Friday, October 17, 2008

Near rationality and the financial collapse

The global financial collapse of 2008 was not only predictable, but actually predicted by numerous individuals.

In 2003 Warren Buffet warned that the trade in derivatives posed a "mega-catastrophic risk," capable of causing a "spiral that can lead to a corporate meltdown." And, as far ago as 1998, a popular article on the mathematics of finance noted "the perils of twentysomething computer whizzes concocting 'financial hydrogen bombs'. Some businesses and local governments have excluded derivatives from their portfolios altogether; fears have even emerged about a meltdown of the financial system." The statistical assumptions underlying the 'value-at-risk' technique for calculating the expected maximum loss on an investment, came under scrutiny in the same article:

Like other modeling techniques, value at risk has bred skepticism about how well it predicts ups and downs in the real world. The most widely used measurement techniques rely heavily on historical market data that fail to capture the magnitude of rare but extreme events.

So, if the financial collapse was eminently predictable, and even predicted by certain luminaries, why did the collapse nevertheless occur? Classical economics notoriously assumes that the actions of economic agents are 'rational', in the sense that such agents are taken to maximise their self-interest, hence one might expect self-interested agents to heed the warnings of collapse, and to change their financial practices accordingly.

The reason this didn't occur is the near rationality of human behaviour, and, in particular, the application of near rationality to the interpretation of financial statistics.

The classical economical assumption that agents act to maximise self-interest, neglects to take into account that an agent's self-interested decisions are only taken relative to the information available to the agent. Hence, there is something of a distinction between enlightened self-interest, and non-enlightened self-interest. Moreover, actions can serve an individual's short-term self-interest, or serve their long-term self-interest. Various research indicates that most economic agents, most of the time, act not with perfect rationality, or with maximally-informed long-term self-interest in mind, but with something called near rationality, in which the agents use only easily accessible information to make decisions which are only in their short-term self-interest. The evolution of the economy is determined by the collective effect of numerous individuals making decisions borne of incomplete information and short-term self-interest. Hence, the collective effect of these numerous self-interested decisions is capable of taking an economy into a recession, despite the fact that a recession is not in the self-interest of any of the agents.

A crucially important special case of this near rationality is the interpretation of the statistics and mathematics of derivatives and financial risk. As Mary Poovey pointed out in 2003:

people tend to believe that numbers embody objectivity even when they do not see (or understand) the calculations by which particular numbers are generated.

Financial managers making investment decisions will typically treat numbers such as the value-at-risk as objective facts. Such numbers constitute the easily accessible information on which nearly-rational financial managers base their decisions, whilst the calculations which generated those numbers, or the assumptions underlying the statistical models, constitute far less accessible information.

The unstable state into which the world financial system fell, where large amounts of debt and risk were hidden by various financial instruments, was a consequence of the application of near rationality to the mathematics and statistics of finance.

1 comment:

passer by said...

I think I understand all that. Good post btw.

It did not stop Buffet investing in them though did it?

In engineering you put in safety measures or fault tolerance, you assume something will go wrong, and you build your system accordingly, which in this case would have been to minimize the size of the banks, and not allow risk to be shared, but then again economics is not a science.

I really don't think we can escape the politics of all this, we used to put down our deposits on our homes and this acted as a sort of insurance on the loan. Securitisation system allowed banks to believe, and the regulators and politicos that this insurance could be dealt with in the market place, thus giving people who would not normally get loans, access to loans, this is a very big carrot for any politician to bite on, and of course when you are sending over billions in tax revenues, the politicians are going to believe in it come what may?

After the banking failure, and the political failure, we have the economic failure.

Central bankers did not do their job, not only to regulate banks (which in the UK they dont) but they should have spotted the capital inflows from the the East into the western market place. They are charged with stopping inflation, but the inflation did not show up and they did not act, this failure I dont think has been addressed by anyone yet.

On a personal level I go along with Hayeks view of the economy, that the market is just a mirror , market failures come about because of what we do. What we are seeing now is unintended consequences that spark government actions, that create other unintended consequences, which will most likely result be deflation, which adds value to money. Hayeks revenge is complete, if we had started with Hard money in the first place, the whizz kids could have just stuck to playing computer games?