Senator David Vitter submitted one of my questions to Federal Reserve Chairman Ben Bernanke, as part of his reconfirmation hearings, and received the following reply in writing (as already published in the WSJ on-line).
Q. Simon Johnson, Massachusetts Institute of Technology and blogger: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?
A. The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. A. (continued) In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.
This answer misses the central issue. Haldane’s argument (and our point) includes “time inconsistency” – i.e., you promise no bailouts today but, when faced by an awful crash, you provide a massive set of bailouts. There is nothing in Mr. Bernanke’s statements, here or elsewhere, that addresses this concern.
His hope is that current proposed changes in regulation will make a crash less likely. This is a strange assertion, given current market conditions: e.g., the Credit Default Swap (CDS) spread for Bank of America now hovers just 100 basis points above that of the US government, despite BoA having a very risky balance sheet. Creditors apparently believe they will not face losses – and the same is true for people lending to all our big banks. This is exactly the kind of thinking that produces reckless lending (and borrowing). Will Bernanke really disappoint them in our next crash?
Until markets price “small enough to fail” risk into our biggest banks, the time inconsistency problem is alive and well – and threatening.
The Fed’s continuing refusal to confront this point directly – even as other major central banks shift their public positions (and more are moving in private) – is alarming and disconcerting. The Fed is falling far behind. This will have much broader consequences for its credibility and independence down the road.
By Peter Boone and Simon Johnson
The Baseline Scenario 
“consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system”
Right. How??? How can the banks accurately assess the risks they pose? Even if the banks can, how can the regulators themselves do the same??
Next time get tough and ask him about his mortgage(s)!
One can break the doom loop very easily – using the infamous inefficiency and slowness of the US political system. Look at how much time it is taking to pass health care reform and the financial reform, both of which enjoy high popular support.
Just make a law, which would require that any direct financial support by any government agency or sponsored enterprise(the Fed, Treasury, FHA, FHLB, etc) to any (one or many) private financial institution must be approved in the following manner:
– The decision to support the financial institution(s) in question has to be recommended by the House Financial Services Committee and then approved by a majority vote in the House
– Then the House decision has to be reviewed by the Senate Banking Committee and then approved by a majority vote in the Senate or sent back to the House for the reconciliation process
– Any decision to provide direct or indirect support must be accompanied by a simultaneous appointment of a Special Counsel with the full plenary power of the Attorney General to investigate the failed financial institution(s) in question as well as action or inactions of the government regulator overseeing that institution(s)
Of course, we can have another scene of the Treasury Secretary getting on his knees before the Congress, but the sequential nature of the approval process and the looming shadow of a Special Counsel would surely throw some cold water on the burning desire to make an exception.
> spread for Bank of America now hovers just 100 basis points above that of the US government
you know perfectly well (or should, it would take you less than five minutes to figure it out if you cared to know) that these two instruments can’t be compared, yet you continue broadcasting comparisons of these spreads when the data supposedly bolsters your case. what gives?
SJ:
“This is exactly the kind of thinking that produces reckless lending (and borrowing).”
But, you see, that is precisely the point. The only way that Bernanke and team can increase the money supply enough to get the economy back on track is by increasing lending (kicking up velocity), even though there is insufficient quality demand for credit.
The response is – force banks to extend credit by stopping the payment of interest rates on excess reserves, and creating a bit of real inflation. Except the Fed doesn’t have the guts to do this, so instead it advocates subsidizing the extension of risky credit to boost the money supply.
In truth, I suppose I prefer this to the worst of all options – a true Depression – but it’s like eating hardtack, saltcod, and sucking on lemons. Yes, it’ll keep you alive.
The proper and necessary response is to directly inject true and permanent currency into the economy in order to get nominal gdp growth back on trajectory. This means covering a significant portion of the deficit with true QE (not merely temporarily created money). This would repair unemployment AND bank balance sheets faster, and give the government a lot more breathing room to enforce decent regulation without killing the economy.
I also suspect that the Fed would need to do surprisingly _little_ QE, so long as it actually committed to an NGDP path.
Instead, the Fed remains utterly dependent on banks as the mechanism for injecting (and removing) new money from the economy.
The banks, of course, like it this way. Dependence means power.
Please let me know how I can write insurance on the US Treasury. The rate sounds quite encouraging. What exactly are the default conditions? The world running out of trees? Ron Paul being elected Fed Chairman? The Chinese Remimbi becoming a reserve currency?
BTW, the Fed also answered Brad DeLong’s question about raising the inflation target temporarily…
The Fed noted that – in spite of its failure to keep inflation steady when it was under 2% – it’s not going to go above 2%, even temporarily. Nice little Asymmetry there. The argument being, of course, credibility.
The problem is that we’re an important dependent economy, so defending a 2% inflation peg is like defending the Dollar’s ability to buy a basket of goods/services that is overly weighted toward _imports_.
In other words, defending a 2% inflation target is implicitly DEFENDING THE DOLLAR PEG. I’m not necessarily opposed to running deficits, but I’m certainly opposed to running deficits to defend the dollar.
This will end badly…
I posted this comment on ssumner’s blog in regards to Paul Krugman’s observation that Spain needed to drop wages due to the effective fixed exchange rate (Euro membership).
“Spain is a useful object lesson in what happens when you don’t have an instrument to simultaneously renegotiate many types of contracts (e.g. value of money). True, wages in Spain are sticky/high. But so is debt.
Many anti-inflation folks give a-priori precedence to keeping money stable at the expense of other assets. In an international context, Spain shows us the result – if the aim of policy is to keep assets that are linked to the nominal currency stable, but domestic consumption is supported by excess imports, then stabilizing the real value of a nominal currency against a basket of goods (which is overly weighted to imported goods) is like stabilizing the exchange rate.
In international finance, this is called “Defending a Peg”.
Thus, when Bernanke indicates that we’re going to target 2% inflation in spite of our import dependence, he’s essentially committing to defending the dollar peg. The cost of this is no longer measured in depleted gold reserves, but rather in debilitating interest rates and high deficits. There are many example in the world where this ends badly.
Targeting NGDP, btw, is not stabilizing a particular asset (currency) class at the expense of others. It’s stabilizing a weighted value of the entire economy.”
Bernanke’s response – typical academic response; he explains how regulation will solve the problem, given that regulation works (underlying assumption).
I would like to see someone play out the scenario of how the new regulatory structure would have handled the existing crisis if it had been in place.
At what point would they have recognized that there was a problem?
What metrics or tools would they have used to identify the problem?
What steps would they have taken to avoid the problem? What are the potential unintended consequences of the solution?
Almost everything that’s wrong with economics today is contained in this post. The use of obfuscating jargon by Mr. Bernanke to discuss very straightforward ideas or problems, the pestilence of mathematical abstraction lurking in expressions like “time inconsistency”.
