October 24, 2008

The humbling of Alan Greenspan

Wall Street's erstwhile spiritual leader has shed his cloak of fiscal infallibity this week

Alan Greenspan has admitted that his thinking about quite fundamental aspects of financial markets was mistaken

According to the Washington Post
The former chairman of the Federal Reserve said that the crisis had shaken his very understanding of how markets work...

In the space of mere months, Greenspan has gone from world guru of high finance and darling of the political elite to being compared to Bill Buckner, the Red Sox first baseman whose infamous fielding error cost Boston the '86 World Series.

In reality is seems probable that Greenspan is neither God nor Goat but simply a victim (like the rest of us) of assuming that the regularity of his fiscal models would be matched by a corresponding regularity in the real world. We are all vulnerable to discounting the possibility of events of great impact and rarity in favor of the seductive regularity of averages. As pattern seeking creatures such biases seem pretty much hardwired into our cognitive architecture.

In fact it seems like the last few months of financial history are playing out as an utterly perfect illustration of the arguments advanced by Trader-Philosopher Naseem Taleb in his books Fooled By Randomness and The Black Swan.

I'm not sure what I found more shocking, Alan Greenspan's utter humility in the face of a crisis
that seemingly calls core aspects of his belief system into question

"You found that your view of the world, your ideology was not right, it was not working?" said Rep. Henry A. Waxman (D-Calif.), the committee chairman.

"Absolutely, precisely," Greenspan said. "You know, that's precisely the reason I was shocked because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well."

Or his subsequent hubris.

"We have to recognize that this is almost surely a once-in-a-century phenomenon," Greenspan said,

Think about that. An 82 year-old man has just conceeded that the events of the past few weeks call into question fundamental assumptions, underpinning his entire professional life and body of work . Despite this, he is then willing to prognosticate with a fair degree of confidence, regarding the frequency of what we have just witnessed. Given that this is pretty much unanimously agreed to be unprecedented, we have exactly ONE data point. And from this we can work out the likely frequency of such events occuring in the future, how?
How do we know it is a once in a century deal? Perhaps this kind of thing happens on average once every twenty years or so and we have got insanely lucky over the last century. On the other hand perhaps it is staggeringly rare and only something we can expect to see once a millennium.

Is pretending to know the unknowable and proceeding to construct a brand new house of cards around that make believe knowledge on the ruins of the old, really the most advisable course of action? The question was not sarcastic I just don't know.

Such arrogance in the face of failure reminds me of a very similiar attitudes following the collapse of the ill-fated hedge fund Long Term Capital Management. (LTCM) Naseem Taleb covers the story in Fooled by Randomness

The market is very risky — far more risky than if you blithely assume that prices meander around a polite Gaussian average [i.e., the bell-shaped curve].

Anywhere the bell-curve assumption enters the financial calculations, an error can come out.

In 1993, [Scholes and Merton] joined some heavyweight Wall Street bond traders in the creation of a new hedge fund, Long-Term Capital Management... The had at one point twenty-five PhD's on the payroll... In August 1998 the Russian government defaulted on its bonds, triggering a market meltdown. LTCM... was stuck without buyers... In the end, several banks reluctantly agreed to bail out the fund... only at the behest of the Federal Reserve Board, which was concerned about a wave of bankruptcies if LTCM went under.

[Merton and Scholes] made absolutely no allowance in the LTCM episode for the possibility of their not understanding markets and their methods being wrong. That was not a hypothesis to be considered... The fact that these "scientists" pronounced the catastrophic losses a "ten sigma" event reveals a Wittgenstein's ruler problem: Someone saying this is a ten-sigma either (a) knows what he is talking about with near perfection... or (b) just does not know what he is talking about... and it is an event that has a probability higher than once every several times the history of the universe. I will let the reader pick from these two mutually exclusive interpretations which one is more plausible.

Incidentally it also strikes me that Alan Greenspan is absolutely the wrong person to look to for advice about this particular crisis, not because I necessarily think he is wrong, or to blame for it, but because it seems to me that to asking a man in his eighties to objectively consider
whether or not, current events invalidate his entire lifes work is asking for the superhuman.

Maybe the most appropriate advice is found not in the pages of John Maynard Keynes or Milton Friedman but in William Shakespeare.

To paraphrase Hamlet, 'There are more things in heaven and earth, Horatio than are dreamt of in your (economic) philosophy.'

Overconfidence that our understanding of things matches the real world seems to be at the root of a lot of tragedy.

So much of todays knowledge may prove to be founded on quicksand tommorow.

How much of todays corpus of economic and financial theory reflects an underlying reality in the external world and how much of it is mere mathematical masturbation? I don't know and I don't think the experts know either.

No comments: