Fundamentals

Fundamentals:

Are the "fundamentals of our economy sound"? That's the question of the day, and it's a fairly interesting one. It starts with this question: just what are the fundamentals of the economy?

If you come up with the banking system, the housing sector, and the strength or weakness of the dollar, then the fundamentals are not looking very good. I think a lot of people look at those as being what "economics" are all about, and from that perspective, the economy looks shaky.

Yet if you look at the infrastructure of the country, the availability of capital for new ventures (even during a financial crisis!), the education of the population, and the availability of raw materials, the fundamentals are not just sound. They are rock solid.

To some degree this is the difference between a short and long term approach. Are you asking, "Is it possible that we will have a quarter or three of negative growth?" Or are you asking, "Is the economy going to survive and grow in the long term?"

What we have going on right now is the destruction of a massive amount of fairy gold. This happens from time to time: the banking sector builds up a vast store of imaginary wealth, and then it goes away. This has repercussions throughout the real economy, and people's real lives, but those arise mostly within the human mind: we believe that some massive amount of wealth has been created and destroyed, and so we act as if it has, and so the economy contracts.

In fact, the money never really existed at all. This is like housing bubble: is your house worth a million dollars? It is if someone will pay you that for it: that is, it is because they believe it is. But is it really? How much labor went into it? What did the materials cost? What is the land worth, in terms of expected revenue from where you are located v. the place where you want to do business?

There is a thinker in statistics for whom I have a great deal of sympathy, because he and I both tilt at windmills. His is financial markets, and mine is psychology, and the two sectors make up the great bedrock of modern American and European life. Both sectors are all about speculation, and he and I keep trying to make the same point: the methodology that underlies the whole field is worthless.

His name is Nassim Nicholas Taleb, and I've mentioned him several times before. This is a good occasion, though, to focus on what he's trying to tell you about the limits of human knowledge and understanding.

I start with my old crusade against "quants" (people like me who do mathematical work in finance), economists, and bank risk managers, my prime perpetrators of iatrogenic risks (the healer killing the patient). Why iatrogenic risks? Because, not only have economists been unable to prove that their models work, but no one managed to prove that the use of a model that does not work is neutral, that it does not increase blind risk taking, hence the accumulation of hidden risks.

Figure 1 My classical metaphor: A Turkey is fed for a 1000 days—every days confirms to its statistical department that the human race cares about its welfare "with increased statistical significance". On the 1001st day, the turkey has a surprise.

Figure 2 The graph above shows the fate of close to 1000 financial institutions (includes busts such as FNMA, Bear Stearns, Northern Rock, Lehman Brothers, etc.). The banking system (betting AGAINST rare events) just lost > 1 Trillion dollars (so far) on a single error, more than was ever earned in the history of banking. Yet bankers kept their previous bonuses and it looks like citizens have to foot the bills. And one Professor Ben Bernanke pronounced right before the blowup that we live in an era of stability and "great moderation" (he is now piloting a plane and we all are passengers on it).

Readers will recognize this form of argument, because it's just the one I field against psychology: the models cannot be proven and they cannot be disproven. They are not therefore neutral, though, because they leave people with the belief that they may be able to know (and control!) things that they really can have no certain knowledge of, and no control over. You can't even know if the model is correct.

Now you would think that people would buy my arguments about lack of knowledge and accept unpredictability. But many kept asking me "now that you say that our measures are wrong, do you have anything better?"

I used to give the same mathematical finance lectures for both graduate students and practitioners before giving up on academic students and grade-seekers. Students cannot understand the value of "this is what we don't know"—they think it is not information, that they are learning nothing. Practitioners on the other hand value it immensely. Likewise with statisticians: I never had a disagreement with statisticians (who build the field)—only with users of statistical methods.

Spyros Makridakis and I are editors of a special issue of a decision science journal, The International Journal of Forecasting. The issue is about "What to do in an environment of low predictability". We received tons of papers, but guess what? Very few addressed the point: they mostly focused on showing us that they predict better (on paper). This convinced me to engage in my new project: "how to live in a world we don't understand".

That is a noble project, and he has much to say about it. I suppose, in a very real sense, it is also the subject of much of my own work in philosophy rather than statistics.

Are the fundamentals of the economy sound? How would you know? What are they, really? And who are the experts you can trust to help you learn, the ones who really know? The same ones who just ran it up on the rocks?