The Tyranny of Optimization

Nature smiles at the union of freedom and equality in our utopias. For freedom and equality are sworn and everlasting enemies, and when one prevails the other other dies […] To check the growth of inequality, liberty must be sacrificed, as in Russia after 1917. Even when repressed, inequality grows; only the man who is below the average in economic ability desires equality; those who are conscious of superior ability desire freedom; and in the end superior ability has its way. Utopias of equality are biologically doomed, and the best that the amiable philosopher can hope for is an approximate equality of legal justice and educational opportunity.

–Will & Ariel Durant, The Lessons of History

When I was younger, I used to believe strongly in what I’ll call “technocratic optimization.” In my view, the Big Problems confronting civilization could be tackled through the decisive application of computational power and human intellect. The idea was that if you got all the smartest people working on all the hardest problems eventually you could solve them. You would discover Truth with a capital T. The rest would take care of itself.

I was a fool to believe this.

Human societies don’t run like giant mean-variance portfolio optimizations, where each individual can be reduced to a personal utility function, then aggregated and mapped to a kind of efficient frontier based on the available resources. Human societies are dynamic systems. These systems are constantly evolving in the face of environmental and social pressures. Whenever we attempt to optimize social and economic systems, our models inevitably end up either overfit or underfit. Hence the abundance of “unintended consequences” that accompany major policy changes.

But here’s the biggest problem with technocratic optimization: even in the best of circumstances, where it’s reasonably self-evident, the mere existence of Truth with a capital T is insufficient motivation for people to change their behavior. As Upton Sinclair famously wrote: “it is difficult to get a man to understand something when his salary depends on him not understanding it.”

So what’s a frustrated optimizer to do?

Well, you can force people to buy into your optimization. Or, you can convince them to buy into your optimization. Or, you can convince them to buy into your optimization by leveraging technology and their behavioral biases (a much better bet than simply relying on the merits of your argument).

If you’re an optimizer, your intellectual journey ends in tyranny.

Russland-Nord, Erschießung von Partisanen

Now, there’s certainly the concentration camp and NKVD firing squad kind of tyranny we’re acquainted with from 20th century history. All very messy. Fortunately, we now have kinder, gentler forms of coercion available to us.

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The social credit system kind of tyranny, and the fiat news kind of tyranny, for example. Here you’re not staring down the barrel of a gun but rather at a smartphone screen. Here, the trick is not only convincing people to buy into your optimization, but that buying in was their idea in the first place. This is tyranny updated for the 21st century. Much cleaner than putting people up against a wall. Once you start looking for it, you see it everywhere.

So, what’s a reformed optimizer to do?

Personally, I’ve gone back to the Lessons of History, and the collective experience of human civilization. I’ve abandoned the view we should try to engineer “optimal” outcomes for individuals or society. I’ve come to believe that rather than engineer Answers, we should focus on the maintaining and improving the integrity of our Processes: the approximate equality of justice and educational opportunity.

I’ve also abandoned the idea that human civilization progresses on a linear trajectory, or, more precisely, that human civilization can progress along a linear upward trajectory. In reality, things move in cycles and mini-cycles. These cycles are driven not only by changes in the natural world, but also the constant friction generated by individuals and states in competition for power and resources.

Put another way: we oscillate between freedom and tyranny, and between varying levels of equality and inequality over time. This is natural and inevitable (which is not to say it’s “pleasant” or “ideal”). We’ve been fortunate that the general trend over time has been upward. That doesn’t mean we’ll never experience another period of dramatic upheaval and regression a la the Dark Ages.

I believe we should be much more concerned with managing the risks inherent in sudden paradigm shifts such as the French Revolution, Russian Revolution, and the spike in aggressive, authoritarian nationalism that occurred in the 1930s.

In finance nerd terms: mind the tails.

We’re not doing a very good job minding the tails right now. In optimizing for short-term economic growth, our default fiscal policy of every-increasing borrowing and default monetary policy of “plunge protection” (a.k.a The Greenspan/Bernanke/Yellen/Powell/Draghi/Kuroda Put) have provided economic and financial market stability at the expense of political and social stability. One of the most powerful voices in our political discourse today is a freshman rep who is an avowed democratic socialist (whatever that’s supposed to mean). If you can’t see how this relates to the legacy of the financial crisis; the legacy of quantitative easing; the deflationary impact of globalization and technological innovation–well, if you can’t see how all this interrelates, I’m not quite sure what to tell you.

