Nassim Nicholas Taleb is a great believer in the notion that investors routinely underestimate the likelihood of large scale events. He popularized this idea in his 2007 book, "The Black Swan." In a recent interview with Bloomberg, he explained why the Federal Reserve's recent actions may have lulled investors into a false sense of security by making them think that it will always ride to the rescue whenever financial markets begin to experience some turmoil.
Why crises are like forest fires
Taleb was asked whether the unlimited liquidity from the Fed could be a sufficient backstop against future financial catastrophes. In his opinion, crises cannot be prevented - only temporarily postponed, and the problem with kicking the can down the road is that eventually the problem will become so big that no one will be able to deal with it:
"What are crises for? Crises are like forest fires - they are there to eliminate firms that should not be [in business], to accelerate the evolutionary process. A firm that will go bust should go bust early, when the cost [of bankruptcy] will not be high on the shareholders, the owners, the employees. You fail early, and you do people a favour by allowing them to fail early. What the Fed has been doing is the reverse - injecting tons of money to keep afloat firms that should not be around, and delaying that failure, which will eventually happen."
Taleb went on to say that the Federal Reserve's emergency policies, which include the buying of corporate bonds, essentially amounted to state socialism, and thus undermined the basis on which free markets should operate. The problem, he said, is that nobody is bigger than the market, even the Federal Reserve.
The growth in the number of zombie firms (companies that are unable to service their own debt load) over the last few decades is a problem that I have talked about before. These are the companies that Taleb believes should be allowed to go out of business. What might happen that would finally cause these companies to fall?
Taleb thinks that at some point, the Federal Reserve might be forced to raise interest rates, either to counteract the inflationary forces that these emergency liquidity injections have unleashed or due to pressure from pension funds and other savers that manage retirement money and want a good return on their investments. An increase in interest rates would likely spell the end for many of these unprofitable companies, with significant consequences for all stakeholders. If you are going to fail, better to fail early.
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