Friday, September 4, 2009

Rethinking Foundations

Paul Krugman, a NY Times columnist and winner of the 2008 Nobel Memorial Prize in Economic Science, writes in this Sunday's NYT about how did economists get the recssion so wrong. He has some important conclusions:

"So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics."

"When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right."

Similar comments can be made about the need for actuarial profession to rethink its foundations. Fortunately, as per my last post, steps are being taken to do that - at least in the area of pension plans. But until this happens, how can we ensure that we don't repeat past mistakes?

Nassim Taleb, author of The Black Swan: The Impact of the Highly Improbable, offers ten principles for a Black Swan-proof world. Of these, three seem particularly important for pension plans:

  • Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.
  • Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products.
  • Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require. Citizens should experience anxiety about their own businesses (which they control), not their investments (which they do not control).

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