Saturday, July 22, 2006

Ambiguous probabilities, uncertainty, and wild risk

The New Financial Order: Risk in the 21st Century by Robert J. Shiller
From Publishers Weekly: Shiller is best known for arguing, as he did in Irrational Exuberance, that stock market movements do not reflect underlying economic reality and that the volatility of the market makes the financial system unstable. It is therefore a surprise to find him advocating vast expansion of financial derivative markets to reduce the economic risk faced by individuals and countries. According to Shiller, governments should swap 10% or more of their gross domestic product with other countries and administer income swaps among entire generations. Individuals should manage risk by trading in new financial instruments based on the lifetime income of their profession, the value of homes in their area or economic statistics like the unemployment rate or inflation rate.
A fairly interesting book, July 10, 2003 Reviewer: Lee Carlson (Saint Louis, Missouri USA) - See all my reviews The author proposes six ideas for what he calls a "new financial order": livelihood insurance, macro markets, income-linked loans, inequality insurance, intergenerational social security, and international agreements. He also proposes the development of massive databases, what he calls GRIDS, standing for "global risk information databases", in order to provide the information that allows effective risk management, and "indexed units of account", which is a new "electronic money" that serves to optimize the negotiating of risk.
All of part three of the book is devoted to these six ideas. The author proposes 'income indexes" as a way of hedging livelihoods and compares livelihood insurance with disability insurance. Those readers in the scientific profession will appreciate his ideas on livelihood insurance, due to the extreme risk in entering a specialized scientific field at the present time. Interestingly, the author compares this risk management device with academic tenure, believing that the latter is a good example of what could be done in society as a whole. He does not elaborate though on how universities reduce the "moral risks" in the tenure system, unfortunately. Optimizing productivity in individuals who are guaranteed lifelong employment is extremely difficult, and there are strong arguments against the institution of tenure for this reason.
The problem is ambiguity and uncertainty,not risk alone, September 7, 2005 Reviewer: Michael E Brady "mandmbrady" (bellflower, california United States) - See all my reviews The major problem with this book is Shiller's basic misconception of what the major problem is concerning decision making about the future, given the incomplete amount of relevant information available in the past and the present, based on what D. Ellsberg called ambiguous probabilities, J M Keynes called probabilities with low weight(uncertainty), and Benoit Mandelbrot called wild risk(as opposed to the mild risk of the normal probability distribution). Shiller bases his understanding on the "new"behavioral economics associated with the work of Tversky, Kahneman, Thaler, etc.
This kind of approach emphasizes not the major problems of ambiguity, uncertainty, or wild risk of Ellsberg, Keynes, and Mandelbrot, but relatively mild problems associated with the Allais Paradox(certainty, reflection, translation, and preference reversal effects plus other assorted anomalies). The problem is that the Tversky-Kahneman approach, and other associated approaches allied with them, are based fundamentally on the view that the normal distribution is the correct distribution to use for educated, rational decision makers. The problem, then, is that decision makers in general are not rational; they are irrational and uneducated decision makers ,who allow their emotions, combined with their hopes and fears, to influence their decision making. All the anomalous behavior can be traced to the basic irrationality and ignorance of decision makers, who supposedly resort to all kinds of heuristic shortcuts because they have not mastered the fields of statistics and probability correctly.
The position of Ellsberg, Keynes, and Mandelbrot is completely different. The decision maker is rational, but must "rely" on probabilities that he knows are unreliable, vague, ambiguous, unclear, and uncertain. In such a world the attempt to gain additional information,as in the stock market, leads to herd, crowd, and cascade effects as each individual decision maker attempts to obtain a little, additional amount of relevant information from other sources that he feels are better informed. Thus, it is the ambiguity or uncertainty of the future that leads to the creation of bubbles, manias, panics, and crashes. These events have little to do with the Tversky-Kahneman approach. The normal probability distribution is completely worthless as a guide to action in the stock market and other financial markets in the face of ambiguity, uncertainty, or wild risk.
In his preface(pp.ix-x), Shiller claims that"...economic thinkers have been limited by the state of relevant risk management principles of their day". Shiller claims that Keynes did not have command of such risk management ideas. The fact is that Keynes, Ellsberg, and Mandelbrot have forgotten more about these ideas than Shiller will ever know. All seven of Shiller's new types of markets and new types of insurance totally ignore the fundamental problem of ambiguity/uncertainty. They are put forth in the misbelief that the kind of decision making problems examined by Tversky-Kanheman are the main explanation for the boom-bust nature of financial markets , the volatility that results, and the unstable nature of such markets in a capitalist system. Shiller needs to completely rewrite this book and base it on a foundation of Keynes, Ellsberg, and Mandelbrot.

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