This article makes me laugh inside: Credit Swaps Thwart Fed’s Ease as Debt Costs Surge
The punch line of the article, similar to the signs we have seen at quant hedge funds is that we are not as smart as we thought we were.
In other words, the same over-confidence that led people to believe that they could construct complex derivatives at a ridiculously breakneck pace without changing the nature of the financial system is now leading to models that just don’t work. To me this is another symptom of a society that has become to easily convinced by “proof” through statistical regression. Statistics are useful and powerful, especially in the context of scientific and medical research. However, once one leaves the sciences and moves into areas that involve human beings and even more complex systems like international financial markets, the idea that we can build a model to predict the future becomes less believable.
At a very simple level, if it was so easy to predict what was going to happen tomorrow, no one would make money by investing because all of this information would be priced into today’s security values. The so-called efficient market hypothesis reflects this basic intuition.
The problem is: predicting the future is ridiculously hard in one person’s life, not to mention trying to do it for a group of people, a society of people, or the world markets as a whole. Add in some leverage, a multi-trillion dollar market of obscure and complex derivatives, some people falling on rough times underneath the whole thing, and you are left with a system fluctuating out of control.
What will slow down the volatility and bring us back down to reality? Hard to know, but one thing is clear: don’t trust the model.