The global credit crisis has claimed many victims. Bear Stearns is the latest. And a rumour or two about the next casualty is never too far away.
But among the battered and the bruised should be another victim—a type of economic and financial reasoning that has elevated quantitative methods to an improbably high pedestal. The credit market freeze has shown that fancy financial instruments that were valued by impressive computer models are essentially worthless.
Finance is about numbers, and some numerical analysis will always be needed to see trends and plan investment strategies. But there are limits to numerical jugglery, and this is the underlying message of the current round of financial turmoil. Any amount of historical data fed into computers will not help economists and traders have a perfect understanding of the future. Financial alchemy will often create dust rather than gold. Rare events—call them black swans or fat tails—can make incredibly smart types look like fools.
(Illustration by: Jayachandran / Mint)
In an article written for T he Wall Street Journal and published in this newspaper on Tuesday, Nobel economist Edmund Phelps launched a sharp attack on what he calls the “conceit in the financial industries and central banking”. He has questioned the widely held belief that the economy is essentially predictable and understandable. The sorry spectacle of stock market gurus getting forecast after forecast wrong on television over the past few weeks, is a lead indicator of a wider malaise. Economists and policymakers need to understand that divining the future with certainty is arrogant and wrong.
Phelps mentions the work of Chicago economist Frank Knight who distinguished between risk and uncertainty way back in the 1920s. Risk is a bit like the toss of a coin. It can be assigned a probability. But uncertainty defies measurement.
Knight said that a modern capitalist economy is deeply uncertain. Others have shown that economic change comes from disruptive innovation rather than random risks that can be measured. This why a modern economy cannot be fully understood by any one group, however impressive its data-crunching ability. Only markets can process the information that flows through an economy every day. We need modesty rather than arrogance. As the credit crisis deepens, we hope this message will sink in.
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