Today’s speaker… Nassim Taleb on the limitations of economic and financial theory.

Last time we had an easy-to-understand walkthrough of the important issue of motivation. This time we are going heavy by introducing Nassim Taleb, a mathmatician, essayist and trader, who has investigated the incompleteness of most mainstream economic theory. The fundamental question he addresses is: When can economic and financial theory be applied?

The answer is: Not in complex settings. And given that the economy is a complex setting, the implication is that most economic and financial theory basically cannot be used at all.

The problem in complex settings, where uncertainty is present, is small probabilities and their impacts. I will not try to explain the reason for this here, but instead I recommend reading one or more of his books, as they are well written, extremely thought-provoking and happen to have some very well formulated arguments against modern economics. And then you should obviously watch this speech recorded at Harvard in April 2010.

Some quotes from his 2004 book “Fooled by Randomness”…

“In economics, for instance, we have very large models of risk calculations sitting on very rickety assumptions (actually, not rickety but plain wrong). They smoke us with math, but everything else is wrong. Getting the right assumptions may matter more than having a sophisticated model.”

“I am glad to be a trader taking advantage of people’s biases but I am scared of living in such society.”

“The difference between utility of wealth and utility of changes in wealth is not trivial: It leads to dependence on the observation period (as a lower observation period leads to a larger number of changes red.). In fact the notion, taken to its limit, leads to the complete revision of economic theory: Neoclassical economics will no longer be useful beyond mathematical exercises.”

“Recall that ideas do not truly sink in when emotions come into play; we do not use our rational brain outside the classroom.”

…And one from his 2007 bestseller, “The Black Swan”

“Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur .... I shiver at the thought. The government-sponsored institution Fannie Mae when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deem these events "unlikely".”

Youtube Economics (Part 2) - Nassim Taleb and the uselessness of Economic Theory

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