I would refer Mr. Johnson and everyone else to Robert Skidelsky and his criticisms of how economics is taught and practised today, and especially a recent speech he gave to the Committee on Economic Development. Mr. Skidelsky made the point during this speech, unchallengable in my opinion, that,”broadly speaking, it’s[economics] been useless…useless” and “no politician wishing to avoid a 2nd Great Depression would take advice…” from an economist today.
Here’s a link to a video of his talk:
Again, I would urge Mr. Johnson, Mr. Kwok and others to step up and start agitating very loudly and consistently for real economic reform, the reimposition of Glass-Steagal, the banning of financial products that no one understands, the abandonment of VAR and other intellectually fraudulent ideas. If this is associated with a revival of Keynesianism, then so be it.
In my opinion, there is no technocratic fix to the problems in our economy or in economics, they must be addressed in a much more fundamental way. Perhaps there could be an institute or thinktank promoting a Keynesian approach to our current situation, but at the very least, the bloggers here can take the first step.
Ben’s refusal is the answer to the question. He will always bailout the big boys. It is after all the unstated mandate of the FED. Why else are the big boys on the board, pick the local governors, and get the bailouts?
A question was raised from the audience to the newly minted CEO of BofA, Brian Moynihan (http://snipurl.com/tssmr), asking him the rather surprising question of whether Bank of America was really too large (and unwieldy) to manage and that partitioning some of the operations (separating commercial, credit, retail, etc…) would actually improve their corporate bottom line profitability; Mr. Moynihan’s answer was that the bank’s size and consolidation would be maintained and that it wouldn’t be an issue for him. (Going forward, their shareholders may have some differing opinions when the next crisis comes around…)
Maybe voters can leverage some ROI by voting out those who aren’t representing their interest and jeopardizing the country into a benign form of insolvency. I apologize for digressing, but I was quite irked by the Senate’s deal making behind closed last Sunday evening (excerpted from politico.com):
Reid was able to hold his caucus together, in part, by writing state-specific provisions that won over senators, one vote at a time.
Nebraska, Vermont and Massachusetts scored $1.2 billion in special Medicaid assistance.
Nelson got something for Nebraska the other states didn’t — a permanent exemption on increased state costs for new patients that come into Medicaid through the plan. (say, what???????)
Montana, North Dakota, South Dakota, Utah and Wyoming secured higher federal reimbursement rates for doctors and hospitals that serve Medicare patients.
Senior citizens in Florida, Pennsylvania and New York will see their Medicare Advantage benefits protected at a time when the program will be trimmed nationwide.
Jim Manley, Reid’s spokesman, defended the special provisions as “a normal part of the legislative process.
Bernanke’s respone is almost as good as his rationale as to why derivatives are not “time bombs”
Senator SARBANES.
“Warren Buffett has warned us that derivatives
are time bombs, both for the parties that deal in them and
the economic system. The Financial Times has said so far, there
has been no explosion, but the risks of this fast growing market remain
real. How do you respond to these concerns?”
Mr. BERNANKE.
“With respect to their safety, derivatives, for the most part, are
traded among very sophisticated financial institutions and individuals
who have considerable incentive to understand them and to
use them properly. The Federal Reserve’s responsibility is to make
sure that the institutions it regulates have good systems and good
procedures for ensuring that their derivatives portfolios are wellmanaged”
and do not create excessive risk in their institutions.”
Click to access getdoc.cgi
Mr. Bernanke, an academic who has never worked a single day in his life. He will take anything off a cliff: a business, a McDonald’s stand, the Federal Reserve. And I have to say I have a certain sympathy for him as a character. He’s ok, but completely useless. I would not even hire him as my butler…Mr Bernanke is a madman, a destroyer of the value of money. And he is a wealth destroyer and an economic criminal. It is the duty of a central bank to keep the value of money. I believe today for ninety percent of Americans life is harder than it was in 1999. Basically I think they are a bunch of crooks.” Marc Faber on King World News
Interesting. Sumner meets Krugman. There are other unorthodox policies that would sidestep the broken transmission mechanism. Helicopter money directly injected into the real economy, for example. Give people a Fed debit card with an opening balance of, say, $5000 in newly printed money and set the interest rate at -8% (i.e. the balance decays over time).
The first sentence of the response is brilliant. The rest is unreadable.
Breaking down the fist sentence:
* Doom Loop is a consequence of moral hazard
* Moral hazard is caused by government backstops.
* Government backstops are bailouts programs, FDIC, and financial support — presumably through low borrowing interest rates.
From this, my 7-year-old could deduce that the simplest solution is to get rid of the cause.
But no, the rest of the answer goes on to advocate keeping the root cause — i.e. government programs — in place and adding more government programs on top of them.
What does “get the economy back on track” mean?
Does that mean back on the path of unsustainable, unrealistic growth? Does that mean overpriced homes and housing prices that can not go down?
What if the downturn was getting back on track — a sustainable, realistic, market-based track?
In 2000, what if the FED injected billions into unsound e-commerce companies like eToys to get the tech sector back on track? It would have been laughed at, because “back on track” was liquidating unsound companies. Why is any different in financial markets, the auto industry, or housing prices?
“Massachusetts Institute of Technology and Blogger” makes Prof. Johnson sound like somebody else entirely.
I very respect your main point, but I can’t reconcile it with the historical fact of TARP’s passage in 2008.
Congress and the President rammed the 700 billion dollar TARP through in a couple of weeks — despite a huge uproar from voters. I mean some of these politicians said that voting for TARP generated more voter heat than the debate about immigration reform.
TARP’s passage last year proved that, when it comes to bailing out Wall Street, the crippled sloth that is America’s legislative process can sprint like a cheetah if it wants to protect Goldman Sachs.
Great line of thought! A judo move: use the dysfunction of the political system to good purposes, for once!
I think they want to keep our banks large so they can take over the world. If GM had seen everyone else downsizing (FOR EXAMPLE), GM might decide to stay big and be the goliath of the bunch who eats up the little guys.
It is clear that only a structural change, such as the reinstatement of Glass Steagall and maybe even interstate banking restrictions will make any difference.
My question is, are we letting the right people know? Everyone on this blog should be contacting their senators and represenatives with your well reasoned and thoughtful concerns and comments. And we should also be encouraging everyone we know to do the same.
Ben notes the “doom loop” refers to “moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise.”
The far larger issue vis-a-vis the “doom loop” is the complete transformation of what is now called banking. And which “banks” are being fully supported and subsidized by the Fed.
