Greenspan's two cents

And with the declining dollar, those two cents are worth even less! Bum-dum-dum. Seriously folks, I'll be at the Holiday Inn all next week.

No seriously, this is a good article by Greenspan. I'm going to print out a million of them and give them to my students tomorrow. We start, more or less, the "shortrun of the economy" tomorrow and it's high time they start getting this now. Better from me than some kid on the street, you know what I'm saying? I was interested in a lot of things, but the perils of models that are "too simple" was especially valuable I thought.

"The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued.

The most credible explanation of why risk management based on state-of-the-art statistical models can perform so poorly is that the underlying data used to estimate a model’s structure are drawn generally from both periods of euphoria and periods of fear, that is, from regimes with importantly different dynamics.