The economy acts as predicted. Except when it doesn’t.
May 5, 2014, Vol. 19, No. 32 • By IRWIN M. STELZER
This caution is repeated by Derman, who comes to his views the hard way, by experience, rather than by studying history, which is Friedman’s vocation at the Harvard Business School. Derman was chief “quant” at Goldman Sachs and remains in the game as a principal in KKR Prisma, which “manages hedge fund portfolios . . . utilizing [a] . . . quantitative approach to risk management,” while directing Columbia University’s program in financial engineering. He argues, “The great financial crisis has been marked by the failure of models both qualitative and quantitative. . . . Models are always inaccurate, and financial models especially so. . . . After more than 20 years of hubris, models collapsed [in 2007].”
By concentrating on these models, Derman brings Friedman’s work to the present day, although he spends less time on the biographies of the bright young things sent by business schools and math departments straight to Wall Street. The current crowd of forecasters, notes Friedman, began with an “optimism that was equal to that of the pioneer forecasters . . . [but] like the pioneering generation, would eventually confront harsh economic realities not foreseen by the models, in this case the stagflation of the 1970s. But by that time they, again like the pioneers, had come to enjoy great influence on economic institutions and ideas.”
Fortunately, Derman does not spend a great deal of time merely trying to debunk the use of models. After all, to use a layman’s description, they do provide the user with a way of putting what-if questions to the modeler. What if interest rates fall rather than rise, as you are predicting? What if the dollar strengthens rather than weakens? That sort of thing. Instead, Derman walks a middle line between those who would do away with models completely and those “naïve idealists [who] pin their faith on the belief that somewhere just offstage there is a model that will capture the nuances of markets, a model that will do away with the need for common sense.” He concludes from his training and experience that models can be useful if the user would only “begin boldly but expect little” and the modelers would “remember as they write their equations . . . the humans behind the equations” and be “humble in applying mathematics to markets.”
In short, Derman writes, “You must start with models but then overlay them with common sense and experience.” Investors have learned this the hard way in recent years, and they seem prepared to admit it. Policymakers not so much. It is comforting that Janet Yellen describes herself as a “sensible central banker,” less comforting that so many policy-making forecasters insist that it is reality that gets it wrong, rather than their forecasts.
Irwin M. Stelzer, a contributing editor to The Weekly Standard, is a columnist for the Sunday Times (London).