Case in point, $10.03 billion of the $12.37 billion in “net revenue” (81%) reported by GS in the 3rd quarter came from “Trading and Principal Investments.” GS now has a bank charter among its financial holdings, granting it access to the discount window and the varied and sundry credit-support and -subsidy programs created over the past 18 or so months to bail out US banks. Yet there is no differentiation among the various activities behind which the Fed will stand. Thus, the “bank” effectively is playing with the House’s money and keeping all the winnings. This isn’t even “investment banking,” since less than $1 billion of “net revenues” came from “investment banking” qua IB. This is pure trading. The Fed’s acting like an investor seeding various hedge funds and commodity trading advisors.
So here’s the new deal: The firm can and is expected to run VaR levels that literally are multiples of earlier levels as a federally subsidized and guaranteed trading house. (GS admitted as much this past summer, when Bloomberg reported its “move to become a bank holding company in September to win the financial backing of the Federal Reserve didn’t curb the firm’s appetite for wagering its capital on trading, a formula that fueled Wall Street profit and compensation records in 2007. … ‘Our model really never changed,’ Goldman Sachs Chief Financial Officer David Viniar said yesterday in an interview. ‘We’ve said very consistently that our business model remained the same.’ ”)
Can Ben provide a plausible-sounding explanation of what he and we are getting in return for providing this seed capital and guarantee?
This is the sort of thing Paul Volcker’s been warning against. Why isn’t Ben & Co. more concerned here. What does he know we don’t know? What was the pitch GS et al made that allowed them to access this seed funding? There have to be 1000s of smallish hedge funds and CTAs out there willing to make the same case. After all, they’re all starting, as GS did last summer, with no equity capital and only a dim understanding of the risks they’re signing us all up for.
I don’t agree with you in your comments about Dr. Bernanke. I think Nouriel Roubini got it right when he said that Bernanke saved us all from a 2nd Great Depression. Interestingly, it was Bernanke the economic historian and not Bernanke the economist that caused him to act to prevent total economic collapse during the winter of 2008-2009. Isn’t one of Bernanke’s specialties the study of the causes of the Great Depression? This, in my opinion and I think Roubini’s as well, had a great deal to do with his ability to recognize just how deadly serious things were a year ago, and how fragile the economy still is. So pardon me, if I don’t join you in your rude remarks about the man.
I’m not really sure how to do that. I tried to contact my rep with a nuanced position on TARP, and all his office wanted to know was whether I was “in favor” or “opposed”. There was no “this is how it could be better” column.
Why not just have the gov’t pay off all consumer debt – mortgages, credit cards, car loans, EVERYTHING. This could solve: the housing market problem by eliminating defaults and allowing the market to reset; undercapitalized banks, since the debts would be paid off thereby repairing their balance sheets; the CDS problem, since none of the debts would default; the main street economic problem, since people would be more likely to spend with all of their debt gone; the local government problem, since sales tax revenue would likely rise; the federal budget problem, since doing this would likely be far cheaper than what they are currently doing; and Bernanke’s honor, since this is pretty much tossing cash out of a helicopter.
I forgot to reference Steve Keen – he ran the numbers on this in one of his lectures available on his website.
More Doom Loops.
(1) an economy based on 70% consumer spending
(2) a healthcare system where — protecting profit — is premised over family and personal access to first world medical care
I think it’s all been said before, but Bernanke’s response shows that he understands the problem, and yet he has no intention of fixing it.
It’s not due to any malevolence on his part, he just doesn’t want to upset the applecart. His rationale is that the damage done by any fix of the underlying problems (moral hazard etc) will be greater than the damage done by keeping things the way they are and just making a few token gestures to acknowledge some of the problems.
Attention Per Kurowski,
I’ve added your Mug Shot to one of my Baseline Fables. (You can find it at the line up at the bottom of the page) Link below …
http://tippygolden.wordpress.com/trail-to-springfield/
Yes, spread over treasuries IS a good measure of credit risk. By buying a BofA bond and shorting a treasury of similar maturity, i-rate risk is neutralized and you are left with 1% gain per year in case of no-default each year. Assuming recovery of close to zero, this means that markets are now assigning 99% chance of survival or bailout.
To prove his case, SJ ought to compare sub-CIT sized banks (i.e. small enough to fail) similar in leverage or risk to BofA and Citi, and show that their spreads are much higher. The smaller spread would indicate moral hazard, and thus the greater ability to borrow and potentially to take more hazardous risks.
Everything’s cool. Timmy hand me another beer. And while you’re at it give Larry another cold one as well…
[Photo taken last week of a framed photograph at New Delhi restaurant, San Francisco] :
Imagine how much we could raise if we got all the fat cats to weigh in for charity! Just a thought….
Kate
I’ll post it on my website – it’s not great quality – but worth a look…
That SOB Paulsen got on his knees ’cause he knew he had $700 million in his pocket. He was saving his own butt, and his buddies.
Here’s one to investigate: Remember reading that all these Treasury(and all other Govt.) employees do not have to pay taxes on their income the previous year if they accept a position with the Govt. Believe they changed this law recently, probably during the 6 years of GW(Not one veto) and his Congress
Just more of the revolving-door looting of our country. The march on Lobbyists is coming.
Indeed, Goldman went to great lengths to declare that its business model was intact, in order to reassure investors that government interference would not harm its profits.
As the poet might say:
“Thou doth protest too much!”
The bar is just slightly higher, since one would expect larger firms in any industry to have a lower cost of borrowing (due to perceived lower risk).
Really, this would require measuring the risk spread on bonds between small/large companies across multiple industries, and then observing the risk spread across small/TBTF companies within finance, and observing a difference in the difference.
Deploying funds from QE for a massive infrastructure (tech/physical/education/energy/food supply) overhaul via state grants/tax incentives/low cost loans or any other mechanism would be a good start.
In any case, the discussion is going to be moot for a while; inflation projections are finally back at the 2% medium term target (not that inflation is a good indicator to target, since it is effectively a Dollar Peg, but why should Bernanke care)? Banks are enjoying the steepest yield curve in… er, I think ever.
The only thing to really worry about is the unemployment rate, but the Fed doesn’t seem to really worry about that (except in so far as keeping it high offers yet another defense against inflation), so that just leaves the commercial real estate market to fret over. But that’s concentrated in regional (non TBTF) banks.
The answer to that problem was already legislated when the FDIC received a HUGE increase in staffing for the next 4 years.
Bernanke is a loop of it’s own. He’s basically saying that, “With regulations in place, which there won’t be, we still have to monitor everything, which, realistically, we aren’t going to do.”
That is a very intriguing idea, Patrick! :-)
Kate, link to your name does not work.
The decision was not sequential (House Committee -> House -> Senate Committee -> Senate) and there was no Special Counsel
Here we are upon the last day of the Saturnalia. One simply must make delirious fun at all the variants of criticism of BB. Good grief, the man understands the way things are not done. We did not get in this pickle by doing things in the manner not done by a society these last couple centuries since Adam Smith’s moral sentmentizing before writing Wealth of Nations.
