Wednesday, December 17, 2008

Financial models versus economic models

Financial models are bearing the brunt of an attack - some going as far as claiming that they have caused the current crisis.
Almost everyone in risk management knew that quantitative methods – like those used to measure and forecast exposures, value complex derivatives and assign credit ratings – did not work... Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”. ... Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. ... Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the ... regulators were using the same arguments. They, too, were responsible.

So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools... As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory... The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen. ...

So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. Do not let him hide be-hind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: “Thou shalt not follow a multitude to do evil.”

Yet economists continue to use their economic models as though there were nothing wrong with them to prescribe fiscal policy or tax cuts as a way out of our current mess.
1. These calculations make everything look so easy and clean.
2. No to fiscal policy and yes to tax cuts.

Isn't the profession in such a disgrace now that it's better to shut up? But then I've never met an economist who doesn't like to hear the sound of his own voice. (Here included.)

The bottom line between tax cuts and fiscal policy is that there is so much uncertainty both sides can claim to be right when nothing works.

But perhaps it is not the failure of individual models that is to blame but the failure of the Fed and regulatory authorities to have models of systemic risks. Agreed that financial institutions subjected their models only to historical shocks and did not consider possibilities outside the past occurrences but there is no incentive for them to do so. What is there to gain in doing this?

So perhaps it is not so much a failure of models but more of a failure of lack of models. However, it is in the interest of regulatory activities to consider extremes and prepare for them. These recommendations were part of Feldman and Stern's book Too Big To Fail. (See here.) Models of systemic risk should be used by regulatory agencies as part of scenario planning and making contingency plans rather than to rely on knee jerk reactions.

Update: Uwe Reinhardt writes more eloquently than I have on the tax cut versus fiscal stimulus debate:
... the empirical literature on this responsiveness offers economists a wide range of estimates from which they can choose judiciously to make their (or their political client’s) preferred case. ... illustrates how easy it is for economists to infuse their own ideology – or that of their clients – into what may appear to outsiders as objective, scientific analysis. ... We are now seeing a replay of this tendency in the debate on the relative merits of added government spending versus added tax cuts as measures to stimulate the economy.

1 comment:

Aryana Capili said...

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Thanks friend