You can’t destroy risk. You can only transform it.

That insight is in short supply among technocratic optimizers.

Wunderwaffen, Part II

My last post was about tradeoffs we must weigh when building investment portfolios. There’s no such thing as a magical asset. Most of the time we spend looking for superweapons (Wunderwaffen) is wasted. In this post I want to riff on Wunderwaffen from another angle: our fascination with things that are exciting conceptually but prove ineffective or even dangerous in practice.

This is a Messerschmitt Me-163 “Komet”.

The Komet was a rocket-powered interceptor designed to combat Allied bombers over Germany. Its distinguishing feature was its incredible speed–it could climb to combat altitude in just three minutes. One test pilot hit a speed of 700 mph in 1944. This set an unofficial world record that wasn’t broken until 1947, when Chuck Yeager set another unofficial record during a secret test flight. Officially, the flight airspeed record remained below 700 mph until 1953.

Unfortunately, the Komet’s incredible engine power was also the source of its greatest weakness. The volatile fuel mixture that fed the engine made it the rough equivalent of a flying bomb. The wiki on the Komet provides these details:

The fuel system was particularly troublesome, as leaks incurred during hard landings easily caused fires and explosions. Metal fuel lines and fittings, which failed in unpredictable ways, were used as this was the best technology available. Both fuel and oxidizer were toxic and required extreme care when loading in the aircraft, yet there were occasions when Komets exploded on the tarmac from the propellants’ hypergolic nature. […]

The corrosive nature of the liquids, especially for the T-Stoff oxidizer, required special protective gear for the pilots. To help prevent explosions, the engine and the propellant storage and delivery systems were frequently and thoroughly hosed down and flushed with water run through the propellant tanks and the rocket engine’s propellant systems before and after flights, to clean out any remnants. The relative “closeness” to the pilot of some 120 litres (31.7 US gal) of the chemically active T-Stoff oxidizer, split between two auxiliary oxidizer tanks of equal volume to either side within the lower flanks of the cockpit area—besides the main oxidizer tank of some 1,040 litre (275 US gal) volume just behind the cockpit’s rear wall, could present a serious or even fatal hazard to a pilot in a fuel-caused mishap.

Ultimately, the Komet had no impact on the European air war. It made very few kills and to the extent it did, its kill ratio was low. This disappointing operational performance hardly justified the many pilot deaths that occurred in development, testing and training.

There are lots of Komet-like investment products out there, including:

Levered and inverse levered ETFs
VIX Futures ETPs
Naked option writing strategies

Most of us shouldn’t get anywhere near these products and strategies. I’ll make an allowance for my trader friends who have a deep and intuitive grasp of the market forces that shape changes in both realized and implied volatility. For us tourists, the leverage and short gamma exposure embedded in many of these products are every bit as dangerous as the Komet’s rocket fuel.

Here’s what an engine fire looks like for these strategies:

201812_HFXAX_Chart — Source: Morningstar

So why are we drawn to this stuff?

Mostly because it’s cool. It’s got Sophistication! It gives us an excuse to talk about things like the volatility risk premium. It makes us feel as if we’re part of some elite fraternity of financial markets people. We “get it.” “Have fun with your index funds, you buy-and-hold simpletons.”

Except really, the joke is on us.

We should never underestimate our deep-rooted weakness for Sophistication! Most of us got into this business at least partly because we’re smart and competitive. We’re captivated by that powerful rocket engine as a feat of human ingenuity. Deep down, we want a shot at that airspeed record.

But it’s not necessarily the most powerful, most sophisticated engine that’s going to win us the war. It might not even make a difference.

And if we’re not careful, it’ll blow up on us.

01/08/19 Addendum: Got into a Twitter discussion on this topic and Corey Hoffstein of Newfound Research was kind enough to educate me on how inverse and leveraged ETFs can be used in a DIY risk parity implementation for small investors. Here is the link to his article. So as always, it seems, #notall applies.

