Monday, April 13, 2009

the bank will experience a run. To deal with this problem, we have deposit insurance

TO BE NOTED: From Derivative Dribble:

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The Unbearable Lightness of Nassim Taleb In Uncategorized on April 13, 2009 at 7:30 am

Also published on the Atlantic Monthly’s Business Channel.

As Conor notes, Nassim Taleb offered up some less than sage advice in a recent “article” in the Financial Times. The article, which takes the form of a talismanic list, was crafted in order to the deliver humanity from its suffering by pointing our mind’s eye towards the failures of our regulatory dogma. Wielding powerful metaphors such as “Make an omelette with the broken eggs,” Taleb fails to meet even the lowest of standard for a statement on regulatory policy. “Counter-balance complexity with simplicity” might be an acceptable policy position for Deepak Chopra. But it is certainly unacceptable for an economist.

Looking beyond Taleb’s absurd delivery, the substance of his policies is, in large part, absent, and where present, addresses the real issues at play in a superficial and borderline whimsical fashion. It is unclear whether this is the product of haste, or the product of a complete lack of command over the issues and concepts. For example, Taleb states that:

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

To say that only Ponzi schemes depend on confidence — they don’t, since they’re the product of fraud and misrepresentation — is factually incorrect and suggests intellectual laziness. The extension of credit and contracting depend on confidence in the ability of a counterparty to perform. In a broader sense, the organizational structure of society depends on people being able to rely on the predictability of certain events around them (e.g., bus, train, and plane arrivals, banks maintaining deposits, etc.).

This organizational structure is itself a product of confidence. I am confident that the train will arrive shortly after I get to the train station in the morning, and as a result, I plan on taking the train to work each day. I am confident that my bank will maintain my deposit level, and so I don’t have a mattress full of cash. When confidence is eroded, the incentives of individuals become misaligned.

Take, for example, the case of a bank run. Each depositor has an incentive to withdraw its deposits based solely upon the assumption that all other depositors are doing so, since we have a fractional reserve banking system. Yet each would be better off if none of them withdrew their deposits. When the assumption rings true in the minds of enough depositors, that is, when confidence breaks down, the bank will experience a run. To deal with this problem, we have deposit insurance, which the Government provides to create and maintain confidence in the banking system."

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