But yesterday, after hitting "Publish" on my rant-y little diatribe about how borrowers need to take responsibility for their own poor financial decisions, I came across a couple of other items that convinced me that I had to add a little more to this topic. The first of those items will be the source of this week's Quote of the Week, while the second will (hopefully) serve to illuminate on it a bit. Let's get to it...
This week's QUOTE OF THE WEEK
"It has been argued that one formula known as Black-Scholes, along with its descendants, helped to blow up the financial world."
- Tim Harford, BBC Radio
First of all, before I launch in, I have a journalistic bone to pick with Mr. Harford, a pet peeve that's been bugging me lately as it's begun to spread. Tim, just who exactly has been making this argument to which you so casually refer? Do you have a specific name, or an example? If you don't, then YOU'RE THE ONE making the argument. Enough with the passive-aggressive bullshit. If you want to make an argument, just make it and defend it--don't try to shift that responsibility elsewhere. Thank you.
Now, that peeve aside, whoever made the argument (whether it was Tim or the Unknown Soldier) happens to have made a brutally flimsy and careless argument, among the worst I've ever heard. To try to deflect responsibility for an economic crisis onto a model (or that model's creators) is fraudulent on many levels, and doing so rivals the behavior that I mentioned yesterday in the annals of denial of personal responsibility.
It's often been said that guns don't kill people, people kill people (hey, look at that, I found a source, unlike Tim Harford). Generally speaking, I agree. Similarly, models don't blow up economies--people blow up economies.
We all use models in our daily lives, because they help us to make sense of what are often very complex problems. Models simplify, organize, and categorize the variables in an uncertain world so that we can better understand the impacts of our decisions. But they DO NOT, ever, have the power to tell us what to do. You don't even need to know a thing about Black-Scholes (and trust me, a lot of people who should know a lot about it... don't) in order to accept that assertion as fact.
The intelligent person knows to use a model only as a guide to confirm (or refute) what our intuition tells us. Very often, our painfully simple heuristic models (which you can learn or hear more about from Gerd Gigerenzer's speech, if you're a nerd like me) actually outperform very elegant statistical models. How can this be? The answer lies in this brilliant polemic from economist Robert Wenzel (which is almost as great as a similar recent rant from Jim Grant).
In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.
There are no such constants in the field of economics since the science of economics deals with human action, which can change at any time. If potato prices remain the same for 10 weeks, it does not mean they will be the same the following day. I defy anyone in this room to provide me with a constant in the field of economics that has the same unchanging constancy that exists in the fields of physics or chemistry.
And yet, in paper after paper here at the Federal Reserve, I see equations built as though constants do exist.Wenzel is dead on. We all know that models are useful, but they do not remove responsibility for rational risk management--only people have the power to do that. When callous risk managers at huge investment banks take another man's model on faith, and make huge bets with billions of dollars on the line without sanity-checking the model, that's nobody's fault but theirs. They can't come around and say "but... the model said...", any more than our old friends at Long-Term Capital Management did back in the 1990s.
When an individual buys a house with a mortgage or takes out a student loan, it's that individual's responsibility to know the risks associated with that loan. Similarly, it is the bank's (or hedge fund's, or mutual fund's, or pension fund's) responsibility to know the risk profile of the trades it is putting on. They can't blame a model or a formula for "understating" the risk--they're the ones who used the model, so the responsibility is theirs.
Black-Scholes is a great formula, an elegant formula, and one that enabled us to easily price contracts that we couldn't price without it. The fact that some people traded those contracts in a manner that was inconsistent with rational risk management standards has nothing to do with Black-Scholes--the formula was at best an accessory to the crime.
Why is it that we have seemingly lost our ability to claim responsibility for our own actions? Will our federal government blame John Maynard Keynes if and when our debt ceiling hijinks finally blow up in our faces? Will people try to blame the food manufacturer when it turns out that chocolate frosting isn't, as it turns out, a nutritious snack? Oh crap... you're right. They already have.
[Economic Policy Journal]