Risk Management: Rebuilding the Model

http://knowledge.wharton.upenn.edu/article.cfm?articleid=2268

As you may recall, we mentioned in our 6/12 blog on "Economic Recovery" that Diebold at Wharton had developed a new statistical tool (the Arouba-Diebold-Scotti Index) which provides a simpler formula to track overall economic performance. In this article from K@W, Diebold is participating as part of a panel at Wharton's 12th Annual Financial Risk Roundtable on what it would take to build a more informed financial risk model.

The basic perspective of the panel is that there are, and were, many things about risk modeling that are not, as yet, quantifiable. And yet, the "risk modelers" became overconfident prior to the ww financial crisis because they had become very good at what they COULD quantify. This is, as Diebold says, like the old story about the person who has lost their car keys at night and is looking for them under a lamp post because that's where the "light" was.

Diebold refers to a project that is ongoing at the Wharton Financial Institutions Center in conjunction with the Sloan Foundation on the known, the unknown, and the unknowable that might be worth looking into. For me, the implications here are that risk modelers didn't know what they needed to know but didn't know it - this is a form of ignorance.

Last, Diebold's perspective is not about how we will get through this latest financial crisis (because we will get thru it one way or the other), but, more importantly, how do we avoid things like this in the future. This suggests the need for ways of dealing with moral hazard balanced with criteria for rescuing financial institutions.

There are a group of very bright people in the Obama administration working on this so, while a solution to the problem of "balance" between latitude to act and regualtions may be a while in coming, the early effort to give more power to the Federal Reserve looks like a good start.

Green Shoots: Housing Starts

http://www.blogger.com/post-create.g?blogID=3084755449310886892

If we look at the graph Krugman has posted today on "Housing Starts" (blog attached), we see an excellent pictorial definition of how little a 17% improvement over last month is. His point, and here I agree, is that we can't even begin to see, from how far down we are, any kind of positive trend forming yet. If we correlate the lower actual number of housing starts now with the massive inventory of homes already built, we probably have 2 years' supply out there that needs to be substantially reduced before that market comes back. One could make the case that we don't need "housing starts". What we need is to sell off our housing inventory overhang. Foreclosure, while a sad thing, makes it possible for a single mom policewoman in Florida to buy her first house because she can get a $275,000 house for $75,000.

So, those folks who are seeing "green shoots" in the "data" and want us to back off fiscal stimulus (especially since we have too much money chasing too few goods: see previous post on Laffer) because potential "hyperinflation" could destroy us all, probably ought to look at current unemployment rates and sales of previously owned homes before they conclude that we need to stop pumping money into the economy.

Paranthetically, in another exercise in small numbers and how meaningful they are, I am very pleased to see a 900% increase in "Followers" for this site in the 24 hours since it was formally announced. And, I realize that people can stop in and read without becoming a follower so we have several more folks who are interested. So, I will continue...and I would like to thank those of you who have expressed your enthusiasm for what we're doing here.

Zakaria's Capitalism

http://www.washingtonpost.com/wp-dyn/content/article/2009/06/15/AR2009061502733.html?referrer=emailarticle

Fareed Zakaria has written a very extensive article on capitalism for Newsweek this week that he has condensed for the Washington Post (copy attached). I recommend it. His perspective is quite direct and historically informing. Basically, he's saying that this "crisis" is not the end of life on the planet as we know it. He quotes many, including Krugman who thought the 1997 East Asian crisis would be as bad as the Great Depression unless "they" put in "currency controls". One Asian country put in partial currency controls and all rebounded within two years. His reference to Robert Shiller (one of the few who predicted the current crash and the dot com bust as well) argues that we in fact will need more derivatives to make markets more stable. So, Zakaria's perspective is that, in a few years, we might need more capitalism! He says capitalism is being rebalanced, regulated and restored: "with all its flaws, capitalism remains the most productive economic engine we have yet invented. Capitalism means growth but also instability. The system is dynamic and inherently prone to crashes that cause...damage along the way."

As I look at it, Zakaria has a point: capitalism didn't fail. Regulators and regulations that didn't keep up with the sophistication of markets failed. I still think about Greenspan's quote that our financial markets are "self regulating". Really, not on this planet.

Stay the Course

http://www.nytimes.com/2009/06/15/opinion/15krugman.html?emc=eta1

http://online.wsj.com/article/SB124458888993599879.html

For those of you who know me, you are aware that I would not ordinarily espouse Paul Krugman and his "Conscience of a Liberal" NYT web site as a place where I'd hang my hat. However; since the worldwide financial crisis, Krugman has made sense where many of the rest of those who occupy his profession have not. Again, since the worldwide financial crisis has ensued, Krugman would be the only economist who's won a nobel prize. Krugman is also a semi-regular guest on the ABC-TV Sunday show hosted by George Staphanopoulis that competes in the time slot with Meet the Press. When he's on that show, he's good and it gets real interesting when he and George Will discuss points on economics, politics, etc.
Krugman's OP-ED in today's NY Times (attached) responds to those who now advocate that we need to shut down "stimulus" efforts because of the potential for hyper-inflation. He uses Arthur Laffer's article in the Wall Street Journal (also attached) as an example of those who are yelling that "the sky is falling". Krugman is right: the sky is not falling. For those of us who ignore economic history (the lessons of the Great Depression), we are doomed to repeat our mistakes. Now is no time to shut down our stimulus efforts. Just because we have some "green shoots", doesn't mean we are out of the woods (see 1937). For those of you who love that "macroeconomic" stuff, Laffer's perspective that we should panic at the rapid rise of the "monetary base", see the period between 1929 and 1939 when our monetary base doubled and prices DROPPED 19%. As usual, Krugman has it right.

Economic Recovery

When my current K@W came in last night, I thought of posting this article because it updates where the Wharton folks think we are on the "Economic Recovery" front. For those of you who were with me in the fall of 2008 and spring of 2009, this would be the next installment of what the best finance faculty in the world thinks about where we are going. What particularly
enthused me about this communication was the new statistical tool Diebold has developed (the Arouba-Diebold-Scotti Index) in order to provide a simpler formula to track overall economic performance: a blend of statistics including weekly initial jobless claims, monthly payrolls, industrial production, etc. I'm sorry I did not provide a "click on" link for the article itself, but you'll see the email address link below.


Economic Recovery: Are Happy Days Here Again?
http://knowledge.wharton.upenn.edu/index.cfm?fa=viewfeature&id=2261