How do you create a Black Swan? It’s not that hard.  Start with something that you know is seemingly useful, true or good.  Then slavishly rely on that idea until it fails.  I’ll toss out a few here:

• The more people that live in houses that they own, the better.  The government should encourage home ownership.  You should own the biggest house you can afford.  (In 1986, a Realtor pitched me with that idea, and I thought it was dumb then.)  Residential housing is an investment for the masses; the prices never go down for the nation as a whole.
• Continually maximizing return on equity will maximize stock prices.  Optimal capital structures and all times.
• We all want high, smooth returns from our investments — high Sharpe Ratios, everyone!
• Proper central banking practice can lead to near-permanent prosperity with moderate volatility.
• Our government can borrow without limit to promote or common prosperity.  Our central bank can cleverly intervene in markets with their assets, and fix things without getting stuck, or creating inflation.

Many ideas that are good marginally aren’t so good if pressed to their logical absurd.  By duping marginal homebuyers into buying what they could not afford, we create a black swan — I remember commentators who were saying as late as 2006 year end, that home prices never went down across the nation as a whole.  It wasn’t true if you looked at the Great Depression or episodes in the 19th century, but people beieved that housing prices could not go down, so they piled into it creating a boom, a glut, and now a bust and a glut.  Behold the Black Swan!  Rapidly falling housing prices across the nation as a whole.

Consider the buyback craze, now deflated.  Was it good to buy back like mad in 2004-2006?  I would tell insurance management teams to leave more of a buffer for adverse deviations.  But it was always easier in the short run for insurance CFOs to buy back more stock, and earnings would rise.  Stock prices would improve as well, and that’s fine during the boom cycle, for then, but many would issue expensive hybrid junior debt with an accelerated stock repurchase.  Short term smart, long term dumb.

The insurance industry is my example here, but it went on elsewhere.  How many acquiring CFOs wish they had used stock rather than cash for the last major acquisition that they did?  Most, I’m sure.

There is always a boom-bust cycle, and there is ordinary trouble during a normal bust phase.  But when the boom phase has parties abandoning all caution, possibly with government acquiesence, the boom gets huge, and the bust too, where the Black Swan appears — things you thought could never happen.

The craze for smooth, high, uncorrelated returns led to a boom in alternative strategies in the investment business.  Return correlations change not only due to cash flows on the underlying investments, but also due to investor demand.  Not so amazingly, as alternative investments go mainstream, the returns fall and become more correlated.  When an alternative is new, typically only the best ideas get done.  When it is near maturity, only the marginal ideas get done.  Alternative asset prices get bid up along with the boom in conventional assets.

Now we get a Black Swan — all risk assets do badly at the same time.  Investors in private equity don’t want to fund their commitments.  Some venture capital backed firms will fail (here and here).  Many hedge funds raise their gates, all at the same time, because investors want out.  Liquidity is scarce.  Companies pay in kind where they can, whether it is on “covenant lite” loans, REIT dividends, etc.  The era of buying back at high prices gives way to equity issuance at low prices.

Now for my final Black Swan, and perhaps the most controversial.  Monetary policy is “optimal” when it follows the Taylor Rule.  A good central banker, applying the rule, should minimize inflation and macroeconomic volatility.

My argument here, which seems intuitively correct to me, but I can’t yet prove, is that continuous application of the Taylor Rule will eventually lead us into a liquidity trap.  That might be more due to the human nature of sloppy central bankers like Greenspan, who want adulation, and err on the side of monetary lenience.  Or, it might be that the central banker overestimates the productive capacity of the economy.  Whatever the reason, we followed something pretty close to the Taylor rule for 15 years, and now we are in a liquidity trap of sorts.  I’ve suggested it before, but perhaps monetary policy should not focus on (at least solely) price inflation or unemployment, but on the level of total debt relative to GDP.

As with so many things in a complex capitalist economy with fiat money, there may not be a right answer.  Optimizing for one set of variables often leads to unforseen pessimizing (a new word!) another set of variables.  What works in the short run often does not work in the long run.

In closing, consider a Black Swan of the future.  Governments globally nationalize financial institutions, run huge deficits and borrow a lot of money to do so.  They “stimulate” the economy through targeted spending, and ignore the future consequences of the debts incurred.  They do it in the face of the coming demographic bust for the developed nations plus China.  My expectation is that these “solutions” will not do much to deal with the economic weakness induced by the debt overhang.

As Walter Wriston famously said, “A country does not go bankrupt.”  Perhaps what he should have said was the country remains in place, only the creditors get stiffed.  Short of war, it is tough to reorganize or liquidate a country.  But I’lltake the sentiment a different way and say that most people believe “A developed country does not go bankrupt.”  That is the black swan that will be displayed here, and Iceland is the harbinger of what might be a future trend of developed country sovereign defaults, or their close cousin, high inflation.

This entry was posted on Friday, January 30th, 2009 at 1:09 pm and is filed under Asset Allocation, Bonds, Fed Policy, Insurance, Macroeconomics, Quantitative Methods, Real Estate and Mortgages, Speculation, Stocks. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.