Not Complex Enough

Things changed and the models did not adapt.  But I am saying that is mostly because the models had no place to put the information.

With 20-20 hindsight, perhaps the models would have been better if instead of boiling everyone in one pot, you separated out folks into 5 or 10 pots.  Put the flippers into a separate pot.  Put the doctors into another pot.  (Did folks really believe that the no doc mortgages represented 10 times as many doctors than previously).  What about the no doc loans to contractors?  Wasn’t there a double risk there?  Put the people with LTV>100% in another pot.  Then model your 20% drop in prices.

And there was also no model of what the real estate market would do if there were 500,000 more houses than buyers.  Or any attempt to understand whether there were too many houses or not.

And the whole financial modeling framework has never had the ability to reflect the spirals that happen.

The models are just not complex enough for the world we live in.

Many are taught to look at a picture like the view above of the situation in Afghanistan and immediately demand that the picture be simplified.  To immediately conclude that if we draw a picture that complicated then it MUST be because we do not really understand the situation.  However, complexity like the above may be a sign that the situation is really being understood and that the model might just be complex enough to work as things change.

The idea that we will change the world so that the models work is tragically wrong headed.   But that is exactly the thinking that is behind most of the attempts at “reforming” the financial markets.  The thinking is that our models accurately describe the world when it is “normal” and that when our models are wrong it is because the world is “abnormal”.  So the conclusion is that we should be trying to keep the world in the normal range.

But the way that our models always fail is when the world makes a change, a non-linearity in the terminology of modelers.  The oft used analogy is the non-linearity that ruined the businesses of the buggy whip manufacturers.  They had a great model of demand for their product that showed how there was more demand every spring so that they put on extra shifts in the winter and rolled out the new models every April.

Then one April, the bottom fell out of their market.  That was because not only did those pesky horseless carriages cut into their businesses, but the very folks who bought the cars were the people who were always sure sales for new buggy whips each and every year.  That early adopter set who just had to have the latest model of buggy whip.

So we must recognize that these troubling times when the models do not work are frequently because the world is fundamentally changing and the models were simply not complex enough to capture the non-linearities.

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One Comment on “Not Complex Enough”


  1. […] The solution is not to get better at being Simple, but to get good at managing complexity. […]


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