The Emperor’s New Clothes


Once upon a time, there was a wise and kindly Emperor, with a faithful retainer called Sid. One day, the Emperor took him aside. ‘You are serving me well, and as a mark of my esteem you will receive a pension which will enable you to maintain your standard of living even when you are no longer fit to work.’

Thank you,’ said the faithful retainer, ‘but what happens, O wise Emperor, if you die before I do?’ ‘Have no fear,’ said the Emperor, ‘My descendants will recognise the prosperity I have bestowed on them. They will honour my commitment, and in fairness to them I have set aside an earmarked sum which recognises the obligation I have undertaken to you and which they will in time assume.

But then Pooh Bah, the Regulator of Everything, appeared. ‘How can Sid be certain that he will receive the pension which you have promised?’ he asked ‘He can’t,’ said the Emperor. ‘The world is full of radical uncertainty. The empire might become a republic. Or be invaded by Putinia or Trumpland. Or its population might fall victim to the Black Death, or covid 29. My faithful servant might live to be a hundred, or fall under the wheels of a coach tomorrow. And none of us know what investment returns will prove to be over the next 50 years. Or what will happen to inflation.

The High Chancellor then made what he thought was a helpful suggestion. ‘I am selling,’ he said, ‘long dated bonds, which will mature during Sid’s retirement. There are two varieties. One pays you a very small amount every year, and repays you decades from now in the greatly devalued money of the time. The other will pay back the value of what you paid in, but you have to pay me an annual fee for the privilege of not losing value.’

These sound like terrible propositions to me,’ said the Emperor. ‘I would much rather invest in houses, and schools and hospitals, and roads and bridges, and new businesses, which will yield a positive return and provide benefits and employment for my people. That way all my subjects will be able to enjoy a prosperous retirement. Who buys these unattractive securities you are selling, High Chancellor?

I do,’ said the Imperial Banker. ‘So the High Chancellor sells them on my behalf,’ said the Emperor, ‘and then the Imperial Bank buys them on my behalf.’ ‘That’s right,’ said the Imperial Banker. The Emperor had never really understood monetary policy, and now he realised it must be even more complicated than he had thought.

‘Does anyone else buy these long dated bonds?’, the Emperor enquired. Yes indeed’, said Pooh Bah. ‘There is a tribe called the Regulatees who must do whatever I tell them. And I have instructed many of them to set aside money to buy the High Chancellor’s bonds.’ ‘Almost all the bonds the High Chancellor issues are now owned either by the Imperial Bank or the Regulatees’, the Emperor’s advisers explained.

By now the Emperor was torn between regretting that he had not undertaken the advanced course in finance which had been offered to him, and relief that he had retained his sanity by focussing instead on the ordinary business of the Court. Especially after the Imperial Banker’s aide, who was a whizz with finance, reported that Pooh Bah’s instructions would be disastrous for retirees. If pension provision was based on bonds with negative real returns, then either the pensions would be inadequate or the cost of providing them would be prohibitive.

That is none of my business’, replied Pooh Bah. ‘My job is to ensure that everyone is certain to get the pension they have been promised, even fifty years from now.’ That seems to confuse security with certainty, mused the Emperor. The criminal I condemned this morning to life imprisonment without parole has achieved certainty about his future, but such certainty is a punishment, not a privilege. Pooh Bah seems to be offering future pensioners a similar deal – although they will experience a miserable retirement, at least they can be sure that their retirement will be miserable.

And, the Emperor continued, ‘I don‘t see how you can offer certainty about the outcome in fifty years anyway. Even if we invested in the High Chancellor’s paper, he might not meet his obligations. And we know he is constantly tinkering with the tax treatment of pensions. And also with indices. At the moment his securities are linked to the retail price index, not the consumer price index, and there is no strips market which enables Regulatees to match assets to liabilities exactly, especially since we are not completely sure what these liabilities are or when they will arise. And we don’t know what returns the High Chancellor will be offering in the future. That is in addition to the ‘black swans’ and long tail events I mentioned earlier which are not incorporated in the forecasts. There are no certainties in business, finance or politics.

The Imperial Wizard thought he could help. ‘The High Chancellor’s bonds are readily accepted as collateral at the Court Casino’, he observed. ‘There is a new strategy, called Luck and Divine Intervention (LDI), which is almost guaranteed to win. Those gains will secure Sid’s pension and relieve the pressure on the Imperial finances.’ To the Emperor’s surprise, Pooh Bah was nodding in enthusiastic support. But the Emperor had to decline. After some mishaps early in their reign, the Empress had banned further visits to the Court Casino.

Then the Court Jester offered a solution. ‘You say you do not know the economic future’, he said. ‘I don’t either. But I can make up all the numbers you and I don’t know.’

‘Investment returns, inflation rates, mortality distributions – the lot.’ ‘But how does that deal with the uncertainty which surrounds all these things?’, asked the Emperor, whose patience was now wearing thin. ‘Easy’, said the Jester. ‘I will make these numbers up over and over again, so that you have a complete probability distribution of the numbers you don’t know. This is a method devised by the Count of Monte Carlo, whose expertise in risk management is renowned worldwide.

This was not the sort of probability distribution the Imperial Governess had described when she had explained probability to the young Emperor, but he had always struggled to understand mathematical statistics. So he allowed the Court Jester to continue. ‘Then you can plug these numbers into a valuation calculation’, said the Jester. ‘That way Sid’s pension will be secure.’ The Emperor didn’t understand how this exercise provided his retainer with any further security at all, or give him any other benefit, but he saw that Pooh Bah was again nodding approvingly.

So if I adopt your proposal’ said the Emperor, with some relief, ‘I will have discharged my obligations to my servant?’ ‘Certainly not,’ said Pooh Bah and the Court Jester in unison. (Sometimes the Emperor struggled to tell one from the other.) ‘You will be responsible for the accuracy of the numbers the Court Jester has made up, and the adequacy of provision for Sid. Every three years, and even (especially) on your deathbed, Pooh Bah reserves the right to ask for more money depending on the numbers the Court Jester makes up at that time.

And so the Emperor decided that he had made a mistake in offering his retainer a pension, and resolved never to do so again. And decided that in future he would give less credence to his courtiers, who were not as knowledgeable or clever as they thought, or as he had been led to believe, and rely rather more on the wisdom of his ancestors and his own common sense.

There is an illustrated version available here.

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