How I Misrepresented Nassim Nicholas Taleb On Barbell Strategies

[long, wonkish, and personal]

If one googles "barbell strategy," one mostly finds discussions of a bond-trading strategy (and a related definition) that involves putting half of funds in long term bonds and half in short term bonds, with no money in intermediate term bonds. The money at both ends makes this a "barbell." Whether or not such a strategy makes more money than the "bullet strategy" of buying only intermediate term bonds (or all time horizon bonds) depends on the shape of the term structure of interest rates and how it changes over time. Another variation is for a takeover raider to buy both very large firms and very small ones, but not mid-sized ones. A more general definition of a barbell strategy is one that combines very safe investments with very risky ones, while not buying ones of intermediate riskiness. In his book, The Black Swan (TBS), Nassim Nicholas Taleb recommends (pp. 205-26) a variation on this in which one puts 85-90% of one's assets in "extremely safe assets, like Treasury bills" and the rest in "extremely speculative bets, as leveraged as possible (like options), preferably venture-style portfolio," with a footnote suggesting that this remaining 10-15% involve "as many of these small bets as possible."

In various blogs, including here, I have described his barbell strategy accurately with regard to the first part, but misrepresented the second part as involving specifically buying puts on major crashes. I then criticized this as a strategy that would lose money in most years (although obviously it would make money this year if properly done) based on a paper by Oleg Bonderenko, "Why are Put Options So Expensive," available at http://tigger.uic.edu/~olegb/research.htm. In a link on his website, http://fooledbyrandomness.com/fake.htm, Taleb has sharply criticized me for this (others dumped on there are Tyler Cowen, Robin Hanson, Alan Greenspan, Robert C. Merton, Kenneth Rogoff, and Paul Seabright, for various alleged sins, some more serious in my eyes than others, some not sins at all). In any case, I have now gone back to his book and see that my frequently repeated description of his barbell strategy was a misrepresentation. For this, I apologize to him publicly.



Needless to say, there is more to this than I have said so far, for those of you who are interested, and I will say that quite a bit of what Taleb says on his website involves serious misrepresentations. I would strongly suggest that he alter the inaccurate parts and publicly apologize, as I altered parts of an original posting back on maxspeak over a year ago at his request that was at the origin of all this. So, for those of you who are curious, here is the rest of the story, at least as I see it.

So, in the summer of 2007 I happened to read TBS. I found it mostly very interesting and stimulating, and in general I was then and remain in agreement with most of the ideas in it. I enjoyed (and still do) many of the tales and neologisms he came up with there, although on my second reading I find much of it more superficial and self-contradictory than I did the first time around, although this may reflect a more critical approach given our bad relations since. Anyway, after reading it, and becoming aware that he had a number of technical papers floating around on substantive aspects of it that were unpublished, I sent him a friendly email, praising his book and inviting him to submit any papers he might wish to the journal I edit, the Journal of Economic Behavior and Organization (JEBO). He has posted part of that email on his site.

What he does not note on his site is that his reply to me, somewhat delayed, was a form email telling me that he was too busy to reply to my email. I was not all that surprised by this as this was the time when TBS was on the bestseller list, and I could understand that indeed he might be very busy. He said nothing about JEBO and did not say anything about my invitation.

Now, there is at this point a crucial event that he did not realize. He argues that what followed was due to my "feeling rebuffed" that he had "refused [my] invitation to submit in his technical journal." Well, he had not refused. He had simply said he was too busy to reply, and I was in fact still awaiting a reply. However, I became aware of this paper by Bondarenko and saw some discussions on some blogs by some other people whom he does not attack and whom I shall not bring up who argued that Bondarenko's results showed that Taleb's barbell strategy was a money loser in most years, even if the losses would not be all that great, which is his ultimate defense of the strategy ("My barbell strategy has nothing to do with making money - although it does OK - but with being robust to model error"). It was after seeing this, and also hearing of some bizarre conduct of his regarding another blogger, whom I shall not mention, that I then put up a post on the old maxspeak, the predecessor of this blog.

