, he didn't fear an opponent who had practiced a thousand different kicks, he feared the opponent who had practiced one kick a thousand times.
Mike Tyson's memorable quote applies to uncertainty as well: "Everyone has a plan until they get punched in the mouth."
The average person has no plan or semi-automatic response should someone try to punch them in the face. Those with some martial arts training might not respond perfectly, but they have higher odds of responding in some semi-automatic way that could lessen the impact or damage of the unexpected surprise.
Part of why the average person has no plan is they consider the odds of someone trying to punch them in the face as near-zero. The martial arts student doesn't follow the line of thinking that because the odds appear low, there is no need to learn self-defense. Rather, being prepared to defend oneself is a permanent state of readiness, perhaps rusty and imperfect, but there nonetheless.
The split second before somebody is about to punch you in the face is not the moment for fancy moves. You either try to deflect the blow or you dodge the blow. Neither are easy or guaranteed to work as intended. We can't choreograph the flux of events as in a movie.
I often think about Mike Tyson's words because I am keenly aware that I would very likely fail to respond as I would hope or intend, and I'll get punched in the face just like the unprepared average person. There will always be uncertainty about how events will unfold when the unexpected happens. I might fail abjectly, or I might escape unscathed. Nobody can predict the outcome. But at least there is a possibility that I might respond in some way that limits the damage. Or I might surprise myself and respond automatically because I've thought about how to respond and practiced a single response.
Interestingly, the opponent's punch is the maximum point of advantage for the defender to land a counter-attack, as the aggressor has no thought of defense; he is focused solely on landing his punch. He is unprepared for the intended victim to respond instantly with a lightning blow to the aggressor's face.
The analogy is that events that devastate the majority financially also greatly enrich the few who bet on non-linear dynamics. This 2002 profile of Nassim Taleb by Malcolm Gladwell offers an enlightening perspective on this approach. Blowing Up: How Nassim Taleb turned the inevitability of disaster into an investment strategy.
Very few of us can pursue Taleb's mathematically sophisticated strategies or become a top martial artist. But that doesn't mean we can't embrace uncertainty and fat-tail risks and think through responses far in advance, and plan a hedging strategy that accounts for possibilities from 1) nothing changes to 2) everything changes.
We don't have to respond perfectly to be successful. We simply need to have prepared responses for contingencies from whatever we consider most likely to whatever we consider very unlikely but still possible.
Investing 101 is that diversification is the foundation of hedging one's bets on what will happen in the future. What goes into the diversification depends on one's age, risk appetite, assets, family responsibilities and many other inputs. There is no one size fits all answer. But we can insert our own initial conditions and tailor our response to fit our personalities and circumstances.
The point here is that embracing uncertainty means we accept that we might still get punched in the face, and make mistakes or fail to perform as we'd hoped, but that the process of planning layers of response may well help protect us from irreversible losses and bad decisions made in the chaos of unexpected events.
Highlights of the Blog
Podcasts:
AxisOfEasy Salon 41: Can't get you out of my head (58 min)
Posts:
The UFO/Fed Connection 4/1/21 (April Fools Day post)
Our "Wealth": Cloud Castles in the Sky 3/31/21
The Hazardous Detour in the Road to "Recovery" Few Foresee 3/29/21
Health, Wealth and What Kills Most of Us 3/27/21
Best Thing That Happened To Me This Week
Watched the entire 6-part Adam Curtis documentary Can't Get You Out of My Head on a "watch this now" recommendation from longtime correspondent Richard M.
From Left Field
Learn 'The Burnout Fix' From Psychologist Dr Jacinta Jiménez (38 min)
Blowing Up: How Nassim Taleb turned the inevitability of disaster into an investment strategy (2002, but worth a re-read)
Headed for a Collapsing Debt Bubble Gail Tverberg...
The History Of Female Surfing
'Your vacation is my home': Hawaii's residents are speaking out against tourists behaving badly
Running out of Ice on the Moon. How we Forgot the Concept of "Resource Depletion"
Why Computers Won’t Make Themselves Smarter
Identity of mysterious 'Hobbits' possibly found -- Denisovans, who were close relatives of Neanderthals...
Inside The Global Race To Build Killer Robot Armies
Japan's Economy Is Again Struggling
Why are more young people getting sick with Covid-19 in Brazil?
The Real Immigration Scandal (via Laserlefty) -- America's insanely ineffective and perverse War on Drugs....
"It is no measure of health to be well-adjusted to a profoundly sick society." (Krishnamurti)
Thanks for reading--
charles |
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