Wednesday, April 9, 2008

Dallas Fed president Richard Fisher:

The risk models employed turned out to be merely formulaic descriptions of the past and created an illusion of precision. Such approaches could not and cannot replace the forward-looking judgment of a seasoned professional.

The entire speech is eloquently incoherent, but this passage in particular annoyed me. What is the "forward-looking judgment of a seasoned professional" except someone making a decision based on experience -- their knowledge of what has happened in the past? And obviously, it was seasoned, knowledgeable people who decided to turn over risk management to the quants in the first place, which is hardly a ringing endorsement of the value of the judgment of seasoned professionals. Like it or not, quant-based risk management is a permanent feature of the financial markets, at least in part because it works, most of the time, works at least as well as the "judgment of seasoned professionals," or the "seasoned professionals" wouldn't have relied so heavily on the models in the first place. When I read things like this I get the feeling the Fed is still out to sea, dog-paddling in any direction that looks like it might be land.

Much better. But even here, I wonder about the "looking out the window" part. A lot of this is just second guessing -- just "looking out the window" doesn't help you much if you don't know what to look for, which is the very problem we're dealing with: we never know what to look for until it's too late, and sometimes not even then. Fisher, in his speech, admits that nobody is yet sure what went wrong, and that's with hindsight. If everyone had been cautious about the mortgage issue, the few people who took the leap would still be reaping outsized rewards, and that won't happen in an efficient system. Instead, people saw the opportunity for bigger profits, went after them, and eventually things got top heavy and fell over. What went wrong here was capitalism, not this or that tool of capitalism. There have been boom-bust cycles as long as there's been capitalism, and all the "seasoned professionals" "looking out the window" in the world won't stop the next one. It's the price we pay for our economic system, and on balance it's a good deal. I just wish people would stop pretending there's a way around it, particularly people, like Fisher, who know better.