In that post I spent most of my time praising TBS, something that Taleb has somehow never noticed or commented on, I guess assuming that everybody should praise his book without any questions or criticisms. I then, as had Tyler Cowen in a review in Slate (the reason Tyler is on his bad list), said that the main weakness of the book was that his barbell strategy would lose money most of the time. I went too far and said that he would probably not be able to make much money personally with it and would do better by writing and selling his successful books.

Well, now within 20 minutes of putting this up, I got an email from this guy who was "too busy" to reply to my friendly earlier email. It warned me in pretty strong language that I did not know how he made his money and that I should be careful what I said, pointing out specific wording mentioned above. So, I altered that wording to make the post not say what he definitely would do or not do in terms of making money, but still criticizing him. He then sent me another email in which he essentially threatened to sue me, which he has done to others who criticize his financial strategies (whatever else he is, he is ridiculously thin-skinned). I then put up his emails in the comments section of the post and ripped him harshly for his hypocrisy.

I now realize that part of what happened here was a miscommunication. He did not realize that I had changed my views somewhat on his book because of something I read after I sent my original email. That was unfortunate, because, as I said to him both on the blog and in an email, he and I are very close in views and admire and respect many of the same people, some of whom we share as friends. We actually ought to get along, but fell into a very unpleasant contretemps. In any case, I have continued to blast him here and there until now on all this.

A few substantive remarks beyond all this soap opera, and I shall let this go. One is that whether or not any barbell strategy either makes money or even succeeds in insuring one against big losses while preserving that option of making big money depends on the details of the strategy. He sells it as insurance against black swans (unforeseen events), but its ability to insure depends on having "safe assets" that will be safe even in the event of a black swan. In the case of his specific recommendation of US T-bills as the safe asset, while all the world has run to them in the last few months, it is now very far from clear how safe they are, at their near zero rates, and with the possibility of a major crash of the dollar sitting out there. Great grandma's old "cash in the cookie jar" may well be better, maybe along with some euros and yen and a couple of other currencies. A crash of US government securities could well be the next Black Swan.

The strategy again only will work if not too many people are doing it. If too many people are doing it, then the generalization of Bondarenko's critique will hold: those endpoint assets will be overpriced and money will be made by buying the intermediately risky ones. Also, if everybody does it, the economy will belly up with no financing of those intermediately risky activities that constitute the majority of the economy.

Furthermore, while it is very popular now to attack "economists" in general, Taleb rather makes a hash of things. On the broader part of his website he says somewhere that the only two economists he respects are dead: Hayek and Shackle. However, in TBS we find him praising Keynes, Knight, Minsky, and Kindleberger, all of whom I also admire. He also cites many living economists at least not critically, and some positively, with Robert Shiller probably most frequently. Yes, Merton and Scholes (and Samuelson) all look bad, and yes, the textbooks should stop pushing models based on Gaussian distributions, but by now most of us, and certainly the contributors to and readers of this blog know better.

Finally, he does remain in contradiction with himself in TBS, although he knows this and sort of acts like it is all very cute and philosophical (p. 296: "Half the time I am intellectual, the other half I am a no-nonsense practitioner... Half the time I am shallow, the other half I want to avoid shallowness," etc.). But he does have major contradictions, which make me less inclined to be so charitable about his slams on so many people over pretty trivial stuff (although not all of his slams are over trivial matters). So, he spends most of the book denouncing Gaussian distributions and those who push them (not very many these days, kind of a straw man). He seems to contrast that "Mediocristan" with "Black Swan" world of "Extremistan." But then, he spends time talking about econophysics and his papers with Mandelbrot on multi-fractal distributions and so forth, which he admits are not really either; they are "grey swans." Yes, he does cover his behind, but after all his rhetoric and carrying on, it looks pretty hypocritical.

A final btw. On his site he states that he did not wish to submit to JEBO because of his "no-nonsense orientation [that] clashes with academic resume building." Hmmm. Well, that might be fine, but I do see him publishing in American Statistician, Quantitative Finance (edited by our mutual friend, Jean-Philippe Bouchaud), and currently in the process of co-editing a special issue of the International Journal of Forecasting. Well, I wish him good luck with all that academic resume building (Oh, and I still think that he is a popularizer, although that is not necessarily a bad thing, but no, he will not get a Nobel for his ideas, sorry).