If moral hazard is to be the guide in all that we do, we should do nothing. One must try to isolate personal risk since that is what one naturally does. What collapsed was not the personal risk avoidance that enabled the decision to engage in any given transaction but the collapse of everyone doing the same thing in generally the same way leading to fears that the risk avoidance will be nought for all en masse.
Now that is Saturnalian funny.
As a joke among my fellow accountants I often brought up the analogy of mark to market accounting being a fraud because almost all big players mark to market on the same day. Thus , if any one of size actually had to sell at market to realize the purported value in cash the realizable values would approach zero in the first few hours of the valuation day. Do not fool with Ma Cost on the Balance Sheet in other words.
Moral Hazard run through realistically is simply not possible to legislate as a principle in action. The reality of the individual moral hazerd decision would be so broad as to be unenforceable. Of course, we could give rise to a very funny saturnalian realization. The best Moral Hazard limiter is for the banker to say no unless you have funds on deposit to pledge to cover the loan. But oh boy. It takes 2 % or better to run the bank before profits. No wonder the banks want bank protection but want to gamble like traders.
The system idealization is now so convoluted with aspirations of goodness never done that it destroys itself…
Either way, we are screwed by complexity.
I agree, Simon, and, actually, the larger point is: why would we want to continue Bernanke at the Fed. He is a symptom of our problem, that is, his belief that the Bigs are important to the US economy to the extent that they actually add to a plausible recovery, regardless of the meaning of recovery. And, yes, the Doom Loop will continue, unimpaired, regardless of regulation, unless the regulation includes a return of Glass-Steagall and a restriction of the size of banks as a percentage of GDP.
Regarding Bernanke, please see the following from Senator Sanders regarding his performance both pre- and post-Crash:
http://sanders.senate.gov/newsroom/media/view/?id=14ca1a8c-752c-4f41-87bc-7900785ec9f5
Ed Beaugard writes: “I would urge Mr. Johnson, Mr. Kwok and others to step up and start agitating very loudly and consistently for real economic reform”
The use of the verb “agitate” reminds me of South Asians in Metro Vancouver (where I live) who commonly refer to the men and women who fought for the independence of India as “freedom fighters” and “agitators”. These words have positive connotations in their culture. India having achieved independence through non-violent political agitation and regime change.
With this in mind, I have added — mug shots — of Simon Johnson and James Kwak at my blog Baseline Fables. You can view their mug shots in the link below.
http://tippygolden.wordpress.com/springfield-rebels/
Hah!
“The last day of Saturnalia” said JerryJ.
Winter Solstice is auspicious.
It’s a bitch being naive, huh Ed?
@tippygolden
Interesting blog you’ve got. Didn’t know about it before.
But I think you’ve mis-identified Per: I believe he was executive director of the World Bank, and not associated with the IMF.
It’s interesting that the abovementioned South Asians are now in Vancouver, British Columbia, Canada. Freedom fighters and agitators may have facilitated India’s independence from Britain. But, 40% of India remains illiterate, and India is very stratified with a new elite, not to mention a continuation of the caste society structure, corruption, and lack of infrastructure. Ergo, South Asians have sought better opportunity in Vancouver, British Columbia, Canada.
Thus, there is a limit to the results that can be garnered with simple freedom fighting and agitation. I believe this limit also applies in the current situation in the United States. An analogous elite is firmly entrenched. It is meaningless to differentiate the financial, pharma, insurance, healthcare, energy, education, government, union, etc. elites in the U.S.-they’re all cut out of the same bolt of cloth, with the same paradigm. And, they are unified in retrenching, protecting or expanding their positions, and extracting wealth and power. They will continue such activity until it is no longer possible-and they are forced by circumstance to change-i.e. hitting bottom and being unable to do anything but change. Ergo, this is why I too live and am pursuing better opportunity in Vancouver, British Columbia, Canada with my Canadian wife who lived on a Green Card in the U.S. for over 40 years, and our two Canadian children.
In essence, I believe the time for agitation and at least non-violent Martin Luther Kingesque freedom fighting is past-it has proven entirely ineffectual. It will take much more to remove the stranglehold the elite possesses in the U.S. Probably, a bottom analogous to an alcoholic’s bottom, from which there is no option to continue to do the same things, and survive. The process and fallout won’t be pretty, and can be fatal. However, if the U.S. survives and comes out on the other side, it, like many alcoholics will be better for it.
“; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability”
I thought the Fed already was supposed to be thinking about financial stability? Considering how many people warned of the subprime meltdown and the interconnectiveness of the whole system (Hoocudanode), why are we to believe that these people will see risk any better in the future than they have in the past???
And even if they saw it, I just don’t believe that they want to be unpopular – they no longer believe in taking the punch bowl away.
“Until markets price ”small enough to fail” risk into our biggest banks, the time inconsistency problem is alive and well – and threatening. ”
“Threatening” indeed. The people are indeed threatened. The people must hazard and endure financial disruption on a global scale. No jobs. No job security. No bargaining power, and so stagnant, and increasingly lower wages, and fewer benefits. Radical inceases in core costofliving outlays; healthcare, energy, housing, transportation, and food, et al.. The predatorclass contrarily is little affect by massive shocks. If you are worth 30bn one day, 1bn the next, – then, no doubt there are some psycholigical impacts, – but a billionaire remains a billionaire and occupies a life the other 99.9% of the earths population can only dream of enjoying.
The point is – the predatrclass will be fine either way. One less yaught, or villa in Monaco – a $20,000 a night suite for your daughter, instead of the usual $150,000 penthouse.
Contrast with working Americans, wherein even the slightest upheaval in finacial or economic stability can prove devastating and catastrophic.
Bernanke is a pathological liar, programmed by the finance oligarchs to shout thier will and enforce their way. Is Bernake a public servant, – or a devious minister of the finance oligarchs and the predatorclass?
Is this the America we seek and support?
The American people are being threatened. Our enemies walk amongst us, and inhabit the highest levels of the government, – how will we defend our children???!!!
From the predatorclass perspective – we don’t exist. We are merely digits. Some ematter. From our perspective – we do exist, and we have tolerated enough abuse. “….You are a den of vipers and thieves. And I will rout you out! By the grace of the eternal god, I will rout you out!” Andrew Jackson. A real leader
When I said ‘agitate’ in reference to Mr. Kwok, and Mr. Johnson I didn’t mean anything more than that I hope very much they will be more like Robert Skidelsky. That is, speaking out very loudly, publicly and consistently for Keynesian reform of the financial system. Further, that they would consistently ridicule the idiocies of neo-classical economics, and the use of very advanced mathematics in economics, things like stochastic calculus for example, or various risk models that explain nothing such as VAR.
