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Beyond Black Swans, De-Leveraging And Re-Leveraging

Economics / Economic Theory Jul 07, 2010 - 05:01 AM GMT

By: Gary_North


Diamond Rated - Best Financial Markets Analysis ArticleThe black swan is the foo bird of modern Keynesianism. It is a threat only because of central bank fiat money and commercial bank leverage.

In a recent report, "China: What Rhymes with 'Crash'?" I wrote this:

China is not an accident waiting to happen. It is a government-engineered disaster waiting to happen. It is not threatened by a black swan event. It is threatened by the Austrian theory of the business cycle.

We hear far too much these days about black swan events. Taleb's book, timed well in 2007, has turned the phrase into a catch phrase. Here is a summary from Wikipedia.

  1. The event is a surprise (to the observer).
  2. The event has a major impact.
  3. After the fact, the event is rationalized by hindsight, as if it had been expected.

Points #1 and #3 are commonplaces. That events take place that are surprises is no surprise. That people try to make sense of them is also no surprise. Point #2 is the unexplained factor. In a free market economy, there can be unexpected events. But the market as a whole is not shaken by them. Losses are contained. Some firms lose. Others gain. There is no systemic threat.

What Taleb's book does not explain is why the containment factor of profit and loss fails to contain a black swan event.

It was this question that intrigued Ludwig von Mises a century ago. He asked: Why do entrepreneurs make the same mistake at the same time? His answer: the monetary system. It is the common link in the entire economy. He looked here to discover the reason for the black swan of simultaneous recessions.

He searched the monetary system for a reason why market forces did not send the signal of vulnerability to a black swan event. His answer: the government thwarts the free market in banking. The government legalizes fractional reserve banking. Then it sets up a central bank to make sure that the market does not overcome the inflationary effects of legalized fractional reserves.

The Wiki article goes on to describe the central idea in Taleb's book.

The main idea in Taleb's book is not to attempt to predict Black Swan Events, but to build robustness against negative ones that occur and being able to exploit positive ones. Taleb contends that banks and trading firms are very vulnerable to hazardous Black Swan Events and are exposed to losses beyond that predicted by their defective models.

I surely have no objection to this goal. On the contrary, I espouse it. The problem comes when we look for an explanation of the black swan event. If we cannot explain it in terms of a theory that is universally applicable, we cannot hope to build in the necessary resiliency.

He identifies commercial banks as the arena of black swan events. So do I. But the question is this: What is it about the commercial banking system that allows a black swan event to wreak havoc on the entire banking system, and move from there to the economy?

Keynesians, monetarists, and supply-siders have different explanations. These explanations conflict. Austrian School economists offer an explanation that is denied, both in theory and practice, by the other schools: legalized fractional reserves.

The fractional reserve banking system offers profits for deception. Banks offer to allow depositors to withdraw 100% of their deposits at any time, yet the banks make their income by lending out the deposits at rates of interest above the rates offered to depositors. The depositors cannot all get their money out on the same day or week.

A black swan event is an unpredictable event that calls into question a bank's ability to pay the depositors. In the old days, depositors lined up outside a bank. That was the kiss of death. Today, a bank run has to do with rolling over very short-term debt – debt obtained from other banks. The lenders decide that a bank or agency is insolvent. All at once, they refuse to roll over the loans. This is a bank run, but it does not involve depositors lining up outside the bank. It involves a rumor in the financial community. Such a rumor brought down Bear Stearns and Lehman Brothers in 2008. It took less than a week in each case. Word travels fast inside the banking system.

What we hear today is endless chatter about another black swan event. But nobody in the banking system takes such chatter seriously enough to pull their banks' money out of other banks. The money is digital. Where can banks put it to work without exposing the money to defaults – black swans? The answer is excess reserves at the Federal Reserve. But this does not pay enough to pay depositors. The banks are losing money on excess reserves.

The nature of fractional reserve banking today is that all money is based on debt, and the debt structure is vulnerable to black swan events. With leverage throughout the financial industry at astronomical levels, only a bank's excess reserves serve as a way to provide safety from the de-leveraging effects of some black swan event.


