Copula Functions and the Current Crisis

24 February 2009 at 6:46 am 10 comments

| Nicolai Foss |

Forget about effective demand failures, malinvestments caused by expansionary monetary policy, or even political regulation of the US housing market: The  true bete noire in the current meltdown is a specific copula function (here is the Wiki on copulas), or more precisely David Li’s application of it to the modeling of default correlation (here). Or, so Wired claims. Writer Felix Salmon is pretty explicit in his condemnation of Li’s approach:

It was a brilliant simplification of an intractable problem. And Li didn’t just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number — one clean, simple, all-sufficient figure that sums up everything.

Apparently, major finance academics — like Darrell Duffie — had warned against the application of Li’s work.

I am by no means competent to pass any judgment on Salmon’s story. I merely recommend it as a highly interesting read — and wonder how long it will take before the performativity-in-financial-markets-crowd picks it up. Actually, it may rather support the Felin & Foss argument that false social constructions are eventually weeded out (here).

Entry filed under: - Foss -, Recommended Reading.

More on the Evolution of Accounting Risk, Uncertainty, and Financial Markets

10 Comments Add your own

  • 1. Peter Klein  |  24 February 2009 at 7:48 am

    That’s a funny coincidence. I picked up a copy of Wired to read on the plane ride to Europe and had much the same reaction as you Salmon’s article (intrigued, but skeptical). Then, on the plane, I watched Darren Aronofsky’s Pi, the hero of which is a mathematician who discovers a magic 216-digit number that allows one to predict stock prices, among other things. Naturally the protagonist becomes insane by the end. Clearly Aronofsky doesn’t buy Misesian strictures against the application of models from physics to the human sciences.

  • 2. michael webster  |  24 February 2009 at 9:55 am

    I thought Salmon’s piece was interesting, but I would read it in a reductive manner – although it makes a better story that way.

    I read him as pointing out how LI’s model made tractable or computable the problem of calculating relative defaults.

    The important story is why this model, when the author acknowledged its limitations, took over and dominated all other models which might have different results.

  • 3. Greg Ransom  |  24 February 2009 at 10:04 am

    “the Felin & Foss argument that false social constructions are eventually weeded out”

    That is a really strong claim, and seems terribly implausible. Guess I need to read the paper.

  • 4. Nicolai Foss  |  24 February 2009 at 10:26 am

    Greg, It is _indeed_ a “terribly strong” claim, and perhaps I overstated it here; we claim it as the opposite extreme of Ferraro, Pfeffer and Sutton’s claim that falsehood is irrelevant for social construction.

  • 5. Funny Math Joke  |  24 February 2009 at 10:38 am

    A funny math joke just destroyed half of everything.

  • […] ever-prolific Nicolai Foss is blogging regularly at Organizations and Markets again, expressing some interest in Wired’s take on David Li, copula functions, and the financial meltdown: Actually, it may […]

  • 7. Rafe Champion  |  24 February 2009 at 2:09 pm

    From the outside it looks like a re-run of the “General Principles” story, this guy told people what they wanted to hear in technical language that they could not understand (so it had to be brilliant).

    What a strange situation, where the soundness of investments in the most solid and concrete thing that most people know, the bricks and mortar of a house, is judged by a far-out mathematical formula that hardly anyone can understand. What happened to old-fashioned horse sense, like how far can these things appreciate in value before something gives?

  • 8. Rafe Champion  |  24 February 2009 at 2:39 pm

    Taking up the Felin and Foss story about weeding out bad ideas, this process will proceed in ratio to the quality of critical discssion, that is the extent to which ideas are exposed to the various forms of criticism (tests, internal coherence, alignment with other well-tested theories etc). It helps to see the many ways that ideas and their exponents can be protected from criticism, for example by being located some distance in time and space from the consequences of bad ideas.

    The dangerous thing is to be stuck on protecting your brainchild so criticism is unwanted. You need to adopt the approach of a person about to climb a very long ladder or a rope, so you test it to find out it if can take your weight and if it breaks under test, you are pleased because the test saved your life.

    But of course in intellectul matters people take the opposite approach, defending their ideas from criticism as though their life depends on it!

  • 9. Ram Mudambi  |  24 February 2009 at 10:20 pm

    Do we really need claims about “false social constructions”? Simple herding (economizing on information gathering) inevitably generates bubbles, some are bigger than others. Bubbles burst when the gap between valuation and economic fundamentals becomes sufficiently large. Markets eventually self-correct, imposing large costs on society at unpredictable intervals. Of course, in general, the costs of regulating markets are even greater, but are paid out at a steady rate.

  • 10. Nicolai Foss  |  25 February 2009 at 3:59 am

    Ram, That’s exactly the point in the Felin & Foss paper. But to engage in a conversation with people who talk about “social constructions”, “performativity” etc, there must be some shared terminological ground.

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Nicolai J. Foss and Peter G. Klein, Organizing Entrepreneurial Judgment: A New Approach to the Firm (Cambridge University Press, 2012).
Peter G. Klein and Micheal E. Sykuta, eds., The Elgar Companion to Transaction Cost Economics (Edward Elgar, 2010).
Peter G. Klein, The Capitalist and the Entrepreneur: Essays on Organizations and Markets (Mises Institute, 2010).
Richard N. Langlois, The Dynamics of Industrial Capitalism: Schumpeter, Chandler, and the New Economy (Routledge, 2007).
Nicolai J. Foss, Strategy, Economic Organization, and the Knowledge Economy: The Coordination of Firms and Resources (Oxford University Press, 2005).
Raghu Garud, Arun Kumaraswamy, and Richard N. Langlois, eds., Managing in the Modular Age: Architectures, Networks and Organizations (Blackwell, 2003).
Nicolai J. Foss and Peter G. Klein, eds., Entrepreneurship and the Firm: Austrian Perspectives on Economic Organization (Elgar, 2002).
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