Warfighting

I want to share a reading recommendation with you all: Warfighting. This is not a manual but rather a philosophy for decision making under uncertainty.

h/t to Verdad Capital for the link in this excellent post (actually a newsletter piece), which opines:

I also learned at Quantico that complex linear planning fails in warfare because the profession involves “the shock of two hostile bodies in collision, not the action of a living power upon an inanimate mass,” as Clausewitz reminds us. In the military-industrial exuberance of the post–Cold War decades, we invested heavily in exotic platforms such as drones, cyber capabilities, and billion-dollar strike fighters. Our low-tech but moderately street-savvy opponents in this millennium decided to fight us precisely where and how these assets were near useless. With few exceptions, the most useful equipment for this environment came from the Vietnam era and the most enduring lessons from the time of the Spartans.

Financial markets, made up of people competing for an edge, are precisely the type of environment designed to bedevil static planning. The financial environment is one where valuation multiples persistently mean revert, where income statement growth is not persistent or predictable, where GDP growth does not correlate with equity returns, where market share and moats do not lead to competitive advantage or price return.

So what are we to do in such an environment where outcomes are determined not so much by the very little we can foresee but by what might unexpectedly happen relative to the expectations embedded in the price at which the security is bought? How would we affirmatively strategize and operate differently as investors if all of our most cherished and marketed crystal balls for forecasting price returns are shattered? How should we operate amidst the chaos without operating chaotically?

In Afghanistan, I found that the most consequential assets on our side were the most robust and persistent throughout the history of warfare. An asymmetric but intelligent adversary had refused to engage us on any terms but those where war devolved to a competition of wills, where discipline, resolve, adaptability, and habituated combat-arms tactics dictated the victor, not drones or robot pack mules. Our own persistent behavioral biases were our worst enemy.

This is precisely why I am so interested in things like tail hedging. And lest you be tempted to write this off as interdisciplinary silliness, consider for a moment that life itself can be viewed as an extended exercise in decision making under uncertainty.

UPDATE: After reading and reflecting on this, it seems clear to me it is essentially providing a mental model for what war is and how it is conducted.

At first glance, war seems a simple clash of interests. On closer examination, it reveals its complexity and takes shape as one of the most demanding and trying of human endeavors. War is an extreme test of will. Friction, uncertainty, fluidity, disorder, and danger are its essential features. War displays broad patterns that can be represented as probabilities, yet it remains fundamentally unpredictable. Each episode is the unique product of myriad moral, mental, and physical forces.

Individual causes and their effects can rarely be isolated. Minor actions and random incidents can have disproportionately large—even decisive—effects. While dependent on the laws of science and the intuition and creativity of art, war takes its fundamental character from the dynamic of human interaction.

Also this bit:

War is an extension of both policy and politics with the addition of military force. Policy and politics are related but not synonymous, and it is important to understand war in both contexts. Politics refers to the distribution of power through dynamic interaction, both cooperative and competitive, while policy refers to the conscious objectives established within the political process. The policy aims that are the motive for any group in war should also be the foremost determinants of its conduct. The single most important thought to understand about our theory is that war must serve policy.

The North Korean Economy Explained

There is an excellent podcast available through the FT Alphachat Series featuring Matt Klein’s interview of Marcus Noland, a researcher at the Peterson Institute for International Economics who has spent a significant amount of time studying the North Korean economy.

The background information included with the podcast is also worth reading. This section in particular struck a chord with me:

The North Koreans depended on subsidies from the Soviets to survive, particularly the ability to buy oil and refined petroleum products at “friendship” prices. As the Soviet economy creaked under the combined weight of the war in Afghanistan, low oil prices, and the perceived need to match America’s defence buildup, these concessions started to disappear. By the late 1980s the North Koreans were paying more to the Soviets than they were getting.

One of the downsides of the North Korean obsession with self-sufficiency was that the country ended up with the most industrialised agricultural sector in the entire world. The only way the North could hope to feed itself without imports was to bathe the soil in fertiliser and other chemicals. (Of course, that required imports of energy from the Soviets, but apparently that was okay…) The North Koreans also expanded farmland by cutting down trees, which eventually led to soil erosion, silted rivers, mudslides, and floods.

All of this meant that the collapse of the Soviet Union made the North Koreans extremely vulnerable to food shortages. In the mid-1990s these shortages combined with the failures of the North Korean state to efficiently distribute the food they had and secure enough food from abroad through aid and imports. The result was a famine that killed about 3-5 per cent of the North Korean population — around 1mn people. (Regular listeners will think of Cuba’s “special period”, which killed far fewer people but had similar causes.)