Mises described all this in 1912 in his book, The Theory of Money and Credit. The book has never been taken seriously by economists. They prefer the theories of Irving Fisher, whom Mises refuted in his book.

It is interesting to see which economist fared best with his own portfolio.

Fisher invented the Rolodex. He became very wealthy. He had his money in the stock market. He lost it all in the Great Depression, and lost his sister-in-law's fortune as well. The Wiki entry on Fisher is worth reading.

He famously predicted, a few days before the crash, "Stock prices have reached what looks like a permanently high plateau."

He went on to state on October 21 that the market was

"only shaking out of the lunatic fringe" and went on to explain why he felt the prices still had not caught up with their real value and should go much higher. On Wednesday, October 23, he announced in a banker's meeting "security values in most instances were not inflated." For months after the Crash, he continued to assure investors that a recovery was just around the corner.

In contrast, Mises saw what was coming. He not only saw the general move, he saw the black swan event that began the second phase of the Great Depression: the 1931 collapse of Vienna's Credit-Anstalt Bank, the flagship bank of the Rothschilds in Austria. It got bailed out by Germany's central bank, but it was too late. The dominoes fell.

Several years earlier, Mises had refused a job with this bank. His widow described the scene in her autobiography, My Years With Ludwig von Mises (1976).

One day Lu told me he had been offered a high position at the Credit Anstalt, the foremost banking institution in Vienna, but that he had decided not to accept it. When I asked him the reason for his refusal, he told me that a great "crash" would be coming and that he did not want his name in any way connected with it (p. 24).

Fisher fell out of favor for a generation, but with the academic triumph of his disciple, Milton Friedman in his book, A Monetary History of the United States (1963), Fisher's reputation soared. Friedman and Schwartz told academia what it wanted to hear: that the Federal Reserve's refusal to inflate in 1931–33 was the main cause of the Great Depression. Problem: the FED did not deflate in 1931, and it inflated in 1932–33.

Second, this had been Fisher's explanation in the mid-1930s, when his reputation had collapsed.

What happened was that 9,000 banks failed, thereby shrinking the M1 money supply. The FED had no control over this. Only with the creation of the FDIC in 1934 did this monetary contraction cease.

Did the economy recover? No. The recession of 1937 rolled back the recovery.

The Federal government adopted Keynesian deficits on a massive scale, before Keynes came up with his theory. All governments did. The depression remained.

What ended the depression? World War II. The government drafted 12 million men and took them out of the labor force. The FED inflated as never before. The government put on price and wage controls.

The next generation of economists adopted Keynesianism. The only strong competition for Keynes came from Friedman, and then only in the late 1970s, after a decade of recessions, deficits, and Federal Reserve inflation.

In the same year that the Friedman/Schwartz book was published by Princeton University Press, across town Murray Rothbard's book, America's Great Depression, was published by a small firm, Van Nostrand. Rothbard's book was either ignored or panned by academia. Only two decades later, when Paul Johnson used it to tell the story of the cause of America's Great Depression in Modern Times (1983), did this book gain even grudging attention.

Today, Fisher is once again the fair-haired boy in academia. His reputation has been restored. He is seen as a scientist because he used equations. He got everything wrong, but he did it with equations. Academic economists do not care about outcomes. They care about looking like physicists, even though their constructs collapse. Appearances count in the world of academic economics. Reality has little effect. This is why there is no academic criticism of the FED today, and very little criticism of the Federal deficit, except from Keynesian economists who say it should be larger. In the name of Keynes, the Paulson-Bernanke policies of ad hoc desperation have triumphed.

Mises had it right in theory in 1912. Fisher had it wrong. Mises had it right as a forecaster in 1929. Fisher had it wrong. Rothbard had it right in 1963: the FED caused the depression with its inflationary policies in the second half of the 1920s, not the 1930s. Friedman had it wrong. But academic economists cheer Fisher and Friedman.

Meanwhile, black swans, like the foo bird, circle above, invisible to economists, waiting for a target. Stay out from under them.