Employment Decline – Casey Mulligan Blames Inward Shift of Labor Supply

Believe it or not this explanation made it in print:

Because productivity has been rising — almost as much as the Douglas formula predicts — the decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire). Why would some people have fewer incentives to take a job in 2008 than they did in 2006 and 2007 (and employers fewer incentives to create jobs)? I will tackle that question in my next post, but even without a specific answer we learn a lot about today’s recession from the conclusion that labor supply – not labor demand – should be blamed. First of all, it suggests that a fundamental solution to the recession would encourage labor supply (perhaps cutting personal income tax rates, so people can keep more of their wages), rather than tinker with demand.

Actually – Mulligan decides not to tell us what specifically induced people to reduce their offering of labor after all. The key item in his first post was referred to his next post? OK. But if there was some supply-side reason why workers decided to reduce their offerings of labor along an unchanged demand curve – wouldn’t that mean real wages would have gone up? Funny thing – Mulligan also fails to talk about this aspect of his bizarre explanation.

Financial Regulatory Daisy Chain

I read that Marc Mukasey, son of Atty. Gen. Michael Mukasey, who works for Rudolph Giuliani's law firm, is representing Frank DiPascalli, whom the Wall Street Journal reports is suspected as being in the center of the Madoff scheme. Of course, Madoff himself and his family had numerous connections with regulators.

Now just imagine that Madoff had been a poor person cheating on welfare. How long could he have gotten away with it?

Feldstein Advocates Surge in Defense Spending

Martin Feldstein says Defense Spending Would Be Great Stimulus:

As President-elect Barack Obama and his economic advisers recognize, countering a deep economic recession requires an increase in government spending to offset the sharp decline in consumer outlays and business investment that is now under way. Without that rise in government spending, the economic downturn would be deeper and longer. Although tax cuts for individuals and businesses can help, government spending will have to do the heavy lifting. That's why the Obama team will propose a package of about $300 billion a year in additional federal government outlays and grants to states and local governments ... A temporary rise in DOD spending on supplies, equipment and manpower should be a significant part of that increase in overall government outlays. The same applies to the Department of Homeland Security, to the FBI, and to other parts of the national intelligence community. The increase in government spending needs to be a short-term surge with greater outlays in 2009 and 2010 but then tailing off sharply in 2011 when the economy should be almost back to its prerecession level of activity. Buying military supplies and equipment, including a variety of off-the-shelf dual use items, can easily fit this surge pattern.

Feldstein’s call for some surge in government purchases with a scaling back when we reach full employment strikes me as good macroeconomics. However, we can do the same thing with public schools, bridges, and roads. Of course, I had a similar reaction to something Bill Kristol wrote.

Merry Christmas from the forest in Tasmania

A human being is a part of the whole, called by us the 'Universe' - a part limited in time and space. He experiences himself, his thoughts and feelings, as something separated from the rest - a kind of optical delusion of his consciousness. This delusion is a kind of prison for us, restricting us to our personal desires and to affection for a few persons nearest to us. Our task must be to free ourselves by widening our circle of compassion to embrace all living creatures and the whole of Nature in its beauty.

Albert Einstein

The Hubbard-Mayer Proposal to Nationalize Housing Finance – Can the Government Make Money on Socialism?

James Kwak has a nice discussion of a proposal that Brad DeLong endorses thusly:

We are drifting toward nationalizing housing finance. And as long as the government can borrow at the Treasury rate it can buy up and refinance the country's stock of mortgages without paying a dime in the long run. The largest risk-arb operation in history--and since the government can mobilize the entire risk-bearing capacity of America, a very low-risk one

According to the Federal Reserve, long-term mortgage rates are near 5.2 percent so the Hubbard-Meyer proposal is to finance them at rates well below current market rates with long-term Treasury rates are near 2.5 percent. How much of this difference represents the expected return premium that Brad hints at versus the expected losses from default, which the government will inherent? I’m not sure but Kwak offers us the following:

One question is whether the loans will be sustainable. Hubbard and Mayer say that 1.9% is more than enough because the ordinary spread is 1.6%. But these are not ordinary times, and even if the plan does help turn around the economy, we are probably looking at 1-2 more years of rising unemployment and resulting defaults. Furthermore, conforming mortgages rates are already down to 5.2% (thanks in part to the Fed talking rates down), so Fannie and Freddie could face the problem of getting stuck with riskier mortgages while the private sector keeps the better ones.

