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19.9.08

The ludic fallacy behind the sub-prime mortgage mess 

I have been reading The Black Swan by Nicholas Nassim Taleb, and this footnote was interesting (bear in mind he wrote this years ago):

As if we did not have enough problems, banks are now more vulnerable to the Black Swan and the ludic fallacy than ever before with “scientists” among their staff taking care of exposures. The giant firm J. P. Morgan put the entire world at risk by introducing in the nineties RiskMetrics, a phony method aiming at managing people’s risks, causing the generalized use of the ludic fallacy, and bringing Dr. Johns into power in place of the skeptical Fat Tonys. (A related method called “Value-at-Risk,” which relies on the quantitative measurement of risk, has been spreading.) Likewise, the government-sponsored institution Fanny Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events “unlikely.”

   While it’s better to read Taleb for his meanings about Black Swan and Fat Tony, a reader can deduce the overall message. By relying on risk formulas, the American hasn’t heard the cry that the emperor has no clothes. And this year, that ‘slightest hiccup’ happened, collapsing numerous , including and .
   The Black Swan concept always made sense to me, even if I never gave it a name. Taleb has worked on Wall Street and exposed its fallacies; for me, it was being confused in my first-year economics’ class (which I still passed, incidentally) because little being taught bore much resemblance to reality. (Dr Michael Cullen still believes it does, as does the Shadow Minister.) The guys who took money and finance (I took marketing and management) seemed to be from another world. Maybe their parents didn’t lose tens of thousands putting money into Chase Corp.
   And now, as a layman, I see that those theories are no longer working. In fact, they are dragging a down.
   We might blame, perhaps rightly, everything from the abandonment of Bretton Woods to an unsustainable of greed-fuelled growth. High share prices not backed by anything other than rhetoric. But we have heard all this before. On October 19, 1987, with the crash, critics pointed at similar things. Taleb himself made a mint out of it because he could see it coming. But we didn’t heed the warnings that time and history seems to have repeated.
   I know there are differences but how substantial are they? Michael Lewis, in Condé Nast Portfolio—one of the few magazines I subscribe to—noted that the model, which was exposed as having shortcomings on Black Monday, was ultimately never questioned. Taleb made a killing that day because he had, prior to that, become obsessed with the limitations of the model and how it could not predict extreme and rare events.
   Black–Scholes allegedly encouraged traders to take bigger risks than they should, argues Taleb, leading him to say to the creators of the model: ‘You guys are parasites. You’re not bringing anything useful to the market. You are lecturing birds on how to fly. You’re watching them fly. And then you’re taking credit for it.’
   I should adjust my criticisms of Black–Scholes above to and portfolio theory in general, because these do fall into much the same box, based on my formally untrained viewpoint.
   This does not have much directly to do with branding, other than the lesson that we at Medinge and others have been trying to preach for years: be . Be real. If you have to bury the reason for your in jargon, then you’re not being authentic. This applies to traders and their actions in the . It is a lesson, one that we failed to heed over the last 21 years.

It also says to me that the various policies that the right-wing governments of Labour–National (let’s also be authentic here, for there’s no point separating the two since they have both pursued policies that drive a wedge between poor and rich in ) that exposed us to the sort of risk that should have been isolated to North America, have not worked.
   The alternative is not new or fortress New Zealand. But we need to recognize that we have allowed foreigners to come in and control aspects of this nation’s and exposed us to greater risk. This has not been done with authenticity or . I am ultimately for some ideal in economics, with self-regulation and global trading. Yet the opening up of the country’s markets in the 1980s have not seen much transparency at all. This is one area that Labour–National has not recognized, with the exception of certain primary sectors that have capitalized on . Tapping in to financial régimes around the world that have blurry, questionable models—as we have—can only end in tears.
   I realize I am talking nonsense if I expect the to change or become more transparent in the wake of the crisis. In such a case we should either be more judicious about investment or demand some form of transparency in dealings between nations. And as the financial establishment has failed to do that, then maybe even in New Zealand it has no choice but to attract the hand of the state. I have too little faith that the traders who exposed us to the risk will admit to their fallacies, and that any real change will happen. There are too many foreign firms that will prevent that, and even Labour–National will not invite criticism of its policies that have weakened New Zealand-owned firms and the New Zealand worker over the last quarter-century.
   The only way change can be encouraged is if some of the same-old, same-old establishment players can be changed, ending the of bad behaviours. I am not talking about taking one bunch of cronies and replacing them with another. I am, however, talking about putting in people who can see the wood for the trees, who can demand transparency and even policies, and end the fear that mortgagees and small- to medium-sized business owners have each time they hear news about interest rates or a financial crisis.
   That is not the only reason I have chosen to stand for Parliament in the General Election this year. I stand for Parliament because I see an opportunity to educate voters that Labour–National is a single party. National has agreed with most of the laws that some true-blue Kiwis say they oppose Labour for passing. And in these elections, there are not too many alternatives if voters seek a balance to the technocratic ways of the major parties, but a balance is what we need. There are the Greens, and us at the Alliance. You read that correctly. Us.
   If you really want a , which is what I hear New Zealanders say they want before I put forward my candidacy, then a vote for National will not deliver it. A vote for Labour certainly won’t, with an economic direction about as vague as Sylvester Stallone’s collective movie dialogue.
   In fact, a party with no ties to rich establishment figures, but a concern for everyday New Zealanders, gets my vote, in more ways than one. Remember, the Alliance invented Kiwibank—something that Labour, through its leader, the current Prime Minister, was initially opposed to. It sent a message to the foreign firms wanting to eat up Kiwis’ savings like vultures that they weren’t going to succeed. It effectively flipped them the bird. Having a bank owned by New Zealanders prevents some of the exposure to the whims of foreign profiteers—and we’ve seen plenty of that happen from the Australian-owned banks. Bank fees, anyone?
   There’s no Jim Anderton—he left the party six years ago—and no potential MPs that have special interests to the or international financiers.
   I am number 12 on the list, which means any betting man—or someone using Black–Scholes—would not put too much faith on my sitting in Parliament after November. But if I can even make a change and open a few eyes to what’s going on in our own country, then I consider myself to have served my fellow citizens. I am, for the first time, putting my reputation where my mouth is, and taking part in the democratic process by saying, ‘I want to serve.’
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Comments:
Jack, you've nailed it.

I wish you success with your fellow citizens.

May you open more than a few eyes!

Keep creating...a true story worth repeating,
Mike  
Thank you so much, Mike! I hope you are well.  
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Entries from 2006 to the end of 2009 were done on the Blogger service. As of January 1, 2010, this blog has shifted to a Wordpress installation, with the latest posts here.
   With Blogger ceasing to support FTP publishing on May 1, I have decided to turn these older pages in to an archive, so you will no longer be able to enter comments. However, you can comment on entries posted after January 1, 2010.


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