A Flaw in the World

New World Bank paper echoing (in only semi-ironic fashion) Alan Greenspan’s epochal quote about having a “flaw” in his model of how the economic world works. Worth a read:

A flaw in the model … that defines how the world works

Summary: The authors of this paper claim that modeling financial markets based on probability theory is a severe systematic mistake that led to the global financial crisis. They argue that the crisis was not just the result of risk managers using outdated financial data, but that the employed efficiency model — also referred to as the stochastic model — is basically flawed. In an exemplary way, the analysis proves that this model is unable to account for interactions between market participants, neglects strategic interdependences, and hence leads to erroneous solutions. The central message is that the existing efficiency model should be replaced by an approach using agent-based scenario analysis.

A helpful economics-to-English aside: For the closing “an approach using agent-based scenario analysis”, substitute “recognizing that people are nuts” and the authors’ intent becomes clearer.