Bad models or bad modellers

by John Quiggin on November 9, 2008

The idea that bad mathematical models used to evaluate investments are at least partially to blame for the financial crisis has plenty of appeal, and perhaps some validity, but it doesn’t justify a lot of the anti-intellectual responses we are seeing. That includes this NY Times headline In Modeling Risk, the Human Factor Was Left Out . What becomes clear from the story is that a model that left human factors out would have worked quite well. The elements of the required model are
(i) in the long run, house prices move in line with employment, incomes and migration patterns
(ii) if prices move more than 20 per cent out of line with long run value they will in due course fall at least 20 per cent
(iii) when this happens, large classes of financial assets will go into default either directly or because they are derived from assets that can’t pay out if house prices fall

It was not the disregard of human factors but the attempt to second-guess human behavioral responses to a period of rising prices, so as to reproduce the behavior of housing markets in the bubble period, that led many to disaster. A more naive version of the same error is to assume that particular observed behavior (say, not defaulting on home loans) will be sustained even when the conditions that made that behavior sensible no longer apply.

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