Without spoiling the podcast here are a couple of high level takeaways from my POV:

Centrally planned economies do not work. In the cases of the Soviet Union, China, North Korea and Cuba, central planning, at its best, manged to produce substandard consumer goods. At its worst, central planning actively contributed to the deaths of millions through the misallocation of resources. The misallocation of agricultural resources has proven particularly devastating.

These lines from the 1965 film version Boris Pasternak’s Dr. Zhivago are fairly evocative:

Don’t be too impatient, Comrade Engineer. We’ve come very far, very fast […] Do you know what it cost? There were children in those days who lived off human flesh. Did you know that?

Autarky does not work. North Korea is probably the closest thing we have to a true autarky. And yet, even in its much diminished state the North Korean economy is still not a true autarky! Initially it was dependent on the Soviet Union. Now it is dependent on China.

Markets do work. The Soviet Union, China and North Korea each developed market-based solutions to the massive inefficiencies created by centralized economic planning. In the early days of the Soviet Union, Lenin launched the New Economic Policy (later abolished by Stalin). In China, it is the advent of a “socialist market economy” (which, unfortunately, has evolved into a massive kleptocracy). In North Korea, market-based solutions to famine arrived in the form of small scale, informal trading relationships, as well as a black market for food.

There is much more than this in the podcast, however. So do give it a listen.

The First Mutual Fund

Vereinigte_Ostindische_Compagnie_bond — Dutch East India Company bond from 1623; Source: Wikipedia

Today the mutual fund industry is a multi-trillion dollar business. It is amazing to think these structures, and other innovations we think of as “modern,” such as asset-backed securities, have their origins in the 18th century.

The material in this post is summarized from an article contained within a 2016 collection of essays, Financial Market History: Reflections on the Past for Investors Today, from the CFA Institute Research Foundation. Specifically, this material is from Chapter 12, “Structured Finance and the Origins of Mutual Funds in 18th-Century Netherlands,” by K. Geert Rouwenhorst.

You really ought to read the whole piece as it contains a wealth of fascinating information not summarized here. If you are the kind of person who is fascinated by the idea of structured finance for colonial plantations, that is.

Anyway, the first mutual fund was launched in 1774 by a Dutch broker and merchant, Abraham van Ketwich. Its name, Eendragt Maakt Magt (“Unity Creates Strength”), goes to show that fluffy marketing copy is as old as the asset management business itself.

Rouwenhorst sets the scene:

The first mutual fund originated in a capital market that was in many ways well developed and transparent. More than 100 different securities were regularly traded on the Amsterdam exchange, and the prices of the most liquid securities were made available to the general public through broker sheets and, at the end of the century, a price courant. The bulk of trade took place in bonds issued by the Dutch central and provincial governments and bonds issued by foreign governments that tapped the Dutch market. The governments of Austria, France, England, Russia, Sweden, and Spain all came to Amsterdam to take advantage of the relatively low interest rates. Equity shares were scarce among the listed securities, and the most liquid issues were the Dutch East India Company, the Dutch West India Company, the British East India Company, the Bank of England, and the South Sea Company. The other major category of securities consisted of plantation loans, or negotiaties,as they were known in the Netherlands. Issued by merchant financiers, these bonds were collateralized by mortgages to planters in the Dutch West Indies colonies Berbice, Essequebo, and Suriname.

The investment strategy and terms went something like this:

Investment Strategy

The fund’s objective is to generate income through investment in a diversified global bond portfolio.

To achieve its objective, the fund will invest approximately 30% of its assets in plantation loans in the British colonies, Essequebo and the Danish American Islands. The remaining 70% of its assets shall be invested in a broadly diversified portfolio of issuers including European banks, tolls and canals.

The fund shall also conduct a lottery, whereby a certain portion of dividends will be used to repurchase investors’ shares at a premium to par value, and to increase dividends to some of the remaining shares outstanding. (You know, just for fun)

Share Classes

The 2,000 shares of the fund shall be divided into 20 classes, each to be invested in a portfolio of 50 bonds. Each class shall contain 20 to 25 different securities to ensure a diversified portfolio.

Custody & Administration

The investment advisor (Van Ketwich) shall provide a full accounting of investments, income and expenses to all interested parties no less than annually.