While this discussion does not answer the question, it does suggest that default risk today is higher that the historical spreads that Hubbard and Mayer are relying upon.

The Griots

"I was .. out walking toward Lycabettus, crossing for one more time the empty ''bombed'' streets, and the looted stores, having the most confused feelings. As the words of Mao ''Great unrest excellent condition'' suddenly hit my mind..." [1]

"What we face in Greece, it is not a simple reaction to the murdering of the young student Alexis Grigoropoulos, but something that we could describe as a general exegersis, somehow simular to what happened in Los Angeles in 96 or in Brixton in the 80's." [2]

"a group seen by an overwhelming majority in society as monstrous has itself labelled other people as monsters who can be attacked with impunity." [3]



[1] GRIOTS _day 4
Wednesday, 10 December 2008
Pictures from fucked up generation blog

[2] GRIOTS _day 2
Monday 8 December
http://foldedin.blogspot.com/

[3] Folded-in and The making of Balkan wars:The game at Monsters exhibition in Dresden. MONSTERS. Part II: Beat the Monsters!
http://foldedin.blogspot.com/
Thursday, 13 November 2008

Oil and Iraq: The Latest

As the Sunni insurgency in Iraq gradually dies down, ethnic and religious conflicts tied to oil are becoming more central, as reported by Ben Lando at Iraqi Oil Report, http://www.iraqoilreport.com. The northern cities of Mosul, and especially Kirkuk, remain violent, flashpoints partly because the struggle between Kurds, Arabs, and Turkmen for control, also involves control of a major oil producing center, with the Kurdish Regional Government already cutting its own separate oil deals with outside companies. Lando also reports that there is a move on now in southern Basra to vote on attaining autonomy, which would allow that region, where most of the rest of the oil is, to cut its own deals separate from the central government. Meanwhile the collapse of oil prices means the central government will probably go from running a budget surplus this year to a deficit, with cutbacks in reconstruction spending, although having been so far down, Iraq may be in better shape than other oil exporters, such as Russia, who needs $70 per barrel to balance its budget (and has had its stock market drop by 80% this year), or even Saudi Arabia who needs the now-too-high $40 per barrel, same price the oil companies reputedly have used to make their long term production investments.

Speaking of oil prices, this is an area where I was partly right, but did not go nearly far enough. So, in late spring, sometime after the price moved above $120 per barrel, I told a local TV station that it was looking like a speculative bubble, and the price could easily go down, "maybe even below $90 per barrel, although probably not below $70, and we will never see $2 per gallon for gas in the US again." Ooops! Wrong again. At least I recently talked a friend out of buying a six month forward contract on oil when it was at $53 per barrel, warning it could go as low as $25, which may yet also prove too high. But then, in 1930, at the beginning of the Great Depression, after the great East Texas oil field was discovered, the price fell in a six month period from about $1 per barrel to about 5 cents. A similar drop now would take it down to a bit over $7 per barrel from the peak of $147 in July, but then I am not expecting a find of an easy to pump oil field on the magnitude of the now largely depleted East Texas one.



Hidden conclusion here.

Notable

"We are not in a recession. We are not even in a depression. We are at the end of an era." -- Robert Paterson (by way of James Fallows).

THE FUNDAMENTALS ARE SOUND: A MaxSpeak Flashback

by the Sandwichman

To commemorate finding $800 in an ATM yesterday, from May 2006: THE FUNDAMENTALS ARE SOUND by the Sandwichman. The story of a poor sandwich-man from Lithuania who found a fortune in a snow bank, went nuts and ended up back where he started, told entirely in headlines.

It's Friday in Tokyo and the Nikkei is down 2.4%
as the Yen rises to a 8-month high against the Dollar.

Gold hit a 26-year high of $728 an ounce
before closing at $721.50 in New York,
while the Dow Jones Industrial Average
"plunged" 142 points on Thursday.

It's time for the Sandwichman to make a prediction:

The stock market will not crash on Friday!

