Editorial: Time Magazine article and some thoughts about how it might relate to the pay-off method.

In the most recent issue ( Jan. 30, 2012) of Time Magazine, Robert Johnson, the executive director of the Institute for New Economic Thinking in New York City, writes about the (crumbled) credibility of economists and economic models. He brings up not only the mistrust and discontent of many students of economics, but also points out the overall demise of the authority of economists everywhere in society.

Johnson brings up four important issues that should be fixed in order to remedy the situation. First, he points out, “economists should resist overstating what they actually know” – referring to the philosopher John Dewey, who called it the quest for certainty in 1929 – in the midst of the great depression, and said that: “Quest for certainty is a dangerous temptress”.

  • This is exactly in line with what the pay-off method tries to do, show uncertainty to the decision-maker in a way that the “false sense of certainty” is not conveyed. Showing the pay-off distributions and not only the single number expected or real option values is key in this effort. Also the cumulative net present value graphs of the different scenarios are a tell-tale part in showing how the NPV is accrued over time and what is the distribution of the pay-back time in present value terms.

Second, he observes, economists should recognize the shortcomings of high-powered mathematical models (which are not substitutes for vigilant observation).  Johnson also cites Kenneth Arrow who said: “The math takes a life of its own because the mathematics pushed toward a tendency to prove theories of mathematical, rather than scientific, interest”. Also Frank Knight observed that radical uncertainty, prevalent in times of crisis, means that expectations cannot be anchored as they have nothing to latch to.

  •  Again spot on for the pay-off method: as there is no benchmark “mean” to which to “revert” to many models fail, and the information that is available must come from managers. This is something that the pay-off method can live with – unlike some other methods. Trying to be “infinitely precise” in the world where our ability to forecast with excellent accuracy even until tomorrow is compromised (as it is, or anyone want to bet on the weather tomorrow?) we are bound to go wrong, especially in uncertain times. For real options times are often uncertain…
  • Interestingly, just an issue before the latest one, of the same Time Magazine, a story told about French quants and them being greatly overrepresented in the investment banks of the world, with a quarter or more of quants being French and about how financial mathematics has fallen out of grace in the Paris top universities. Obviously the financial shocks and the Black Swans as Nicholas Nassim Taleb would call them are real and give the models a bad name – not only give them a bad name, but actually prove that they do not work in turbulent times.

Third, Johnson discusses about introducing the context back to economics (modelling). Indeed if the mathematical models used to drive economic (and financial investment) decision-making are not based on the real world context then they are based on something that is really not of relevance. Objective, Cartesian, approach to economic models may work in theory, but if they work in practice is anybody’s guess.

  • Context is in the heart of the pay-off method; it is partially because of the will and the need to include context in a simple way the model was built. Assuming  things and believing that “the market is like the assumptions say” is just plain ignorant. By using the know-how and expertise of the managers about the markets and the firm that owns the real option we can get just that, context, in their estimates for cash-flow scenarios.

Fourth, he argues economists must acknowledge the relationship between politics and economics.

All in all a very welcome viewpoint article with some, not so often voiced commentary on the dire state of economics. For someone who does not believe in the infallibility of mathematics and humans as estimators of the future I would gladly see more of the same…

Mikael Collan (posted from onboard Finnish State Railways train going from Lappeenranta to Salo)

Info about the articles mentioned:

Economists: A Profession at Sea – How to keep economists from missing the next financial crisis by Robert Johnson, Time Jan. 19. 2012 LINK

Making French Bread: Why are France’s Math Graduates in Such Demand? Time, Monday. Jan. 23, 2012 LINK