The securities owned by the trust shall be held in custody at the office of the investment advisor. Specifically, securities shall be stored in a heavy iron chest that can only be unlocked through the simultaneous use of separate keys controlled by the investment advisor and a notary public, respectively.

Expenses

The investment advisor shall receive an up-front commission of 50 basis points upon the initial sale of fund shares, and thereafter an annual management fee of 100 guilders per class of securities.

Rouwenhorst argues the driving force behind the creation of the fund was investor demand for portfolio diversification. To purchase a diversified portfolio of bonds would have been prohibitively expensive for small investors of the day. These investors may also have been gun shy following a financial crisis in 1772-1773, which nearly triggered defaults by several brokers.

Nonetheless, the fund endured a tumultuous trading history. By 1811 it was trading at a 75% discount to par (!) and was eventually liquidated in 1824, after making a final distribution of 561 guilders. Interestingly, Rouwenhorst notes that the fund actively repurchased shares when they traded at a discount–what looks to be an early form of closed-end fund arbitrage.

I do not have anything especially profound to conclude with here, other than to observe that financial markets have been complex and global in nature for quite some time. The first mutual fund is a perfect example.

Lethal Risk Management Failures: The Battle of The Narrows

For some reason people find risk management boring. I do not understand why. Some of the most influential and fascinating events in history were a direct result of poor risk management. The sinking of the Titanic; the near collapse of the global financial system in 2008; the Ford Pinto’s fuel system. One of the things I find fascinating about catastrophes is that they typically do not follow from a single point of failure—risk management failures are really systemic failures and are therefore worth considerable attention.

I am currently reading a book about the decline and fall of the Ottoman Empire (The Ottoman Endgame: War, Revolution And The Making Of The Modern Middle East (1908 -1923), by Sean McMeekin). The Ottoman Empire controlled Turkey, the Balkans and much of the Middle East and North Africa for several centuries. It entered the terminal phase of its decline (the exact reasons for this are still debated) in the late nineteenth century. The First World War ensured its demise.

Despite this unhappy end the Ottomans achieved some notable victories during the war: preventing the British and French navies from forcing the Dardanelles for one and thwarting the ANZAC landings at Gallipoli shortly thereafter for another. This post is concerned with the first of these military debacles, which I believe has something to teach us about systemic failures and risk management.

This post is structured like a Tarantino film. We will see the outcome first and then explore why things went down the way they did. The date is March 18, 1915. The place is the Dardanelles Narrows (below is a visual). Simply imagine a fleet of British and French warships steaming into the Narrows and you have got the idea.

Dardanelles_defences_1915 — Image Source: Wikipedia

Now I will turn things over to McMeekin:

Just past noon de Robeck sent in the French squadron, commanded by Vice Admiral Guepratte, to see what they could do from shorter range. Guepratte obliged with his usual dash, sending the Gaulois, Charlemagne, Bouvet, and Suffren up the Straits, right into the teeth of the Narrows defenses. Now the guns were booming on both sides, with the channel all but choked in smoke and rocked with one detonation after another. At 1:20 p.m., the Bouvet came within range of the Hamidie battery, which rained down fire on the French ship. At 1:50 p.m., Hamidie scored two direct hits from a 355 mm Krupp gun, causing an immense explosion, with a “column of smoke shot up from her decks into the sky.” The Bouvet, listing to her side, then ran over a mine, capsized, and sank within minutes.

[…] Toward 4:00 p.m., the Irresistible had come in range of the deadly Krupp monster gun at Hamidie, which hit her fore bridge and set it on fire. At 4:09 p.m., de Robeck observed that the Irresistible “had a list to starboard”: she had raised a green flag, indicating a serious hit on that side. Though having passed out of range of Hamidie, the then drifted into range of the Rumeli Mecidiye Fort, which rained down shells on her. All the officers could do was evacuate wounded men onto the swift destroyer Wear, which pulled up alongside, and prepare for possible towing.

[…] At 4:11 p.m., the Inflexible, hitherto undamaged, ran over a mine and immediately began to list, down by the bows, in more serious trouble than the Irresistible. Inflexible, at least, was near enough the mouth to limp away from the battle: the Irresistible, having passed up the Asian shoreline into the teeth of enemy fire, was not. Trying to salvage something from the burning, de Robeck sent in HMS Ocean to tow his wounded battle cruiser – only for Ocean, too, to suffer a huge explosion at 6:05 p.m. — leaving both ships helpless under enemy fire at short range.

