Big (No) Deal

Economics as fraud: Bystanders to this financial crime were many

By Nassim Nicholas Taleb and Pablo Triana
Published: December 7 2008

On March 13 1964, Catherine Genovese was murdered in the Queens borough of New York City. She was about to enter her apartment building at about 3am when she was stabbed and later raped by Winston Moseley. Moseley stole $50 from Genovese¹s wallet and left her to die in the hallway.

Shocking as these details surely are, the lasting impact of the story may lie elsewhere. For plenty of people reportedly witnessed the attack, yet no one did much about it. Not one of the almost 40 neighbours who were said to have been aware of the incident left their apartments to go to Genovese¹s rescue.

Not surprisingly, the Genovese case earned the interest of social psychologists, who developed the theory of the ³bystander effect². This claimed to show how the apathy of the masses can prevent the salvation of a victim. Psychologists concluded that, for a variety of reasons, the larger the number of observing bystanders, the lower the chances that the crime may be averted.

We have just witnessed a similar phenomenon in the financial markets. A crime has been committed. Yes, we insist, a crime. There is a victim (the helpless retirees, taxpayers funding losses, perhaps even capitalism and free society). There were plenty of bystanders. And there was a robbery (overcompensated bankers who got fat bonuses hiding risks; overpaid quantitative risk managers selling patently bogus methods).

Let us start with the bystander. Almost everyone in risk management knew that quantitative methods  like those used to measure and forecast exposures, value complex derivatives and assign credit ratings Âdid not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with
it (Robert Merton and Myron Scholes) and their school of thought called ³modern finance². LTCM was just one in hundreds of such episodes. Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. Listening to us, risk management practitioners would often agree on every point. But they elected
to take part in the system and to play bystanders. They tried to explain away their decision to partake in the vast diffusion of responsibility: ³Lehman Brothers and Morgan Stanley use the model² or ³it is on the CFA exam² or, the most potent argument, ³modern finance and portfolio theory got Nobels². Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the police itself may have participated in the murder. The regulators were using the same arguments. They, too, were responsible.
So how can we displace a fraud? Not by preaching nor by rational argument (believe us, we tried). Not by evidence. Risk methods that failed dramatically in the real world continue to be taught to students in business schools, where professors never lose tenure for the misapplications of those methods. As we are writing these lines, close to 100,000 MBAs are still learning portfolio theory; Â it is uniformly on the programme for next
semester. An airline company would ground the aircraft and investigate after the crash; Â universities would put more aircraft in the skies, crash after crash. The fraud can be displaced only by shaming people, by boycotting the orthodox financial economics establishment and the institutions that allowed this to happen.

Bystanders are not harmless. They cause others to be bystanders. So when you see a quantitative ³expert², shout for help, call for his disgrace, make him accountable. Do not let him hide behind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel¹s credibility can be extremely
harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: ³Thou shalt not follow a multitude to do evil.²

Nassim Nicholas Taleb is a professor of risk engineering at New York University PolyTechnic Institute. He is the author of The Black Swan: The
Impact of the Highly Improbable¹ (2007). Pablo Triana is a derivatives
consultant and author. His new book, Lecturing Birds on Flying¹, will be
released in spring 2009.

This is especially disturbing as the reason for s&&t-canning the money last night, the hatred of unions by the deep-south senators, is now being hidden behind the veil of "well, you wanted reasoned debate on giving out money, so don't complain." The same lie (average wage for UAW workers is in the 70+per hour range) has been trotted out more often than a dog with the run (and stinks just as much).

apparently senators who are partially bought and paid for by toyota, honda, bmw, et.al., don't have much concern for honesty.

The reasons for this falling apart seem to be:

1. Payback to the unions. Note that the sticking points were these Republicans' demands that unions make concessions to make their pay equal to those of autoworkers in foreign-owned companies in the U.S. Republicans did not forget that the UAW lobbied hard for Obama and that it threw all of its remaining weight behind a bid to unseat as many Democrats as possible, even more so than it usually does.

2. Regional war. Most of the Senators who opposed this have large presences of foreign-owned auto factories in their states, such as Nissan, Mercedes-Benz, Toyota, etc. If the Big Three fall, they potentially profit. Of course, this forgets that even Toyota doesn't want GM, Chrysler, or Ford to fail because of the cascade of failures their collapse would induce among U.S. parts suppliers. After all, these foreign auto companies use many of the same parts suppliers that the Big Three do.

3. Bailout fatigue. After giving away the store to bankers whose greed, arrogance, and incompetence led to the current financial meltdown, Congress is once bitten, twice shy.

It looks as though my home town is screwed. Chrysler is toast and probably would have been toast even if the bailout had passed. Ford has a reasonable chance of surviving if things don't get too bad. GM is probably toast too but conceivably might file for Chapter 11 and survive.

Actually on the parts front, even if GM collapses, the assets will eventually have to go on sale. I half expect one of the Japanese companies to acquire the parts-making divisions. If GM doesn't collapse but needs to sell assets to stay in business as part of its restructuring, that might happen anyways.

Orac, I agree with "Chrysler is toast", but it is my understanding that the company that owns Chrysler is quite flush. Is there some reason they are not putting some of their money into this?

@ dean - the reason they are not putting money into Chrysler is they didn't plan to own it for any length of time. They are an investment holding company, who bought Chrysler off Daimler with the express intention of selling it at some point to a group of other investors (at a nice profit no doubt). They don't want to own Chrysler, so if it fails they aren't actually in a bad position - they just sell off the pieces and move on.