Excellent discussion on the crisis at Digital Life Design

Late January at Digital Life Design in Munich, there was an interesting panel with Nasim Taleb (always insightful and full of common sense | his site) and Nobel laureate Daniel Kahneman (always fascinating pioneer of psychology applied to finance and the economy | his Nobel profile ). Taleb has a realistic approach by saying that what he basically want is not to improve forecasts but rather to review the way the world is working in order to make it resistant to forecastign errors. Like Roubini he advocates the nationalization of banks. I suspect he means the "utility" part, not the "casino" part of the banking system (for a view of utility vs casino listen to the podcast at the end of this post). Kahneman shows how human psychology is a key driving force for understanding organizations, companies, the economy and markets because, as he very correctly points out, these entities do not exist in any other way than through human behavior.

Video and comments below.

Kahneman shares fascinating insights taken from experiement in
psychology showing how ill prepared we are by education to deal with
the unexpected and with uncharted territories.If you're interested in Kahneman's work, reading the Tsversky-Kahneman paper of 1974 on Judgment under Uncertainty.
In
that paper the authors discuss in a remarkable and most interesting
manner the importance of prejudice, pre-conceived truths, integration
of past-patterns and beliefs affect human judgment and decision making
regarding uncertain events. It's a most recommended read for anyone
active in a highly unstable environment although like all good
scientific papers it does not provide ready-made recipes: you'll have
to do your own introspection and adapt what you learn to your own
situation. In this discussion Kahneman makes a strong point showing how the mismatch between the time-scale of the individual and the time-scale of society is a key factor to take into account if there's any serious intent to reform the financial system. He also makes a great point about the fact that the situation we have now did not happen simply because of incompetent, arrogant, self-serving, greeding and dishonest financiers (and not all financiers are such animals; I have the privilege of knowing more than a few very decent and brilliant finance professionals who will be part of the solution). Kahneman rightly suggests that every participant in the economy has a share of responsibility because each one of them accepted the system, indulged into the benefits he or she could extract from the system regardless of the relevance or economic sense of gaining those benefits.

Taleb develops his views of the roots of the crisis, blasting the CFA and business schools for teaching portfolio theory in the process, what should be done now and why it's important to get down to what the exact situation is no matter how bleak so as to be able to resume work from a known starting point instead of being in a constant slump. Nasim Taleb has been focusing on how "ideas" and beliefs actually fool us. I'm currently reading Fooled by Randomness, which I recommend. Listening to Taleb in this video and reading his materials you will see why a deterministic approach to economics, finance and business management is simply an illusion, an abstract construct of the mind. The world is chaotic and the order we're trying to build in it is emergent as opposed to pre-determined. Taleb speaks of a complex world and highlights inconsistencies of economic agents who insure their cars but don't insure multi-million dollar portfolios because that would harm returns.

His take is that the current financial crisis is largely due to the underestimation of extremely rare events by financial experts and the quants who built sophisticated financial models for funds. That's one part of the problem, the other being that:

1. the international financial system as structured by the Basel II regulations has generous intents, but eventually leads to distorsions in capital allocation in favor of large institutions and rich nations... (and eventually we end up saying that some banks are too big to fail and we support them with public money when part of the problem was that we facilitated their becoming too large to fail)


2. the mark-to-market extremism, based on the idea that the market is good at estimating risk and setting prices, which in fact amplifies the instability of the entire financial system especially when software used by funds is built to automatically trigger transactions in the event of "larger than normal" fluctuations


3. the established practices of developing nations lending to developed ones at a price of money lower than they themselves borrow for their own development

Below is a podcast of a recent program of the BBC in which you can listen to former President Clinton's economic adviser discussing the current economic situation and sharing a way of looking at the financial system as being a "utility attached to a casino", the utility being the payments system and the lending system for individuals and companies. The utility is too serious a part of finance to be left in the hands of bankers. Taleb is 1000% correct when he says that the "utility" part should be controlled by government and the hedge funds should be left alone to do what they want and never be bailed out by government.