[…] Doubtless believing the rumors about panic in Constantinople […] Keyes and Churchill seem to have applied them to the shore batteries without thinking things through from the enemy’s perspective. The Turks and Germans, after all, had just witnessed three enemy battleships sink to the bottom under their Straights under their fire from shore; the crippling of the modern, near-dreadnought-class battle cruiser Inflexible; and the rout of the entire French squadron. Over six hundred men had perished on the Bouvet alone, with the British suffering another sixty casualties. By contrast, only three Germans had been killed and fourteen wounded, with Turkish losses scarcely higher, at twenty-six killed and fifty-two wounded—a reasonable price to pay for knocking out fully a third of the invading fleet (six out of eighteen ships).

What Went Wrong

The root cause of this disaster was that allied military planners refused to accept that the Ottomans had the resources, wherewithal or ability to put up this kind of defense.

This was partly a result of poor intelligence. The British did not appreciate the extent to which German military advisors had improved the overall competency of the Turkish officers and soldiers defending the Straights. This is always a risk in war. Rarely does one have perfect information.

The bigger mistake — and one that should have been preventable — was that military planners did not want to believe the Ottomans were capable of such a defense:

Just as they had heard what they wanted to hear in the [Russian] grand duke’s (vague) request for a diversionary strike, so did British policymakers believe what they wanted to believe about the enemy’s dispositions–and fighting capacity […]

[I]n December, Captain Frank Larken, commanding HMS Doris, had subdued the minimal shore defenses of Alexandretta (Iskendurun) simply by showing up in port and getting the Ottoman vali to agree to dynamite two rail locomotives in lieu of bombardment, in a curious face-saving compromise.

The British certainly had experience with more robust Ottoman fighting spirit, during an earlier operation in Mesopotamia (modern day Iraq). McMeekin again:

Shatt-al-Arab was a British victory, to be sure: but it had been a bloody slog, requiring a month to secure a lightly fortified waterway that had been all but abandoned by the Ottomans since Enver was committed to his Caucasian and Suez offensives.

As I see it, British military planners failed to appreciate the risks associated with the Dardanelles operation because they had little incentive to appreciate them. They were engaged in a massive, unproductive slaughter in Western Europe and were eager to achieve tangible results somewhere else on the global battlefield. A direct strike at the Ottoman Empire would serve that purpose nicely. What’s more, because the French were touchy about British military action in certain other parts of the Middle East, options outside the Dardanelles were limited.

Warren Buffett coined the term “institutional imperative” to describe this type of inertia:

In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence.

So it was with the British in 1915.

Critically, there is no risk management process that can counteract the institutional imperative. As Buffett points out in his 1989 letter, “any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.” No amount of fact-finding or analysis will help. Only prudent leadership can prevent systemic failures resulting from institutional inertia.

How To Destroy An Economy

FT Alphaville has up a transcript of a fascinating interview with Venezuelan economist Ricardo Hausmann. If you don’t keep up to date on the latest happenings in Venezuela, the below video of a gang of bikers attacking a cargo truck with Molotov cocktails illustrates the post-apocalyptic state of the Venezuelan economy.

And if you have ever wondered how best to blow apart an economy, the interview pretty much walks you through the process. Here is an illustrative passage:

Let me just give you a sense of the magnitude of the mismanagement of the oil industry. In 1998, the year before Chávez got elected, or the year in which in December of that year Chávez got elected and he took power in February 1999. In 1998, Venezuela produced 3.7 million barrels of oil [per day]. Today it’s producing about two. If Venezuela had maintained its market share in the world oil industry — which it could have because it had infinite reserves, it had the largest reserves in the world — it would be producing two million barrels more than it is currently producing. With the same market share. So the collapse is immense relative to history, and it’s immense relative to this opportunity cost of where it should have gone had it just kept its market share the way it was.

That collapse of the oil industry happened in two steps. First, all the know-how of that industry, centuries of man-years of experience was lost in the firing of these people. They were not only fired but persecuted, so most of them left the country. Many of them left the country. And they caused, for example, an oil boom in Colombia [where many of them moved to]. Colombia went from producing 200,000 barrels of oil [per day] to a million barrels of oil thanks to the fact that Venezuelans knew how to extract much more oil from the fields that Colombia was already exploiting.