It seems to me and I could be wrong about this, that baselinescenario.com tends to take “policy-making” and other such nonsensical, pointless technocratic discussions a lot more seriously than for example, Mr. Skidelsky.
One example of this is the whole “too big to fail” policy discussion which is treated with way too much credulity by baselinescenario.com. As Skidelsky has pointed out governments must abandon the mistaken ideas of neo-classical economics altogether and not simply try to adjust things around the edges.
Let us all keep in mind the Wittgenstein of the Tractatus(the only one I know at the moment) where he said among other things, it’s impossible to predict a future state-of-affairs just because we know a present state-of-affairs.
By the way did anyone watch the Skidelsky talk at the Committee on Economic Development? Here’s the link again:
That’s strange, I didn’t mean to put the actual video there, just to copy the link.
Hillbilly Daryl and family, welcome to British Columbia. (sigh) The whole world wants to immigrate to Vancouver.
When we thought there was plenty of energy out there and that we faced no climate change problem it was not that hard to see some tracks… but now where are the tracks we are to put the economic train on?
I don’t think I used the word “credulity” quite correctly in my previous post. Probably I should have said “credulously” or “the too-big-to-fail debate, as it has proceeded over the last year, is treated way too respectfully by Mr. Johnson and Mr. Kwok”.
There is a great old paper by B.A. Lietaer advocation
script currency in times of depression. I have
a copy, but it is _much_ too long to reproduce
here. But Lietaer has a bio on Wikipedia, and I
bet the paper could be tracked down there.
Or you can E-mail me. I am reachable through the
web site http://www.waifllc.org .
Best wishes,
Alan McConnell, in Silver Spring MD
The capital market’s structural problems stem from the conceptual conflation of “risk” and “uncertainty.” Markets are complex systems. If there is complexity, there is uncertainty. The gravamen of this problem stems from our policymakers being almost exclusively deterministically trained—law, accounting, and economics. They therefore have difficulty identifying, analyzing, and solving issues that are increasingly becoming more indeterminate. The legacy governance system for the US capital market is in disrepair. To achieve real regulatory reform, policymakers have to move beyond the legacy, one-size-fits-all deterministic regime or be caught in a recursive loop of errors of commission (boom-bust bubble inefficiencies) and errors of omission (externality market inefficiencies). Such inefficiencies will eventually render our source of economic wealth ineffective.
For more effective and efficient capital market governance reference the GAAMA Model (http://www.sfomag.com/article.aspx?ID=1338&issueID=c ). The GAAMA model is a capital market thermostat that provides 3-D, orthogonal governance for normative markets and market externalities of Controlled (too big to fail) Offshore, Balkanized (too small to care), Underground market externalities. The model’s feedback mechanism drives market efficiencies that mitigate unintended consequences resulting from ambiguous, confusing, conflicting, and/or disproportionate commands. Notwithstanding bureaucratic attempts to gerrymander a one-size-fits-all regulatory regime, the GAAMA model uses economic realities to define compliance boundaries for normative and externality markets.
“This is exactly the kind of thinking that produces reckless lending (and borrowing).”
This is an ok complaint, but more so, this is the kind of thinking that blithely transfers larges amounts of value from the public purse to private hands through unaccounted instruments we call guarantees, among others.
Come on, credit where credit is due. From The Economist Nov 21st,
“To aid the recovery, Goldman launched a scheme to help 10,000 small businesses, to which it will donate $500 over five years.
Some were left unimpressed; Goldman pulled in at least $100m on 36 separate trading days in the third quarter and on 46 days in the second quarter. It has set aside $16.7 billion for pay and compensation so far this year.”
We must have balance in our commentaries!
Why “The Zombie Bankers”? Why not “The Zombie Regulators are now blaming the mortgage brokers and the bankers for the financial meltdown”?
More than “The Doom Loop” I guess a more appropriate name should be “The Dumb Loop”
Just consider the dumbness involved having government appointed regulators using credit risk ratings issued by credit rating agencies to decide how much equity banks need to have, so that the banks won´t fail and the governments will not have to bail them out while they must know that the rating agencies, when rating the risk of banks, explicitly measure the government´s willingness to bail out the bank. Can you think of a sillier loop than that? Well perhaps the following:
The Financial Times reports: “The Europeans banks are now net sellers of insurance against the chance of their own governments going into default – even though those same banks are implicitly backed by those governments”
Well, I’m flattered that you took the time to read my comments, thank you.
However, apart from the first sentence in your reply, sadly, I don’t think we agree on anything.
To take a strict Russellian or a Wittgensteinian approach based on the Tractatus(the only Witt. I know at the moment), even the use of the term “capital markets” represents a greater conceptual misuse or fuzziness than, as you rightly said, the intellectual confusion mostly by economists I guess, between ‘risk’ and ‘uncertainty’.
To illustrate why “capital markets” and how it’s used in economics is an abuse of thought, take the comparison of price movements on the NYSE to Brownian motion by Burton Malkel in “A Random Walk Down Wall Street”. First, I believe that Mandelbrot demonstrated that Malkel was wrong about price movements in general, although they may mimic Brownian motion for short periods of time(the least significant periods of time at that.) Second, and more dangerously, if one is comparing price movements on the NYSE to Brownian motion, that opens the door to thinking that economics can be approached as a natural science, and hence the introduction of all kinds of advanced mathematics, theorems, and even laughably, quantitative “laws” in the last 30 or 40 years, something decried by Mr. Skidelsky among many others.
My objection to the use of the term, ‘capital markets’, is that capital is not a commodity, it’s not something that can be thought of in the same way as trading cars, oranges or metals. Using the term ‘capital markets’, loses or can lose this very important distinction, in my opinion in a way similar to how the seemingly harmless comparison of price movements to Brownian motion led to or was a sympton of the catastrophic illusion that economics can be thought of as something like mechanics.
Just curious, but has the GAAMA model been back-tested?
Also, I would refer you and everyone to Nassim Taleb’s books, especially his discussion of the use of models in economics and finance.
I don’t think we disagree that much conceptually
For example:
I am a Coasian by nature and do most of my analytics through 3×3 matrix analysis rather than formulaic so-called predictive models
“Mandelbrot demonstrated that Malkel was wrong about price movements” – GAAMA externalities are fractals
Read Taleb: externalities are where the “Black Swans” roost
has the GAAMA model been back-tested? In the process
Metaphyscically– regulation in the Conceptual Age requires adding a third dimension for effective and efficient capital market governance. Before you can think outside of the box, you first must think outside the square.
