models/ finance and climate

I think we all know what has been going on in the finance markets of late without having to go into it. There is more than enough evidence to suggest bankers were too heavily reliant on financial modeling in helping them price fairly complex instruments across various asset classes. According to sensible geeks banks continued to follow these models even when it was obvious there were red lights going off everywhere in terms of pricing and valuation.

I worked as a trader for a while and saw my fair share of models used either for trading or valuation purposes. Trading models were basically useless as they were essentially trend following in various degrees. They made money when the trend was in full swing, but they gave all the money away when there was no trend. Valuation models to assess risk across markets arriving at a firm wide risk envelope were not only silly, they were actually quite dangerous.

Why then are we relying on models to predict climate change and adjust our way of life as a result? Are they more accurate than financial models in figuring the impact of GHG’s in climate for a period of 100 years? The IPCC has handed out confidence levels of 90% as a result of models suggesting global temps will rise around  2 degrees over the next 100 years.

I highly recommend reading the link that shows just how human minds can close down as a result of group think. I’m seeing speculative evidence this is also happening to climate scientists that mostly rely on models to make climate predictions.

We live in interesting times.

15 thoughts on “models/ finance and climate

  1. JC,

    no offense, but comparing models across different scientific domains is pointless. Why not have the opposite like “we have amazingly great models of how atoms work, therefore our climate models must be great”. That wouldn’t be correct either.

    Aside from that, the type of people doing climate modeling vs. trading are completely different. I believe that with the trading models, there are people that simply click the button without knowing anything about how the models actually work — you could confirm that (let’s face it, you can become a trader with no knowledge of statistical physics). Most of the people with this level of knowledge about climate modeling generally only get to write columns for newspapers.

  2. Climate modeling tends to have a greater empirical basis then economic modeling (not that economists don’t perform empirical research, there is just more research weight on the former).

    Look I think the recent financial crises shows that a free market even with its economic predicting is fairly unpredictable at times. Whats the solution? I think most of us would agree that socialism sure isn’t the answer, and I would rather the traders and economic/financial specialists make the sketchy predictions and models then in some mixed economic system where government takes guesses on the market.

    So we are left with free market capitalism, like it or hate it its the lesser of all evils.

    At least now people will be more scared of sub-prime mortgages. Which is a good thing.

  3. Yes both are complex non linear systems, but there is a big difference. The financial modelers assumed the system was stable, it isn’t. Climate modelers are assuming the system isn’t stable and are trying to tell us so. Your trying to pretend it is.

    In the end the turmoil in the financial markets doesn’t really matter, moneys is just something we made up and it will be fixed, in my view, as the supply is not limited to the amount of gold held in a vault, it will be fixed sooner than later.

    Climate on the other hand; when we push the world into a new state we won’t be bringing it back.

  4. Conrad:

    My point is that models are fine as a rough guide but should never replace real science done in labs. The climate science models are crap as far as I’m concerned. Not one of these models predicted the recent cooling.

    I’m not suggesting that GHG’s aren’t an issue by the way. However modeling the climate and then suggesting that’s science is the biggest load on nonsense I seen for a while.

  5. There’s a glaringly obvious difference to me:
    Financial transactions involve human free choice, climate is metaphysical.
    Predicting every individual’s free choice actions is impossible.

    Climate calculations are incredibly complex and require a massive amount of computer power.
    A model designed on one set of data, doesn’t work so well on another data set. There is debate on the values of constants etc.
    Basically, we don’t know enough about the science of climate, and you need the very best super-computers in the world for cutting edge climate calculations.

  6. BUT people will still fall for modelling and systems, because we like planning and order. We like arranging our own grounds, and it seems a simple step to scale up and plan whole societies. We need to learn to leave others alone. What else is socialism, but town planning over everyone else? A too-active planning complex, perhaps an enflamed left hemisphere? With correct medication, nobody would be a socialist!

  7. “The financial modelers assumed the system was stable, it isn’t.”

    Do you even know what you’re talking about charles?

    Financial systems are remarkably stable and self correcting, as long as the self correction mechanism is allowed to operate.

    The restrictions on lending discrimination (wishful thinking) and cheap bailouts funded by inflation or taxes (socialism for the rich) do not allow the self correction mechanism to operate.

    Tim R summed it up best.

  8. This is a good post. I think the parallels are worth reflecting on.

    Tim – climate models are physical models not metaphysical.

    There is an important difference between markets and climates. The former is effected, often dramatically, by human beliefs. The latter is not. Modelling how human beliefs will change is in one sense a heck of a lot harder than modelling climate. George Soros refers to this distinction in one of his books and uses the word “reflexive” to separate the behaviour of markets from the behaviour of physical processes. Soros suggested that he made his billions by finding trends, seeking out the beliefs that drive them and then figuring out the limitations of those beliefs and what it would take for them to change.

    I think a better point of comparison for climate science and climate modelling is the field of medicine and models of processes in the human body. It has taken hundreds of years to get our models of the body reasonable reliable. And we have had millions of specimens to work with. Climate scientists only have one specimen to test their models on and the time scales necessary for proper model validation are longer.

  9. TimR — but humans are also made up of chemicals that respond to the laws of cause and effect. So you should be able to model humans too. 🙂

    And the climate isn’t metaphysically given. It was given to us by physics.

    I think JC is right to bring up the analogy, though as other people have noted it’s not perfect. Modelling is often useful… but it should always be taken with a grain of salt. The people doing the modelling often know this. The people reporting the outcomes of the modelling often do not.

  10. Why is it that Nobel Prizes in Economics are given for the most accurate economic ‘models,’ while Nobel Peace Prizes are given for highly inaccurate ideological rants in climatology?

  11. charles – your presumption that financial markets aren’t stable infers that recession and losses on investment are the norm

    17 years of uninterrupted economic growth in Australia and the massive accumulation of wealth in the securities markets globally are testament to this. You merely only have your opinion which is contrary to the facts of history.

    It isn’t because I say so, it is because it is a fact. You can choose to accept this or cognitive dissonance.

    How much do you know about the financial regulations that were the foundations of the credit crisis

    – implicit guarantees

    – banning income based discrimination on lending policies

    – inflationary monetary policies

    seems like there is plenty of evidence to my assertion that

    “Financial systems are remarkably stable and self correcting, as long as the self correction mechanism is
    allowed to operate.”

    whereas your evidence against this is a smug retort “if you say so”.

    I suppose you are right charles, in your own mind, if you say so.

  12. Actually, to some degree it is true (and a good thing) that markets aren’t “stable”… if by “stable” you mean always doing the same thing and perfectly predictable.

    The market is the best way of collecting and managing the amazingly complex and diverse amount of knowledge in the world and using that knowledge to put resources together in the most efficient and effective way. But the world changes, and so markets are constantly changing too. They are dynamic.

    It would be more correct to say that the market is a process of constant evolution and change. Mark is of course correct that the rules underlying economic change are fairly stable… but the actual process can be full of turmoil.

    That’s not a bad thing. The alternative is stagnation.

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