So there was a massive loss of human capital. They also wanted to create a politically conscious oil company, so they started to put an enormous amount of social programmes and other things on the books of PDVSA, the oil company. And as a consequence they starved the company from investment and they ran the company in an amazingly corrupt way, and this is really not just talk about corruption but evidence of corruption in massive ways. There were these foreign oil companies… These foreign oil companies have been complaining to the government that they want to wrest control of the procurement of oil projects because they know that this procurement is being done at multiples of what things should cost. There’s people that have been found in the US owning hundreds of millions of dollars of money that has been laundered out of PDVSA and so on.

So they really destroyed the hen that laid the golden eggs, at the time when their own plans and their own announced plans was to move Venezuela to produce six million barrels of oil. And instead of increased production they have never been able to stop a very rapid decline in production.

The (understandable) gut reaction of many people to what is happening in Venezuela is to kind of chuckle and shake their heads and say, “that’s socialism for you — good luck with that Bernie Sanders.” However, I’m not so sure the late Hugo Chavez even made a proper go at running a socialist economy. When you read Hausmann’s description of asset expropriations under Chavez it all sounds rather whimsical and Qaddafi-esque:

Chávez won re-election in 2006. And in early 2007 he announced that he was now going to move towards socialism, and he started with a spree of nationalisations. In those days the price of oil was very high, so he could afford to just buy everything that moved or that he fancied.

So for example he nationalised the telephone company that was owned by Verizon. He nationalised the three cement companies that were owned by the Mexicans, Cemex, Holcim and Lafarge. He nationalised one of the largest banks, which was owned at the time by Banco Santander. He nationalised the supermarket chain. He nationalised 3.7 million hectares of land.

So he went on an expropriation spree. At the beginning, when he had money, he would pay for things, and then if these were things owned by people he didn’t like, he would just expropriate and not pay for them. So he changed the contracts of the oil companies in a way that essentially extracted part of the expected cash flows out of them, and many of them accepted but a few of them, Exxon, Conoco Phillips and so on sued. And these suits are now being adjudicated by the International Court for the Settlement of Investment Disputes, and these investment disputes in Washington now add up to $16 billion of claims. Of expropriations that he didn’t pay for. And these are only the foreigners.

He expropriated the service companies that provided services to the oil company, because they started to protest that they were not being paid so instead of paying he just expropriated them.

So he took over significant chunks of the Venezuelan economy, and the typical thing is that the moment they took over a company, they ran it to the ground. Production collapsed. They nationalised the steel company. The steel company at the time of nationalisation was producing 4.5 million tons of steel with 5,000 workers. It now has 22,000 workers but it’s producing something like 200,000 tons of steel. So they ran those companies to the ground. Aluminium is almost not done any more, when Venezuela was producing about a million tons of aluminium back when…

So essentially they expropriated the economy and collapsed it on the public sector. And in the private sector they created all these constraints and this enormous uncertainty over property rights because everybody else was being expropriated and you never knew when it would be your turn. Owens-Illinois was a company making bottles. They were expropriated. Why bottles? Another company making detergents was expropriated. Why detergents?

So everybody else would not know when would his turn come up.

To me that reads more like a dictator and his cronies stripping assets. Which isn’t to defend the merits of socialism so much as argue socialism provided a convenient platform for Chavez to justify the systematic looting of the Venezuelan economy. In fact, dictators in general seem fond of socialist posturing as a means of bamboozling the masses. So-called Arab socialism is littered with examples of strongmen spouting vaguely socialist pronouncements while consolidating political and economic power within single party authoritarian states.

In a serendipitous convergence of themes, the Wikipedia entry for Nasserism contains the following reference to Chavez:

Hugo Chávez, late President of Venezuela, and leader of the self-styled ‘Bolivarian Revolution’, cited Nasserism as a direct influence on his own political thinking, stating: “Someone talked to me about his pessimism regarding the future of Arab nationalism. I told him that I was optimistic, because the ideas of Nasser are still alive. Nasser was one of the greatest people of Arab history. To say the least, I am a Nasserist, ever since I was a young soldier.”