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Friday, November 05, 2004


the black swan

of the myriad things that might change in a second bush term, one of the policies with the lowest chance of meaningful change is probably deficit spending. in an administration where "deficits don't matter", a continuation of current trends looks likely.

an acceleration, in fact. in his first second-term press conference, president bush sunk his teeth into social security privatization. the general idea is to absolve the shortfall in the social security adminstration (ssa) balance of payments by distributing funds from the government to private account holders, in a program akin to an IRA, of up to half the amount you have paid into the system. this, presumably, will be invested privately at greater returns on investment than the ssa can get, closing the gap.

forgetting for a moment the merit (or lack thereof) of the assumptions underlying the idea, the implementation would mean dishing out cash to millions of americans for the funding of such private accounts. whereas, under the current situation, future tax collections pay for future benefit outlays -- known as 'pay-as-you-go' -- private accounts need to be funded immediately so that they can be invested according to the wishes of the account holder. government IOUs no longer suffice. all such funds would obviously have to be borrowed -- as with all new spending initiatives when you're running a deficit -- via the issuance of treasury bonds.

in the short run, then, privatization means empty promises about guaranteed benefits to citizens become empty promises of debt repayment to the bond market.

while citizens are ignorant, stupid and generally undemanding, the bond market is often not. such a commitment to massive expansion of debt -- $6.9 trillion for the ferrara plan by ssa's estimates -- is so fantastic by any previous standard that it may simply break confidence in the government. the plan could well be interpreted by sensible bondholders (particularly overseas) as damning evidence that the united states either cannot or does not intend to make good on its debt; or, if it does, that it will do so with radically devalued dollars which would be relatively worthless in their home currencies.

the accumulation of national debt represents, imo, a manifestation of the black swan problem, or hume's problem of induction. nassim taleb presents it:

How many white swans does one need to observe before inferring that all swans are white and that there are no black swans? Hundreds? Thousands? The problem is that we do not know where to start –- we lack a framework of analysis to know if our ex ante estimation is appropriate, which is key.
reaching the "government budget constraint" -- the point at which the system shifts violently due to a loss of confidence -- has become a black swan, that rare event for which no one is prepared but is inevitably out there. we've seen so many white swans now that no one discounts the possibility anymore. consequently, tremendous unprotected bets are made on seeing nothing but white swans. american society (indeed, global finance) is playing a probability game without understanding that the fatal probability is not zero:

I believe that we would have to model the satisfaction of the government budget constraint as a probabilistic combination of three different possibilities:

1) Recognize that there is a chance that the tax cut will be reversed. Perhaps once again, as in the early 1990s, an unwillingness to cut spending combined with mounting debt and debt servicing costs changes the complexion of politics. I would have said that the chances of this are high given the 7% of GDP long-run fiscal deficit that America appears to have, and the unwillingness of any politician to propose cuts in the growth rates of Medicare and Social Security spending. But the chances of this have dropped since Kerry reached his peak bubble value of 80% on the Iowa Electronic Markets Tuesday afternoon.

2) Recognize that there is a chance that there will be a long period of rising debt and debt burdens accompanied by cutbacks in spending shares as various institutional mechanisms force the legislature to face and try to meet the government budget constraint. We know what George W. Bush thinks of the pay-as-you-go mechanisms that restrained Congressional action so effectively in the 1990s: he thinks they are a joke: "You know what pay-go means? It means you pay--and [Kerry] goes and spends!" I would say that the chances of this have also dropped since Tuesday afternoon.

3) Last, there is the remaining possibility: that the government budget constraint itself will take its own non-policy steps to make sure that it is met, and generate an Argentina-style meltdown. By the principle that probabilities sum to one, I conclude that the chances of this have risen since Tuesday afternoon.

it wouldn't be the first time for the united states. no one living had the experience of the continental currency debacle that financed the american war of independence, but it is one of many such incidents in the long historical record. but when it hasn't occured within the living memory of the society, the lesson is lost to experience and has to be relearned -- unfortunately, by experience. a most recent example was the 2000 stock boom -- it was no coincidence, imo, that it occurred just as the 1929 generation died out.

human beings display this failure to learn from rare events so consistently that it virtually must be a hardwired genetic trait common to all of us, by which we are conditioned to heavily weigh the recent over the distant. risk assesment in an abstract world has never been a human strong point.

as long as we play the game, we run the risk. with time, the risk becomes a certainty.

The Black Swan is not just a hypothetical metaphor: until the discovery of Australia common belief held that all swans were white; such belief was shattered with the sighting of the first.
responsible social security reform would be to radically reduce payouts while maintaining or even raising payroll taxes. my favored solution is to phase out ssa benefits gradually, arithmetically reducing payouts over 40 years to zero, while maintaining/raising the payroll tax as needed to balance payments with tax receipts.

in other words, we need to bail out the ill-considered plans of our parents before the situation gets any worse. but that is it's own kind of fantasy, isn't it?

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