Skin in the game — how to make economic models contact reality

7 Jan, 2014 at 15:51 | Posted in Economics, Statistics & Econometrics | 5 Comments

Eight years ago, I showed, using twenty million pieces of data from socioeconomic variables (about all the data that was available at the time), that current tools in economics and econometrics don’t work, whenever there is an exposure to a large deviations, or “Black Swans” …

The implication is that those tools used in economics that are based on squaring variables … such as standard deviation, variance, correlation, regression, or value-at-risk, the kind of stuff you find in textbooks, are not valid scientifically.
 
Lier
 
The results of most papers in economics based on these standard statistical methods—the kind of stuff people learn in statistics class—are thus not expected to replicate, and they effectively don’t …

I thought that the story had ended there and that people would pay attention to the evidence … Nothing happened …

It all became clear when, one day, I received the following message from a firefighter. His point was that he found my ideas on tail risk extremely easy to understand. His question was: How come risk gurus, academics, and financial modelers don’t get it?

Well, the answer was right there, staring at me, in the message itself. The fellow as a firefighter could not afford to misunderstand risk and statistical properties. He would be directly harmed by his error. In other words, he has skin in the game. And, in addition, he is honorable, risking his life for others not making others take risks for his sake.

So the root cause of this model fraud has to be absence of skin-in-the game, combined with too much money and power at stake. Had the modelers and predictors been harmed by their own mistakes, they would have exited the gene pool—or raised their level of morality. Someone else (society) pays the price of the mistakes. Clearly, the academics profession consists in playing a game, pleasing the editors of “prestigious” journals, or be “highly cited”. When confronted, they offer the nihilistic fallacy that “we got to start somewhere”—which could justify using astrology as a basis for science. And the business is unbelievably circular: a “successful PhD program” is one that has “good results” on the “job market” for academic positions. I was told bluntly at a certain business school where I refused to teach risk models and “modern portfolio theory” that my mission as a professor was to help students get jobs. I find all of this highly immoral—immoral to create harm for profit. Primum non nocer.

Only a rule of skin in the game, that is, direct harm from one’s errors, can puncture the game aspect of such research and establish some form of contact with reality.

Nassim Taleb

[h/t Noah Smith]

5 Comments

  1. The problem with the – correct otherwise – thinking of Taleb is that if policies depend on power laws nothing will happen and society will have to go back to caves. Boom and bust is necessary part of the game and standard statistics facilitate this mechaniism – maybe on purpose. If you are afraid of black swans you will never invest, never go into space, never start the trip to find America. The world has moved ahead because of people who ignored black swans. Now, as far as stock market black swans and things Taleb worries about most, this is a zeros-sum game and agent-based economics do nto care who’s got the money.

    • There is a way around the boom, bust cycle. Democracies mostly figured this out with elections – so no revolutions. Now the economy needs elections every so many years. That’s called debt release every 7 years. Economic stress is released every 7 years, so no big crash.

  2. The tools of economics don’t work because economists assume independence in their models and use the “normal” distribution. People are not independent of each other. Herding happens. There is a positive feedback loop pushing society forward in time – just like forests and sandpiles.

    The solution: Stop assuming independence, and start using the power law distribution.

  3. Having some sort of ‘skin in the game’ seems necessary but not sufficient. It is hard to see how things will improve unless and until we properly attribute the harm. ‘Raising the level of morality’ seems impossible unless you know ‘which way is up’.


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