“Best Fit for Best Practice Governance” http://www.sfomag.com/article.aspx?ID=1281&issueID=c posits that disclosure of the underlying economic environment randomness as either determinate or indeterminate is a precondition for effective capital market governance. The current “one-size-fits-all” legacy approach is obsolete and requires continual updating to accommodate capital market complexities. Trying to reconcile the informational discontinuities of determinate and indeterminate domains in a one-size-fits-all regulatory regime is analogous to having one motor vehicle code for the US and UK.
“Reflexive Governance” http://www.sfomag.com/article.aspx?ID=1324&issueID=c borrows from George Soros’ investment approach to correct systemic excesses and scandals. Effective and efficient regulation should mirror market metrics. The article advocates more appropriate market-driven regulation that uses techniques such as back-testing and stress-testing to raise early-warning, regulatory red flags as compared to more legalistic rule-driven regulation. To illustrate, if the market proved Citigroup’s one-size-fits-all financial supermarket to be flawed, why does the SEC persist in governing with a one-size-fits-all regulatory regime?
Finally, suggest you look at a book review by Brenda Jubin, Ph.D Thursday, October 8, 2009
http://readingthemarkets.blogspot.com/search?updated-max=2009-10-15T06%3A23%3A00-04%3A00&max-results=7
I’d like to continue this discussion with you, but I have to get ready to leave soon for the Holidays. I’ll reply later in more detail to your response.
Dear Mr. Boyko,
Just in passing I read a comment by Brenda Jubin, she remarks that you wrote in your book that risk is quantifiable, is that correct?
If you do believe that, then we truly don’t agree on anything although I’d be happy to keep talking.
Further, unless I’ve misread Taleb, someone you seem to like, doesn’t he pour scorn on the idea of quantifying risk, in general not just through the VAR model and such like?
Thanks anonymous … you might be mixing Mug Shots of SJ with Per. Double checked and captions look OK :)
Brilliant.
Risk is meaurable, i.e. acturarial.
Uncertainty is not measurable.
Can’t be goverend with one-size fits-all.
Welcome your comments.
Interesting article in the NYTimes.
“But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.”
“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”
Nicely put.
He denied and did not recognize any “problems” until they bit him in the ass. It takes no special skill to pump money to your future Banker employers. Bernanke will be the most hated Central banker in history when the Crash resumes consuming trillions more in hidden losses.
What is Bernanke doing about JPM’s 80 TRILLION in notional derivatives? Or will THAT implosion also be called “unforeseeable?”
Lee S.
Politicians are bought and paid for. How much cash in an envelope are you willing to give them to listen to you?
Goldman Sachs is playing its role by supporting the headline Stock Indexes. The Fed would prefer the DOW Crashes from 11,000 to 5,0000 than from 6,000 to 2,000.
This market supporting activity is being done for purposes of “National Security” and will further enrich the insiders.
Lee S.
Take it away? TAKE IT AWAY? Why, they manufacture the punchbowl and mix the punch! Why ever would they take it away??
Lee S.
sorry, i didn’t quote enough of simon’s and so my comment wasn’t what i was thinking. let me try again:
> the Credit Default Swap (CDS) spread for Bank of America now hovers just 100 basis points above that of the US government, despite BoA having a very risky balance sheet.
the CDS spread for the US government is a completely bogus number, and even if it weren’t completely bogus, what it means is very different from what the CDS spread of BAC means.
Rudeness or ad hominem attacks suggests a lack of ideas from which to respond, HOWEVER, the recognition and attendant disclosure of the prevailing economic environment is the foundation that drives governance for either determinate or indeterminate regimes. Innovation is the hallmark of capital markets, yet innovative solutions for global markets create greater complexity. Complexity begets uncertainty as innovative financial products evolve from earlier, simpler versions to address heretofore uncertain and unforeseeable circumstances. New York University economist Nouriel Roubini distinguishes between “Risk and Uncertainty—the former can be priced by financial markets while the latter cannot … Indeed, for many reasons the current market panic has more to do with unpriceable uncertainty rather than measurable risk”.
Necessary for operational efficiency of robust markets is transparency as to the distinction between the between determinate and indeterminate economic environments. This distinction was made famous by economist Frank H. Knight in his seminal book, Risk, Uncertainty, and Profit (1921). In brief, “risk is present when future events occur with measurable probability” while “uncertainty is present when the likelihood of future events is indefinite or incalculable.” To ensure the best fit for best-practice governance, policymakers should balance stakeholder rights with stakeholder responsibilities by disclosing the underlying economic environment and its related segmented governance regime (see: http://www.sfomag.com/article.aspx?ID=1281&issueID=c)
The question for Mr. Bernanke is what bank capital treatment was afforded indeterminate financial instruments with uncertain and unforeseen consequences or was TARP a cover for past conflation errors?
Yes, on a second reading you’re right, SJ should have said spread over treasuries, not CDS difference. And StatsGuy’s point is also valid.
That said, I think once it became clear that creditors would come out unscathed (after Lehman, WaMu, etc), moral hazard / TBTF came into play and lowered the spreads on the banks over the next few months, which fed back into the system at large. Spreads or CDS both indicate that default risk is very low and expected recovery high.
CDS on USA credit is not completely bogus; there are other CDS written on countries and companies without any deliverable external debt (e.g. Kazakhstan or Estonia). If the US issues Eurobonds in yen or euros or sterling, the CDS will help investors benchmark that bond, and then there will be a possibility of default. Right now there is no such chance (unless maybe something is buried in the ISDA definitions for CDS).
FYI: Taleb and Risk vs. Uncertainty
More on risk, uncertainty, and Nassim Taleb
http://ahorseofpeas.blogspot.com/2009/03/more-on-risk-uncertainty-and-nassim.html
To follow up on my previous post on Nassim Taleb and his work, there is a critical distinction that is often overlooked between risk and uncertainty.* Risk is quantifiable. Whether or not it has been properly measured, it refers to something that is measurable. Uncertainty is not quantifiable. Risk can be “bought down” or hedged in ways that uncertainty cannot. A standard example of risk is the sort of game you find at a casino, like roulette, where the odds are clearly known. The state of affairs that will result from a war (the outcome or outcomes), on the other hand, is uncertain, relying on too many variables, complex interactions, and unknown unknowns to be meaningfully quantified. The outcomes of risks have known probability distributions. Not so with uncertainties. Here’s an example of these concepts in action, in the context of baseball.
This conceptualization of risk and uncertainty is sometimes mapped onto the “known unknown” vs. “unknown unknown” divide, with known unknowns characterized as risks and unknown unknowns as uncertainties. But the distinction between known unknowns and unknown unknowns is based on the knowledge of the observer, while the distinction between risk and uncertainty is in some respect a difference in “knowability.” There are plenty of “known uncertainties” in the “known unknown” category, where we are perfectly capable of identifying something we don’t know which nonetheless has a probability distribution we do not or cannot know.
