The Role of Risk Models in the Financial Crisis
October 16th, 2008Posted by: Roger Pielke, Jr.
That’s the title of my new column for Bridges, which you can find here, and here is an excerpt:
In our 2000 book on the role of geophysical predictions in decision making (Prediction, Science, Decision Making, and the Future of Nature, Island Press, 2000) we developed a set of guidelines indicating when to rely on predictions in decision making. The criteria are met when (1) predictive skill is known, (2) decision makers have experience in understanding and using the predictions, (3) the feedback loop between use of the prediction and evaluation of that use is relatively short (such that it can feed back into future decisions), (4) there are limited alternatives to relying on prediction, and (5) the outcomes of decisions based on predictions are highly constrained (in other words, the magnitude of the consequences of decision error is limited).
In the current financial crisis, it appears that each of these guidelines was violated . . .
Read it here, and as usual the entire issue is worth your time.
October 16th, 2008 at 4:36 pm
Those criteria are striking when one considers “The Climate Crisis”.
In my opinion, none are met.
Number (1) is a work in progress and is not being properly conducted. Number (2) is why we have highly technical, and absolutely apolitical, regulatory agencies in all other endeavors that have the potential to affect the health and safety of the public. And we certainly never rely on The Members of the House and Senate. Numbers (3) and (5) are simply blown out of the water relative to the ‘CO2 problem’ because of the enormous time scales involved, both for the physical space and the mitigation/adaptation space. No enormous and critically necessary infrastructure can be replaced in less than four or five decades, and I think it will be significantly longer than that.
Of course this might lead to discussions of the predictions/projections/what-ifs problem. But whatever it’s called decisions are being made.
These criteria are also striking when we consider the number of critical issues over the years that have become political footballs and the resulting failures of each and every one. Off the top of my head, I think all relate to Green/environmental issues. Oh, why am I beating around the bush here. Political footballs means buying the votes of special interests.
October 17th, 2008 at 7:54 am
Roger,
Models break down during crises because they are fundamentally flawed in a key basic assumption — volatility is used a substitute measure for risk. The volatility of a security or an index during normal trading has no relationship to the actual probablilities of risk. Because the events which trigger crisis often come from outside the knowledge of market participants.
Financial models (to the extent they are used in an effort to assess genuine risk, as opposed to merely providing guidance of ordinary market behavior) are an excellent example of building an enormous and sophisticated structure atop a fundamentally flawed foundation.
Carelessness in the definition of terms leads to flawed understandings of what is actually measured.