However, just in case it does,
below the jump is an improbable story,
told completely in headlines,
about a poor sandwich-man
who found a fortune in stock certificates
in a snow bank on Wall Street.

——————————
'Sandwich Man' Restores $45,000
To Brokers but Goes Unrewarded
—————
$1-a-Day Sign Carrier Finds Wallet
in Snow Outside Stock
Exchange and Gives It to Policeman
— Owners of Stock
Think Recompense, if Any,
Is Up to Surety Company.
—————
$1-A-DAY MAN FINDS
$45,000 IN STOCKS
—————
Wouldn’t Keep Real Money Either.
—————
Once Found $60 at Dance.

——————————
REWARDS SHOWER
ON ‘SANDWICH’ MAN
—————
Finder of $45,000 Securities
Gets $105 Cash and Promise
of Clothing and Job.
—————
WEEPS AT PRESENTATION
—————
Surety Concern Also Will Give
Him $20 for Next 10 Weeks
— Banker Among Donors.
—————
Saw 'Sandwich” Man in Gale.
—————
Surety Concern to Give $275.
—————
Gets $25 More.

——————————
FINDER OF $42,000
'IN WALL ST.' NOW
—————
'Sandwich' Man Lays
Aside His Boards to Take Job
as a Broker's Messenger.
—————
EATS WITH NEW EMPLOYER

—————
Trips to Haberdashery and a

Barber Shop Complete His
Busy Day Downtown.
—————
Reports on New Job Today.
—————
More Gifts Are Sent in.
——————————
'SANDWICH MAN' HELD
IN PSYCHOPATHIC WARD
—————
After 'Look' at Him,
One Man Drops Dead

——————————
LUCK BRINGS WOE
TO 'SANDWICH MAN'

—————
Finder of $45,000,
Glorified for
Honesty, Is Deranged by
Sudden Affluence.

—————
RICHER DIET MAY BE CAUSE
—————

Doctors Hope for Recovery of
Former Derelict Whose ‘Look’
Killed an Associate

——————————
THE TOO IMPROBABLE.
——————————
SANDWICH MAN UNCHANGED
Tests on Greges at Bellevue Not
Yet Completed.
——————————
DELUSIONS ENDED FOR
SANDWICH MAN
—————
Finder of $45,000, Who Rose
to Sudden Riches and Fame,
Leaves Bellevue Today.
—————
BUT DOCTORS ADVISE REST
—————
Frank Greges, However, Says He
Is ‘Full of Pep’ and Wants
to Get Back to Job

——————————
‘SANDWICH MAN'
GOES HOME IN TAXI
—————
He Leaves Bellevue to 'Take It
Easy' on Rewards for His
Return of Securities.
—————
PHYSICIAN GIVES HIM $5
—————
With This ‘Change’ in Pocket,
He Poses for Photographers,
Then Rides Off on $1.20 Trip

——————————
‘SANDWICH MAN'
RETURNS TO BEAT
—————
Greges Carries Boards Once
More After Touch of Fame
for Restoring $45,000.
—————
PHILOSOPHICAL ABOUT IT
——————
Has ‘Maybe a Couple Hundred
Dollars’ of His Rewards for
Honesty — Snubs Farm Work

Fiscal Stimulus of $850 Billion Over Two Years

Me thinks Lori Montgomery needs a new calculator:

President-elect Barack Obama and congressional Democrats have entered discussions over an economic stimulus package that could grow to include $850 billion in new spending and tax cuts over the next two years ... Obama is putting together a package of $670 billion to $770 billion but that he expects additions by Congress to jack up the total to about $850 billion, or 6 percent of the nation's economy.

GDP is about $14.4 trillion per annum so $850 billion over two years is just under 3 percent – not 6 percent. Aside from this nitpicking on my part, there is some interesting information in this story:

A package of that size - which would include at least $100 billion for cash-strapped state governments and more than $350 billion for investments in infrastructure, alternative energy and other priorities - is a significant increase over the numbers previously contemplated by Democrats. It would exceed the $700 billion bailout of the U.S. financial system, as well as the annual budget for the Pentagon ... Furman and Schiliro said the package would include $100 billion to help states cover the expanding cost of Medicaid, the federal health program for the poor. With more than half of states reporting budget shortfalls this year, the package also could include big increases in state block grants and other programs intended to help local governments avoid layoffs or tax increases.