The financial media talk a lot about de-leveraging. They worry that the assets on the banks' books are still bad, the CDOs and other arcane contracts are still at risk, and the sovereign debt of sovereign governments might not be immune to default. This is mostly chatter. Few people in the mainstream recommend abandoning digits for gold. Everyone knows that the financial system is all digits and all based on debt. Everyone can't get out at once.

The acceptable answer is central bank inflation. People nod in agreement when Bernanke talks about winding down the FED's balance sheet. "Winding down" is a neutral term for "de-leveraging." As long as Bernanke avoids calling de-leveraging de-leveraging, no one panics. The word games go on. The financial system rests on word games. Word games and debt: united, they stand!

Divided, they fall.

The Great Depression was all about de-leveraging. Friedman and Schwartz's criticism of the FED was all about the lack of re-leveraging.

The people who predict inevitable price deflation insist that the de-leveraging process cannot be reversed by central bank re-leveraging. They point to the impotence of the FED, 1931–33. But what they ignore is that the monetary base rose, 1934–38. The FDIC stopped bank runs. M1 rose. Then came World War II. Mass inflation would have arrived, except that price and wage controls created repressed inflation: the ration book economy.

The ability of central banks to create monetary inflation is unlimited . . . at some price (rising). The FED can transform the $1.2 trillion of excess reserves into a doubled money supply in one day. All it has to do is charge 5% or 10% per annum fee on all excess reserves – a negative interest rate. That the FED has not done this indicates that the policy-makers are still worried about price inflation. They are willing to let things ride until there is another black swan event. The FED is in a holding action. The FED's charts reveal this clearly.

The FED was able to shoo the black swans away in 2008 by doubling the monetary base in about five weeks. It swapped Treasury debt for toxic debt at face value, but only for the too-big-to-fail banks. It sold off liquid treasury debt for Fannie Mae and Freddie Mac bonds. In other words, it re-structured its own portfolio in order to shoo away the black swans.

It did not kill the black swans. It did not kill the leverage that makes the black swans so dangerous. The commercial banks have reduced the leverage: excess reserves. They still fear the return of a black swan.


The modern state uses its central bank to bail out state policies that backfire in full public view, such as low-interest loans for poor people, who then default. The state wants a lender of last resort. The central bank wants a monopoly over money, more control over the banking system, and sweetheart deals for the largest banks. This has been going on since 1694. It will not change for as long as there is a central bank.

The voters know none of this. The non-Austrian economists reject all of this, or else embrace it as the savior of the system.

The system rumbles on. It rests on fractional reserves, which is another word for leverage. The central banks cannot unwind their portfolios, because that would de-leverage the system. This would attract black swans the way 16-year-old pages attract Congressmen.

There is no solution to black swan events for as long as central bank protection is available to the largest banks, which are too big to fail. Being too big to fail, they are leveraged to the hilt. They can borrow 90-day money at less than two-tenths of a percent. They can lend it at 4% or more. They are borrowed short and lent long. This is the traditional practice of commercial bankers. It always leads to a crisis.

Another Princeton University Press book has made a name for its authors. It was published in 2009. Its authors examined the economic record for 800 years. They conclude that banking failures produce economic crises and downturns. The book had a perfect title, Thus Time It's Different. The book has sold 100,000 copies – unheard of for a university press book.

The book has done the near impossible. It has been praised by academic economists and the mainstream financial media.

The book says that black swans are still flying, and will surely strike again.

The difference between this book and Mises's Theory of Money and Credit is this: Mises explained why this time it will not be different. His explanation was too radical.

Ron Paul extended Mises's insight in three words: "End the Fed."

Until that day, the black swans and the foo bird will remain a threat.


More interesting than Taleb's three criteria of a black swan event are the three stages of acceptance of events that run counter to any Establishment's official explanation of the way the world works.

  1. It isn't true.
  2. It's true, but so what?
  3. We always knew it was true.

With respect to the Austrian theory of the business cycle, we are still in stage #1. What will it take to move the Establishment to stage #2? A really bad black swan event, I think.

The governments and the central banks will surely deliver that event.

Gary North [send him mail ] is the author of Mises on Money . Visit . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .

© 2010 Copyright Gary North - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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