Friday, March 9, 2012

Naked Idiocy: A Review of Econned by Yves Smith



Readers may have noticed”, writes Yves Smith, “that I offer no remedies for the economics discipline”. There are a few other things I noticed reading Econned, the new book from the creator of the successful blog Naked Capitalism. But let the record state that I count myself amongst the hundreds of thousands of subscribers to Naked Capitalism, and appreciate Smith’s extraordinary ability to bring an entertaining news summary to my inbox every day.

Indeed Smith is at her strongest accumulating nuggets of juicy information and in Econned, the coverage of Magnetar's structured finance escapades provides a good example. A sufficiently hungry reader should have no problem picking other morsels from the broth of assertions like “[CDS] … have almost no legitimate uses”  , “criticism from within the profession has fallen on deaf ears” and “All the models in the financial economics edifice assume a normal distribution”. That's why I'm sending you a copy of Econned. And I’m going to help you through the first hundred pages just in case you need a nudge.

Let’s build up some momentum by noting that Nouriel Roubini and Lord Robert Skidelsky think highly of this work. Skidelsky, in particular, is one of Keynes more noted biographers and perhaps like Smith, felt the nuances of the master were lost on some of the math jocks who tried to surf his wake. At one point Smith wonders aloud how this came to be, and why “economists rely on interpretation rather than source”, especially when the golden source was Keynes himself.

Yet on the topic of mathematical models it rapidly becomes clear that Smith has relied on interpretation rather than source, where by source I refer to papers and textbooks. As a consequence, she falls into a tedious rendition of an all too familiar tune: Mandelbrot could have saved the world from Gauss. Had Smith relied on the source, rather than the interpretation, we might have been spared from the same old blunders: like conflating Gaussian with least squares or normal cumulants with value at risk. I was hoping for more of a death-by-a-thousand-cuts than being beaten unconscious with a ludicrously blunt instrument. No such luck.

Still, having developed a thick skin for this sort of thing your blogger was coasting along and wanting rather badly to believe that this salvo from outside the profession, as Smith refers to her own work, might be a notch above what we’ve seen. If you’d like to take the same upbeat approach please don’t let me stop you. Later in the book Smith even appears to catch a whiff. She notes that “it is all too easy for the top level of the firm to become hostage to the needs and demands of profit centers”, which is undoubtedly true. Sadly though the loop never closes as least as far as mathematics pushing is concerned. Who were these math producing profit centers, I wonder, and could they spell Normal Copula?

        Dumb ...

Thus it becomes a little difficult to take Smith seriously on journalistic grounds. But that is merely the beginning. When she wanders into allegedly logical arguments things get very scary indeed:
Note that there is already some circularity in the[Markowitz’] logic. To create the prized “efficient portfolio” you need to know the future!
Um, no Smith, you don't. The point is very much that you don't know the future. If you knew the future you'd pick one stock, obviously. Now surely that would have occurred to the author of this fine document? Oh wait...
But the reason for diversifying and creating a portfolio in the first place was to diversify risk because the investor does not know what will happen and thus is not willing to put all his money in one instrument. But if you did know future prices, you would simply buy the security that would go up the most over your chosen time horizon.
Amazing! I'm constantly stunned by people who attempt reductio ad absurdum arguments without noticing the meta-reductio ad absurdum: if you argument is so totally facile and derives a contradiction in something that has been carefully considered by others for a long time, then perhaps you didn't understand the premise. 

We can certainly agree with Smith on one thing. This level of logic places the author "outside the profession" which is her desired posture and not likely to be disputed any time soon. (Btw I read this passage several times just to makes sure I wasn’t suffering from lack of oxygen on my Jet Blue flight and had misinterpreted Smith.  I hadn't. Out of mercy the copy of the book I'm sending to you is missing this section. I ripped it from the spine out of mercy).

By positing arguments this stupid the author saves herself from my charge ironically: that her theoretical arguments rely on third hand accounts originating from people who never worked anywhere near a source (those interpreters include semi-famous semi-quants, though these authorities never worked in the relevant asset class, never mind the business units at the center of the mess).

So no, Smith is not entirely guilty of complete reliance on the distant speculations of others. That’s because nobody else firing salvos at models, critiquing financial economics, or purporting to say anything remotely intelligible about anything remotely related to probability could possibly have come up with anything as lame as Smith's arguments which are, surely, her own.

    ... and dumber

Here's what I mean:
But if prediction markets really were all that good at seeing the future, the horse with the best odds would always win the race.
Oh my goodness! In general it's not so easy for devoutly non-mathematical people to stay on that high wire when writing about probability. But even accounting for that, this fall is truly spectacular. Is the author suggesting that an even money favorite should win all the time rather than fifty percent of the time, roughly? Is she suggesting that if that doesn't happen then we can pooh pooh prediction markets?

I can't even delve into the multiple levels of confusion about the basics of probability and markets that must have been swimming in the author's mind in order to pen something like that. Is the bar for prediction markets to be raised so high that if they don't always predict the result we should ignore them and turn to tea leaves instead? But then wouldn't the favorite's odds always be 1000:1 on? Has Smith contemplated the possibility that there might be genuine chance involved and that prediction markets could do a bang up job and still leave the favourite at 6:1?

Addendum: Smith will be happy with the result of the 2016 Kentucky Derby: 



The market picket the first four horses in order. Happy now Smith? If the market had no ability to aggregate information at all this would happen once every 116,280 Kentucky Derby's. 

Unfortunately for you your copy of the book still has page 87 in it, where Smith's excruciatingly idiotic statement can be found. I’ve laminated the section and added some extra stitches so you can’t rip it out either. Econned will open to that page if dropped accidentally and there, on almost the first line, you will have no choice but to read this over and over again:
But if prediction markets really were all that good at seeing the future, the horse with the best odds would always win the race.
See? Just as painful the second time. And even more embarrassingly, the author, completely oblivious, tries to play this hand like a nut flush:
How often does that happen?
because hey, there is nothing quite like a rhetorical question with an answer too obvious to state. Maybe the favorite wins about as often as the market says it will Smith! Did you contemplate that possibility. Oh God have mercy. I don’t know about you, dear reader, but the only thing that saves me from utter despair when reading this sort of thing is the image of Smith and her apparent hero Taleb sitting down to compare notes on the longshot bias at the racetrack. Let’s hope they don’t rely too heavily on interpretation rather than source.

2 comments:

  1. David Li's formula for pricing risk was a scam. It enabled the scam of securitization. It also was continued as sound even after other risk management models, like big corporations, failed. Enron was one, and there are others.

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  2. I'm not permitted to comment on industry matters these days Gary, including several assumptions implicit in your question. But I will make one simple comment on mathematics. And that is that the Normal Copula model can, by choice of parameter(s), manifestly model dependence that is far in excess of any reasonable real world assumption.

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