Redstate

By Pejman Yousefzadeh Posted in Alan Greenspan | Economy | Financial Modeling | The Credit Crunch — Comments (1) / Email this page » / Leave a comment »

Many will read the editorial and say that it is this:

The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

I read it and say that it is the following:

The crisis will leave many casualties. Particularly hard hit will be much of today's financial risk-valuation system, significant parts of which failed under stress. Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance.

Read on . . .

(Emphasis mine.) Here's another very educational passage:

The essential problem is that our models - both risk models and econometric models - as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other's movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued.

(Emphasis mine.) Greenspan is right. The free market is an incredibly complex and complicated system and no model can successfully capture all of its many intricacies. Models are useful but they are limited, as Greenspan explains throughout his valuable editorial. There is a lot more information under the surface of any model. There always is.

And finally, let's pay special attention this passage:

In the current crisis, as in past crises, we can learn much, and policy in the future will be informed by these lessons. But we cannot hope to anticipate the specifics of future crises with any degree of confidence. Thus it is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.

(Emphasis mine.) Couldn't have put it better myself.