Part of Taleb’s argument with regards to the financial crisis could be framed in these terms. Financial managers thought they had transformed some types of uncertainty into risk that could be reliably estimated through new statistical techniques. But they were operating with assumptions about the underlying probability distribution of events that were unwarranted, meaning that all they had managed to do was conceal significant uncertainties (unquantifiable indeterminacies) that ultimately came back to bite them. (See this Wired Magazine article for a fascinating description of how this came about.) The more generalized form of this argument is that we tend to operate as though we are facing risks, rather than uncertainties, in part as a result of our psychological biases. (Taleb discussed a variant of this a bit in the podcast I referred to in the earlier post.)
This may all seem rather esoteric, but in a world where there is a fresh appreciation for the limits of statistical knowledge there needs to be a way to act under uncertainty. The elemental caution reflected in Taleb’s advice on operating in what he would call the “fourth quadrant” and what I would call conditions dominated by uncertainty is as reasonable a response as any to decision-making in this type of environment. When faced with less-structured problems, dominated by uncertainties and unknown unknowns, highly structured analytic tools are frequently neither appropriate nor helpful. Gaming can be one of the least-structured analytic approaches, which limits its outputs but allows it to constructively address issues characterized by deep uncertainty.
* These definitions do not conform to popular usage of either term, but they are generally used in this way in policy analysis and represent a helpful way to characterize different types of indeterminacy. Risk in this case is not limited to costs or negative events, but instead applies to probabilistic outcomes both positive and negative.
Posted by Tim at 12:38 PM
Labels: decision science, Nassim Taleb
1 COMMENTS:
Robert E. said…
Taleb is very cool. Chaos and the law of initial conditions rule. I posted this on my blog http://www.beyondrealtime.com in an article about Taleb’s book, The Black Swan. What’s really interesting now is a new theory gaining traction regarding fractals and the uniting of quantum and relativity. Now that’s something to get excited about. I will link your blog to mine as I am learning a lot about economics, war games and uncertainty. I like the name as well.
If you throw a coin, betting on head or tail, and then suddenly it lands on its side then that is a real and natural Black Swan event. But, if you alter the coin in such a way that it must land on its side, more sooner than later, then when that happens can no longer be referred to as a real and natural Black Swan since it is a manmade event. At best we could perhaps refer to it as a genetically modified Black Swan.
The current financial crisis would not have happened had the regulators not required the banks to hold capital depending on the credit ratings and then empowered some few credit rating agencies as their official risk surveyors and these had not with their AAA signs guided the risk adverse herds of capital in an absolutely wrong direction.
The Black-Swan event that perhaps occurred was the immense magnitude of the mistakes of the credit rating agencies mistakes, but that was a risk the regulators should never have ignored.
Also, you might measure risk perfectly well, but if you do not know what to do with those measures you´re equally doomed to go wrong. Regulators have no role to play in discriminating against risk-taking per se, since risk-taking is the oxygen the world needs to go forward.
RE Per Kurowski:
6th slide of book signing powerpoint presentation
3-Mis policies beget bad economics
Mischaracterization by conflation
> Risk vs. uncertainty
> Governance vs. rule-writing
> Systemic crashes vs. specific crises
Misapply: improper use of correct tool
> Securitization of NINJA mortgages
> Demographic demand increased for AAA paper
> Flawed AAA rated NINJA mortgages
Misspecify: use wrong tool
> Rule-writing uses retrospective crises to plan
> Deterministic metrics for uncertainty
The legacy governance system for the US capital market is in disrepair. To achieve real regulatory reform, policymakers have to move beyond the legacy, one-size-fits-all deterministic regime or be caught in a recursive loop of errors of commission (boom-bust bubble inefficiencies) and errors of omission (externality market inefficiencies). Such inefficiencies will eventually render our source of economic wealth ineffective.
If this happens, we’re all screwed.
Stephen A. Boyko
http://www.n2kecosystems.com/
Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System”
http://w-apublishing.com/Shop/BookDetail.aspx?ID=D6575146-0B97-40A1-BFF7-1CD340424361
Book Review: Brenda Jubin, Ph.D Thursday, October 8, 2009
http://readingthemarkets.blogspot.com/2009/10/boyko-were-all-screwed.html#comments
We are on the same track, in February 2000, in the Daily Journal of Caracas in “Kafka and global banking”, I wrote the following:
“I refer to the consolidation currently going on among banks. With every day that passes we have fewer and fewer banking institutions worldwide with which to work. This trend has been marketed as one of the seven wonders of globalization.
I believe the trend introduces risks which have either not been sufficiently commented on or which have simply been ignored. Among these I can identify the following:
A diminished diversification of risk. No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.
The risk of regulation. In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.
Excessive similitude. By trying to insure that all banks adopt the same rules and norms as established in Basle, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs.”
Much more in:
http://subprimeregulations.blogspot.com/
http://www.theaaa-bomb.blogspot.com/
Just a short comment:
Yes, risk is measurable in PHYSICAL processes, not in pseudo-sciences like economics or sociology, or rather, that people try to pretend that economics and sociology are sciences. This is the ‘physics envy’ on the part of economists that Skidelsky talks about.
Just briefly:
As I mentioned before, there is a huge difference, as in, entirely different in my opinion, between measuring risk in physical processes and measuring risk in economics, things like sudden price changes, for example.
Also, don’t Taleb and Keynes(I think) argue that probability distributions change all the time, so any model based on the normal distribution, for example, may work for a time, but then not work, because of this.
Further, doesn’t Taleb, at least according to Chris Wilmot, entirely reject the use of quantitative methods in finance?
“An analogous elite is firmly entrenched. It is meaningless to differentiate the financial, pharma, insurance, healthcare, energy, education, government, union, etc. elites in the U.S.-they’re all cut out of the same bolt of cloth, with the same paradigm. And, they are unified in retrenching, protecting or expanding their positions, and extracting wealth and power.”
Exactly. That is what Hayek described in “The Road to Serfdom.” We are there. The cartels have taken over government, placed their people at the helm of all the lawmaking and regulators functions with the sole aim of protecting and expanding their control over the allocation of our society’s resources.
Taleb has said complex derivatives are a cover for fraud and they (complex derivatives) should be banned.
Also, I don’t accept the use of terms like “Conceptual Age”. As Keynes said, the world is run by ideas, it always has been, and ‘indeed, it is run by little else’. There’s really nothing else to say about the subject. We have always lived in a Conceptual Age.
Earlier, you talked about “thinking outside the box”, which again seems rather vague.
