Tuesday, December 25, 2012

Nassim Taleb's anti-fragile system is the FDR Framework

In his NY Times editorial, Nassim Taleb calls for
an antifragile system — one in which mistakes don’t ricochet throughout the economy, but can instead be used to fuel growth. The key elements to such a system are decentralization of decision making and ensuring that all economic and political actors have some “skin in the game.”
Regular readers know that the FDR Framework is an anti-fragile system.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  This combination promotes decentralized decision making and ensures that market participants have 'skin in the game'.

How does the FDR Framework do this?

Please recall the under the FDR Framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed investment decision.

Each market participant under the principle of caveat emptor has an incentive to assess the disclosed information as they have skin in the game because they are responsible for all gains and losses on their exposures.

This skin in the game builds robustness into the system as each market participant restricts their exposures to what they can afford to lose given the risk of each exposure.

Back to Mr. Taleb.

First, in a decentralized system, errors are by nature smaller....
It’s a myth that centralization and size bring “efficiency.” Centralized states are deficit-prone precisely because they tend to be gamed by lobbyists and large corporations, which increase their size in order to get the protection of bailouts. No large company should ever be bailed out; it creates a moral hazard. 
Consider the difference between Silicon Valley entrepreneurs, who are taught to “fail early and often,” and large corporations that leech off governments and demand bailouts when they’re in trouble on the pretext that they are too big to fail. Entrepreneurs don’t ask for bailouts, and their failures do not destabilize the economy as a whole. 
Second, there must be skin in the game across the board, so that nobody can inflict harm on others without first harming himself. Bankers got rich — and are still rich — from transferring risk to taxpayers (and we still haven’t seen clawbacks of executive pay at companies that were bailed out). 
Likewise, Washington bureaucrats haven’t been exposed to punishment for their errors, whereas officials at the municipal level often have to face the wrath of voters (and neighbors) who are affected by their mistakes. 
If we want our economy not to be merely resilient, but to flourish, we must strive for antifragility. It is the difference between something that breaks severely after a policy error, and something that thrives from such mistakes. Since we cannot stop making mistakes and prediction errors, let us make sure their impact is limited and localized, and can in the long term help ensure our prosperity and growth.
In short, we need to adhere to the FDR Framework and ensure that transparency is brought to all the opaque corners of the financial system.

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