Wednesday, February 11, 2009

New Scientist and economic modeling

I was looking for this when I was writing the past two posts on the economy as a complex nonlinear system, and couldn't find it.

It's worth thinking about when we are getting ready to trust our entire economy to a Keynesian philosophy that predates modern quantiative modeling techniques and a Moody economic model of stimulus bang for the buck that appears to be fundamentally linear.

From New Scientist last November:

Now that disaster has struck again, some financial risk modellers - the "quants" who have wielded so much influence over modern banking - are saying they know where the gaps in their knowledge are and are promising to fill them (see "How the risk models failed the world's banks"). Should we trust them?

Their track record does not inspire confidence. Statistical models have proved almost useless at predicting the killer risks for individual banks, and worse than useless when it comes to risks to the financial system as a whole. The models encouraged bankers to think they were playing a high-stakes card game, when what they were actually doing was more akin to lining up a row of dominoes.

How could so many smart people have got it so wrong? One reason is that their faith in their models' predictive powers led them to ignore what was happening in the real world. Finance offers enormous scope for dissembling: almost any failure can be explained away by a judicious choice of language and data. When investors don't behave like the self-interested Homo economicus that economists suppose them to be, they are described as being "irrationally exuberant" or blinded by panic. An alternative view - that investors are reacting logically in the face of uncertainty - is rarely considered. Similarly, extreme events are described as happening only "once in a century" - even though there is insufficient data on which to base such an assessment.

The quants' models might successfully predict the movement of markets most of the time, but the bankers who rely on them have failed to realise that the occasions on which the markets deviate from normality are much more important than those when they comply. The events of the past year have driven this home in spectacular fashion: by some estimates, the banking industry has lost more money in the current crisis than it has made in its entire history.

Once you've digested that, head back over to New Scientist and read the more detailed explanation of why many of the current financial and banking models are failures.

Which raises the question of why in the world we would place this much confidence in the Moody's model being pimped by Mark Zandi.

A number of commenters have written to ask me essentially, "So are you saying we should do nothing?"

No, I haven't said that.

But what I am saying is that our leading administrative economists, as well as the new Privatize here, privatize now theorists, most of whom are talking very quickly in case someone decides to ask why none of their models predicted anything during the summer of 2008....

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