Subscribe to this BlogNew theories attempt to explain the financial crisis
One salutary side effect of economic collapse: it gets people thinking. Or, rather, rethinking.
Case in point: "Recipe for Disaster: The Formula That Killed Wall Street," a fascinating story in Wired magazine that traces much of the blame for our current financial mess back to a highly abstruse mathematical formula, invented in 2000, that allowed Wall Streeters to easily model the complex risks of mortgage derivatives and other big messy investments.
Trouble was, the formula — known as a "Gaussian copula function" — wasn't quite as magical as it appeared to be, and in the end left investors blind to the dangers that came up and bit them — bit all of us — on the behind.
Wired attributes rather too much of our current mess to this one equation; there were many other factors as well, the same mixture of greed and shortsightedness found in every financial bubble we've seen from the Tulip Mania onwards. But the article's conclusion is dead-on:
“In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent. They think they can model just a few years' worth of data and come up with probabilities for things that may happen only once every 10,000 years. Then people invest on the basis of those probabilities, without stopping to wonder whether the numbers make any sense at all.”
Speaking of which …
Case in point number two: "The Financial Crisis And The Systemic Failure Of Academic Economics," a manifesto of sorts recently formulated by a bunch of (mostly European) economists at an academic conclave called the Dahlem Workshop. (You can download a pdf of the paper here.)
As you might have gathered from the document's cumbersome title, economists aren't natural manifesto-writers — heck, legendary commie economist Karl Marx turned to journalist-cum-philosopher Friedrich Engels when it came time to write the Communist Manifesto. The Dahlem paper is filled with references to "'fat-tailed' Levy processes" and "the Arrow-Debreu two-period model."
While lacking something in style, the paper presents an argument that is blunt and convincing: while developing more and more abstruse mathematical models, economists ignored the glaringly unreliable (or just plain incorrect) assumptions upon which these models were based, leaving the economic profession as dumbfounded as the rest of us when the financial system came tumbling down.
Without the data they needed to prove their arguments, the paper notes, economists resorted instead to "simulations with relatively arbitrary assumptions on correlation's between risks and default probabilities. This makes the theoretical foundations of all these products highly questionable – the equivalent to building a building of cement of which you weren’t sure of the components."
On a more basic level, most models simply ignored the — seemingly theoretically remote — chance that everything could fail at once. "If one browses through the academic macroeconomics and finance literature, 'systemic crisis' appears like an otherworldly event that is absent from economic models," the Dahlem economists note. "In our hour of greatest need, societies around the world are left to grope in the dark without a theory."
Meanwhile, the economists themselves "have had no choice but to abandon their standard models and to produce hand-waving common-sense remedies. Common-sense advice, although useful, is a poor substitute for an underlying model that can provide much-needed guidance for developing policy and regulation. It is not enough to put the existing model to one side, observing that one needs, 'exceptional measures for exceptional times'. What we need are models capable of envisaging such 'exceptional times.'"
I think I speak for many when I say: I wish you guys had told us that a little bit sooner.
–David Futrelle
I think the economic debacle is even more simple than the "wrong" mathematical model, equation or anything of that nature. It really boils down to human GREED, which is also "cyclical". One scheme winds down until another one is born. MANY got sickeningly wealthy off of other people's backs, and now…off of their pain. This time, however, the manifestations were worldwide as the GREEDY just get GREEDIER; Madoff is not alone by any stretch, but he's one darned good example, although he's a drop in the bucket in the final analysis.
Mises had it right, the rest of this drivel serves the masters of statism, which is the desired intent.
Central banking with artificial control of interest provides the fuel for the chaos we have today. I don't think people will ever understand this however because the government has a vested interest in hiding the truth.
CNN moderators will likely not post this anyway….
In the UK quality housing is always in demand, yet people who have the money to build and replenish our housing stock find it almost impossible to get ‘permission’. Homes are not exempt from supply and demand issues, it’s insane that banks and mortgage brokers have been allowed to trade on the back of house price inflation caused by misguided legislation. For around half the price of even the current ‘market value’ the equivalent modern home could be built – that is if you can find a plot. And the price of a plot? If you have £100.000 you might start looking….but for that money don’t expect anything larger than a postage stamp site in someone else back yard.
We will never crack this issue in the UK until the high cost of building plots is addressed and the planning laws that have caused the hype are radically revised.
It is very clear that the economists use mathematical models that are inapropriate.
To develop an astronomical theory of the solar system, it took:
firstly, a man whose name was Tycho Brahe who accumulated observations of the movements of planets for decades,
then a man called Kepler who, using these observations enacted the 3 laws that bear his name,
then a genius called Isaac Newton that discovered the law of gravitation,
and, much later, another man called Albert Einstein, who, with the help of mathemayical models developped by Poicarre and Levi-Civita, generalized this law in the theory of relativity.
And the quest goes on…but these theories allow us to go to the moon and have space probes navigating in the solar system with an extreme precision…
It is not the case in economics nor in biology, where we do not have the relevant math tools…I have seen totally creazy equations which can only be applied in continuous sets, whereas the reality is discontinuous.
Moreover, assumptions are based on creeds. Most of the economists are intellextual crooks like most of their masters, the politicians. They have forgotten that money has only one counterpart ie the creation of goods and services through WORK…
Anything else is BS
I prefer a more fundamental deconstruction of the issue. Mathematical (and other) models are fine, if they are based on solid theorems. I don't consider economics a science, as I tend to view it more as educated gambling–with a twist. Its very tenants are human-contrived and subject to manipulation on a whim. Until this component can be removed, or severely policed, we will continue to see the likes of Enron, the derivative-mortgage debacle, Madoffs and others.
To the anti-global warming poster: Do you get paid to find open forums to post your politically inspired anti-global warming rhetoric?
Very interesting intro to some heavyweight articles. The problem with mathematical models for human behavior is that the results are often elegant whereas so often we, as a whole, are not quite easy to formulate. The human part of the equation is too often minimized, or, one might say, beautified.
We aren't always nice.
Just as these models had deastating errors, so too have the models for global warming…and trillions of dollers, euros, yen, etc will be wasted because of it and productiity will be drastically lowered also … with results that will be far worse than the false financial models…hopefully we will wake up to this sham "science" before it is too late.
regarding economists there are of course the two famous quotations:
All of the world's economists laid end to end could not reach a conclusion.
and as Truman said Give me a one armed economist. They are always saying on the other hand.
On a more serious note, why is any economist who missed something as serious as the curent collapse still employed? Why are my tax dollars being poured into state sponsored universities to pay outstanding salaries to these guys who were blind to the problem and whose prescriptions may have caused it? If I had missed something that big and obvious I would be unemployed. Mike Whitney, Nouriel Roubini and others saw it coming. I saw it coming and am not a professional economist. Maybe economics is no more a science than astrology and alchemy, which were once taken seriously and state funded also.