THE BIZOP NEWS

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David Brooks writing in the New York Times discusses the popular view of behavioral economists.

"Economists and psychologists have been exploring our perceptual biases for four decades now, with the work of Amos Tversky and Daniel Kahneman, and also with work by people like Richard Thaler, Robert Shiller, John Bargh and Dan Ariely.

My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy.

At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking.

Nassim Nicholas Taleb has been deeply influenced by this stream of research. Taleb not only has an explanation for what's happening, he saw it coming. His popular books "Fooled by Randomness" and "The Back Swan" were broadsides at the risk-management models used in the financial world and beyond."

It is worthwhile to review the brief history of economics, since the late 50's. Because Brooks does not make a convincing case.

Tversky and Kahneman were in the classical economist tradition expanding on counter-examples to the axioms of expected utility theory - Allais and Ellsberg had made similar trenchant counter-examples earlier. These theorists were attacking the classical assumptions behind rationality, in particular the axioms which would allow one to derive a risk function which valued complex outcomes, known as lotteries.

Thaler, Shiller and to an extent Ariely followed in this tradition, questioning the empirical adequacy of the axioms which stated the necessary and sufficient conditions for expected utility.

But, none of these theorists have any overall plausible explanation about why the new insurance industry which tried to quantify the risk of subprime mortgages or derivative credit swaps failed.

Consider what Shiller has recently written about bubbles: "Speculative bubbles are caused by contagious excitement about investment prospects. I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally."

This isn't a theory - it is a mere description about what we see; "contagious excitement" is not an explanation. A laugh in a crowd produces contagious excitement, but I am unaware of any sit coms responsible for our current economic crisis.

Taleb, while both amusing and illuminating, is probably the worst theorist. His overall target is constantly changing: at times it is normal distributions, then it is risk modeled as variance, and at other times it is model risk. As the Court Jester to the quant world, Taleb states what every serious risk practioner knows but dares not say.

But, let us be realistic here: we do not have a serious sophisticated theory of this failure of credit. We don't even have a decent model of what caused the Dutch Tulip bubble, let alone an explanation of the simplest Ponzi scheme. We need to accept this ignorance before we can move on.