Must Read Article on the Financial Meltdown
Via Tyler Cowen at Marginal Revolution, an excellent article in Wired about how one formula, embodying one assumption, catalyzed the meltdown. I recommend you read it and ponder it. There are many useful lessons for modeling complex systems in general.
However, I will summarize for those of you short on time. A fundamental problem in securitization is figuring out how different components of a security are related. Think of it as measuring how well the components are diversified. The more independent the components, the less risk embodied in the security. Thus AAA rated tranches of mortgage-backed securities are supposed to be very safe because the components are supposed to be highly independent.
A Chinese mathematician named David X. Li had an insight. You don’t have to analyze the dependencies directly, you just have to observe the correlations in the market prices of the components. Then you can compute these really tight sounding confidence intervals on the correlations of various components because you have all this market data. Of course, the market can’t take into account what it doesn’t understand. So you see a bunch of 25-sigma events. At least, your model says they are 25-sigma. Oops!
But I Was Probably Right About Climate Models
I try not to practice false modesty (those of you who know me well probably just did a spit take at that understatement). So while I try to stand up and admit when I’m wrong, I also like to stand up and point out where I’m right.
It shouldn’t be a surprise to any of you that I came to the conclusion that climate models are pretty much total bullshit. My problem with them is that they are incomplete, overfitted, and unproven. It turns out that one of the foremost experts on forecasting in general also thinks that these models have no predictive value. In fact, items (6) and (7) of their statement shows that you can predict the future temperature really well simply by saying it will be the same as the current temperature.
You can read their more formal indictment of climate forecasting methods here.
Oh snap!
I May Have Been Wrong About Macroeconomics
When I was an undergraduate studying macroeconomics, I came to the conclusion that it was pretty much total bullshit. Because I was in a co-terminal masters program, I was also studying graduate level decision theory, game theory, microeconomics, behavioral economics, and dynamic systems. In comparison, it seemed clear to me that macroeconomics was not a coherent study of a complex system.
Lately, Arnold Kling’s blog posts have been reinforcing this belief. However, we may both be wrong. Arnold studied and practiced macroeconomics in the late 1970s. Given the delay in propagating knowledge to the undergraduate level, that’s probably also what was taught in my late 1980s undergraduate textbook. However, Will Ambrosini observes that Arnold’s views are outdated and this is a problem with non-macro economists in general. He points to this essay and I find myself convinced that modern macroeconomics is a coherent study of a complex system.
I thought this might provide you some measure of comfort. If anyone wants me to summarize the particulars of why I changed my mind, let me know.
Particle Physics Follow Up
In the comments to this post, Rafe and Daniel asked me to tell them the punch line of Lightness of Being. I’ll do my best. Spoilers ahead.
Society According to Kevin: Part 1
How Our Moral Compasses Fail Us
From the comments on my Introduction to this series, it appears I have discovered a controversial topic. Good. My first objective will be to illustrate why we cannot rely on moral compasses to guide society. After some thought, I have decided to break the topic of moral compasses into two posts: how they fail and why they fail.
Good Particle Physics Book
I apologize for the posting lull. I’ve had a bad cold and been struggling to add Monte Carlo simulation to my discrete stochastic model of the startup lifecycle (if anyone is planning on using Oracle’s Crystal Ball, I can tell you the good and bad). But I’m almost finished with my next substantial post.
In the meantime, I finished a really good physics book: Lightness of Being by Nobel prize winner Frank Wilczek. It requires a basic knowledge of quantum mechanics (I suggest Al-Khalili’s Quantum) and particle physics (any recent popular book that spends more than one chapter on the Standard Model).
Given that, it does an awesome job of explaining three things that have always bothered me. First, how the strong force can possibly get more powerful the farther away you get. Second, why we can’t break protons and neutrons into their component quarks. Third, where the heck a proton’s mass really comes from. It turns out all three things are related and the explanation is quite elegant. I don’t know why the dozen other physics books I’ve read in the last five years ommitted an explanation (or at least an explanation that stuck with me).
Society According to Kevin: Introduction
I was recently having a conversation with a mutual friend of Rafe’s and mine. Like the two of us, he’s quite smart, well educated, and socially aware. I respect his thinking a lot. However, during the course of this conversation, it became clear to me that he holds what I think of as an overly moralistic view of human behavior.
From my perspective, it seemed like he thinks that people’s behavior is governed primarily by an internal moral compass rather than incentives. So if you want to change their behavior, you should redirect their moral compass rather than adjust their incentives. People who don’t adjust their behavior are defecting from society and should be sanctioned.
I encounter this view quite often in my social circle and this instance inspired me to write a series of posts to explain how I think things actually work. You’re free to disagree with me, of course. In fact, I expect most people to disagree with me. But I’ve thought rather hard about this issue and I’ll put my model up against the moralistic view when it comes to predicting a population’s average behavior or choosing an effective policy prescription.
Poetic Justice in the Financial Crisis
Bloomberg reports that Credit Suisse has decided to pay managing directors’ and directors’ bonuses in the form of an ownership interest in the bank’s toxic mortgage-backed assets. The value of these assets will emerge over the next eight years as the assets mature or default. This is outstanding! The executives have to lie in the bed they made. Of course, this would have been better if they did this prospectively back when the executives were the making decisions that created these securities. But perhaps banks will adopt some sort of similar long term performance measurement mechanism going forward.
Via Volokh Conspiracy via Megan McArdle via ClusterStock.
Required Reading on Financial Crisis
Remember Liar’s Poker by Michael Lewis about 80s Wall Street excess? Well, he has a terrific article on some guys who saw the subprime meltdown coming and bet heavily on it. It’s great narrative and a reminder that whenever someone’s model departs substantially from reality, there is an arbitrage opportunity. Hey, maybe we should rename this blog “Reality Arbitrage”.
What I’m Working On: Supercharging Innovation
[EDITED 05/08/2009: see here] If you’ve been following my posts on the financial crisis (here, here, and here) and Singularity Summit (there, there, and there), you might wonder, “Uh, but how do we get there from here?”. It’s pretty obvious to me that the the road to economic advancement is paved with innovation. So we have to innovate our way from here to there.
I’m pretty sure I’ve figured out a way to supercharge what I call the “Innovation Economy”. My thinking was catalyzed by reading Nassim Taleb‘s The Black Swan. The basic idea is simple: if we want more groundbreaking firms like Google to come out of the Innovation Economy, we have to shove more startup feedstock into it.
Possible Insight 