RSSNobel Prize For Oxymoron
By Kevin Cook | October 13, 2008 | 11:05 PM | 0 Comments
This weekend the Nobel committee awarded economist Paul Krugman the 2008 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (you may need an advanced degree just to remember that one). Mr. Krugman probably deserves an award for something in his illustrious career, not to mention his criticism of George W. Bush. But, we'll leave him alone today because it's the prize itself we want to look at.
A long-time critic of the Nobel for "Economic Sciences," Nassim Taleb surfaced on the radio bright and early this morning to talk to NPR's Renee Montagne about why he thinks the prize should be revoked from Myron Scholes and Robert Merton, the pair of 1997 winners who supposedly invented the option pricing model which bears one of their names. The Black-Scholes option pricing model was formulated by these two and Fischer Black in the early 1970's (Black's name is on the model, but not the later prize because Nobel does not award posthumoulsy).
What is Taleb's argument? In the 3-minute radio interview, he only skims the surface of the issue compared to what he has to say in his 2007 book The Black Swan, but here's the gist:
1) Black, Scholes, and Merton did not really invent much new at all--they just marketed it better
2) The model doesn't actually do what it proports to do--namely, accurately define risk
3) Ultimately, because of the ubiquity of the model and it's ilk (Modern Portfolio Theory, or MPT), financial institutions endanger society with enormous build-ups of derivatives for which they don't truly understand the risks
Those were Taleb's talking points this morning. Kinda broad, kinda tabloidy. Not really justification for "revoking" the prize from Scholes and Merton now is it? The Black Swan presents the arguments more fully and more convincingly:
1) Financial models like Black-Scholes, MPT, and the Capital Asset Pricing Model (CAPM) all use the statistical measure standard deviation. Taleb goes to great lengths in The Black Swan to show how standard deviation was invented and where it works extremely well--and where it fails miserably. I'll save you a few hundred pages: it works well in physical domains (like I talked about in my Thursday blog) but not so great in social realms like markets where variability is much more wild.
2) Because of the above, Taleb thinks "economic science" is essentially an oxymoron. Trying to apply scientific statistical methods of risk analysis to securities that trade on fear and greed is a bit like measuring how good a romantic comedy was by counting the popcorn on the theater floor. He spends a good deal of the book dealing with our theories of knowledge (induction vs. deduction) and paying tribute to Karl Popper who introduced "the black swan problem" into philosophical discussion.
3) The "Nobel Prize in Economics" is a fraud to begin with. The other existing prizes--5 in all for physics, chemistry, medicine, peace, and literature--all began in 1901 after Alfred Nobel commissioned them in his will five years earlier. In 1968, Sweden's central bank, the Sveriges Riksbank, invented the sixth Prize "in memory of" the founder. Taleb wonders if he rolls in his grave to this day.
Of course, in a short radio interview, Taleb could not have gotten all this across. He went for the sound bites which would stick and shock. And he left out what he believes is actually good about Black-Scholes and its option pricing offspring--that they are ideal for evaluating and trading short-term fluctuations in options. Taleb made his first marks as a currency options trader during the 1987 crash and wrote the heavily-mathematical and model-ridden Dynamic Hedging in 1997. He is just critical now of how the models have been used for all sorts of over-the-counter, unregulated, over-leveraged securities that were sold to investors as "low risk" and "long term." And he was blowing that whistle before the sub-prime meltdown began in the summer of 2007.
I guess the damage done lately by risk models that gave the illusion of knowledge is too severe to bother talking about how option traders who know how to manage risk and hedge can do quite well in markets like this. All markets are experiencing shocks, but regulated, exchange-traded derivatives like options and futures will be the risk management tools that survive and thrive. They may even be credited with smoothing a way out of this crisis.
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