In another post, you used the term, “states of affairs” in one of your comments, but my guess is that you’re not Wittgensteinian, at least not a reader of the Tractatus. If you were you and you agreed with Wittgenstein’s conclusions in the Tractatus, you would probably agree that it is impossible to think “outside the box”. We cannot account for “externalities” either in language, or in mathematics because the only things we know that are possible are the things that have already happened. We cannot explain “everything that is the case”, i.e. the world, we can only describe it.
Respectfully,
Ed Beaugard
Again, I don’t agree with the way you’re using the term “risk”. Risk or probability can be measured in PHYSICAL processes, not in human affairs, economic or otherwise.
Do you have a counter-argument about this?
A Keynesian approach to economics as a “moral science” not a natural science would clear up a lot of, in my opinion, confusing jargon.
Knight, Taleb, Roubini and blogger Horse of Pease, all use a similar paradigm to mine, yet you try to justify an alternative. Fine! Provide a definition citing a real world example. Address realities with your examples rather than your “feelings.”
reference:
Thursday, March 19, 2009
More on risk, uncertainty, and Nassim Taleb
http://ahorseofpeas.blogspot.com/2009/03/more-on-risk-uncertainty-and-nassim.html
To follow up on my previous post on Nassim Taleb and his work, there is a critical distinction that is often overlooked between risk and uncertainty.* Risk is quantifiable. Whether or not it has been properly measured, it refers to something that is measurable. Uncertainty is not quantifiable. Risk can be “bought down” or hedged in ways that uncertainty cannot. A standard example of risk is the sort of game you find at a casino, like roulette, where the odds are clearly known. The state of affairs that will result from a war (the outcome or outcomes), on the other hand, is uncertain, relying on too many variables, complex interactions, and unknown unknowns to be meaningfully quantified. The outcomes of risks have known probability distributions. Not so with uncertainties. Here’s an example of these concepts in action, in the context of baseball.
This conceptualization of risk and uncertainty is sometimes mapped onto the “known unknown” vs. “unknown unknown” divide, with known unknowns characterized as risks and unknown unknowns as uncertainties. But the distinction between known unknowns and unknown unknowns is based on the knowledge of the observer, while the distinction between risk and uncertainty is in some respect a difference in “knowability.” There are plenty of “known uncertainties” in the “known unknown” category, where we are perfectly capable of identifying something we don’t know which nonetheless has a probability distribution we do not or cannot know.
Part of Taleb’s argument with regards to the financial crisis could be framed in these terms. Financial managers thought they had transformed some types of uncertainty into risk that could be reliably estimated through new statistical techniques. But they were operating with assumptions about the underlying probability distribution of events that were unwarranted, meaning that all they had managed to do was conceal significant uncertainties (unquantifiable indeterminacies) that ultimately came back to bite them. (See this Wired Magazine article for a fascinating description of how this came about.) The more generalized form of this argument is that we tend to operate as though we are facing risks, rather than uncertainties, in part as a result of our psychological biases. (Taleb discussed a variant of this a bit in the podcast I referred to in the earlier post.)
This may all seem rather esoteric, but in a world where there is a fresh appreciation for the limits of statistical knowledge there needs to be a way to act under uncertainty. The elemental caution reflected in Taleb’s advice on operating in what he would call the “fourth quadrant” and what I would call conditions dominated by uncertainty is as reasonable a response as any to decision-making in this type of environment. When faced with less-structured problems, dominated by uncertainties and unknown unknowns, highly structured analytic tools are frequently neither appropriate nor helpful. Gaming can be one of the least-structured analytic approaches, which limits its outputs but allows it to constructively address issues characterized by deep uncertainty.
* These definitions do not conform to popular usage of either term, but they are generally used in this way in policy analysis and represent a helpful way to characterize different types of indeterminacy. Risk in this case is not limited to costs or negative events, but instead applies to probabilistic outcomes both positive and negative.
Posted by Tim at 12:38 PM
Labels: decision science, Nassim Taleb
1 COMMENTS:
Robert E. said…
Taleb is very cool. Chaos and the law of initial conditions rule. I posted this on my blog http://www.beyondrealtime.com in an article about Taleb’s book, The Black Swan. What’s really interesting now is a new theory gaining traction regarding fractals and the uniting of quantum and relativity. Now that’s something to get excited about. I will link your blog to mine as I am learning a lot about economics, war games and uncertainty. I like the name as well.
See Al Gore’s former spreech writer Dan Pink’s “The Right Side of the Brain” and “The 3-D global spatial data model: foundation of the spatial data infrastructure” by Earl Burkholder for reference to Conceptual Age and 3-D metrics.
You have to get beyond the constraints of your feelings. Either establish your bona fides or the bona fieds of your references.
Just a general point to all the commentators this season of good will, and it is this.
I am not an economist or an academic, have never run a large organisation (small ones, yes) or really achieved anything ‘great’ in my aged life.
So reading the comments submitted by you all, over so many Posts on this Blog, in the last year has been deeply interesting and, at times, very educational.
Thanks guys and gals!
Wonder what 2010 brings us all?
P.
You have gotten the “who.” Statist elites whether left or right seek power for self-aggrandizement. But “how” is the question? I am contemplating back-testing the GAAMA controlled market externality (2B2F—see GAAMA Model http://www.sfomag.com/article.aspx?ID=1338&issueID=c ) to test how regulation enables oligopolies not competition. The cost of regulation is a fixed-cost barrier to entry for would be financial competitors. By correlating the growth in the Fed Register regulations with the growth in financial firm capital base the, I posit the oligopolistic effect of regulation can be measured.
Dear Mr. Boyko,
I’ll assume this is at least partly addressed to me.
You tout the GAAMA model, ignoring that all the most sophisticated, mathematical models in finance and economics almost led to the destruction of the world economy in the winter of 2008-2009.
I’m not proposing the use of models that explain nothing, you are! Mathematical modeling is the problem, economics is a pseudo-science when it’s thought of this way!
In short, it is you who must establish your bona fides, not I.
You mention Nassim Taleb and then ignore my remark that Taleb essentially thinks that all of finance is a scam, that all quantitative finance is worse than useless. Is my understanding of Taleb incorrect? You don’t reply one way or the other.
Further, perhaps this is unfair and I don’t mean to be uncivil, but the use of jargon in your posts on baseline.com is not reassuring.
Also, as against everything that I understand Taleb and others to believe, you insist that risk is quantifiable. I’ve pointed out that the people you seem to like, Taleb, Keynes and others do NOT agree with you! And yet you say nothing about that.
Of course, since you integrate fractal geometry into your model, you’ll say that it’s better than the models that have been used heretofore(sp.?)
But I’m trying to tell you a la Wittgenstein, Taleb, Keynes, and all the people you admire that outside of the natural sciences, it is impossible to predict(model) a future state-of-affairs based on knowledge of a present state-of-affairs as Wittgenstein says in the Tractatus.
Well, Happy New Year!