Uh oh – I have to nitpick again. First of all, it is true that defense spending is running at something near $700 billion per year so how is $850 billion over two years a larger figure? And if the extra cost of Medicaid eats up all of the $100 billion devoted to “cash-strapped state governments”, then what is left over to address what we discussed here? Maybe Ms. Montgomery needs more than a new calculator. Maybe she needs a better editor.

Not Quite Radical

Minus the amazement about the money multiplier, this proposal published in Yes! Magazine bears a superficial resemblance to mine. The big difference, of course, is that Brown would have the good citizens assume responsibility for all the liabilities of the banking system she would seize. This is why I have argued against bank nationalization and for new public institutions to take their place. A minor note: Germany is a somewhat more substantial instance of public banking than North Dakota. Not that I have anything against North Dakota. In fact, we’re having their weather right now in the Pacific Northwest.

Sandwichman Finds $800 in ATM

by the Sandwichman

Times are tough. But not so tough that some people won't go and withdraw 800 bucks from an ATM machine and then forget to take the money (and the withdrawal slip)! Of course I did the right thing and turned the money over to the credit union where the bank machine was. Coincidentally, there was a story in the New York Times in the 1930s about a sandwich man who found $45,000 in securities in a snow bank on Wall Street. I did a post on that story on MaxSpeak. I'll have to see if I can dig it up again.

The End of Federal Reserve Open Market Operations As We Knew Them

It is being widely noted that the latest Fed interest rate cut pretty much uses up that tool for stimulating the economy, even though zero is a floor only in convention, and we have seen negative interest rates in fact. But there is more going on here than has been remarked on. To a substantial degree the latest Fed move involves covering up how seriously it has lost its ability to control the federal funds rate, its supposed main policy tool. The latest cut to 0-.25% simply moves the target down to where the actual ffr has been in recent weeks, well below the previous target of 1%.

The deeper problem is that the recent turmoil and decline of interest rates to near zero is collapsing the repo market. This point was made on Dec. 16 in "Ultra-low US rates undermine repo market" by Michael Mackenzie, also linked to on marginal revolution by Tyler Cowen. MacKenzie stresses the general problems for liquidity in financial markets arising from this collapse, but did not note the rarely made point that this has been the market where the Fed has generally carried out its open market operations that control the ffr. So, the collapse of this market may well be why the Fed has been unable to control the ffr, which fact they may now be trying to cover up. MacKenzie notes that a major problem in the repo market is that people borrowing securities from dealers are not returning them on time, leading to "failed trades." Also, the low rates leave too small spreads for the dealers to engage in intermediation. In any case, the Fed has lost its favorite policy tool.

Local Government Spending Cuts – This is Why We Need Federal Revenue Sharing

Our graph, which shows the share of GDP from both revenues and expenditures of our state & local governments from 1999 to current, has a surprise – at least for me. While we often hear about the pro-cyclical nature of state & local fiscal policy, expenditures have appeared to be countercyclical – but this might change:

The worst budget crisis in decades is forcing states to cut funding to cash-strapped cities, which already are slashing police, firefighters and other services … In today's recession, both state and local revenues are suffering across the board. In the past 30 years, state spending has grown by an average of 6.3%. States cut a total of 0.1% from their budgets for fiscal 2009, which ends in June; the faltering economy is increasing projected deficits in the coming months. States are facing $30 billion in budget deficits for the current fiscal year, according to the Fiscal Survey of States released this week by the National Governors Association and National Association of State Budget Officers. That figure is likely to grow in the coming months. Twenty-two states, including Georgia, California and Nevada, already have cut spending from their 2009 budget. This week Minnesota's governor and legislators said cities and counties can expect aid to decrease soon. The state is coping with estimated shortfalls of $426 million for this year and $5 billion for the two-year budget period that begins in July. New York Gov. David Paterson's budget proposal, released this week, would cut about $240 million in aid to New York City.

The story continues with all sorts of suggestions as to how to avoid the spending reductions. All good ideas but state & local governments are often restricted from running deficits so the best idea seems to be Federal revenue sharing as the states appear to be ready to reduce their aid to the local governments.