Wednesday, March 18, 2009

There Are Experts Out There, But No One’s Speaking To Them

From Paul Wilmott's blog:

Governments around the world are fumbling their way through the darkness trying to get out of the current mess that their banking friends got us into. As far as I can make out the politicians are not asking the advice of independent experts in this matter. None of the people I consider to be truly excellent in this field have been asked for their advice. Mind you, the number of people I think are truly good is pretty small!

No, governments are still talking to their banking pals. In a sense that would be fine, speak to the burglars about how to protect your valuables, but only if those burglars have turned over a new leaf. Sadly there is every indication that the current bunch of criminals is still as hell bent on stealing our money as they ever were. Look at the RBS and AIG bonuses.

I am reminded of a conference on earthquake and other catastrophe insurance that I attended in Zurich several years ago. One lecture, given by a financial consultant, concerned modeling the losses caused by hurricanes. He showed a plot of how wind speed varied with distance from the centre of the hurricane. It was a plot that looked something like shown here. And the thrust of the lecture was how to model this mathematically.

(Now, before I say anything else, if there are any fluid mechanics reading this, be warned, what follows is shocking, hilarious, and also insulting.)

Ok, so how do you model the wind speed as a function of distance from the centre?

There are different types of fluid flow: viscous, invsicid, compressible, incompressible, turbulent, rotational, irrotational, etc. Which one you’ve got depends on speed, various parameters, geometry. A simplifying assumption for a hurricane is that of symmetry, that the air rotates about the centre. In the middle the speed will be zero. There are two simple symmetrical flows for large speeds, one is irrotational and the other rotational with constant vorticity. As functions of distance from the centre the former is inversely proportional to distance and the other is proportional to distance. So if you have a central core that is rotational and join that up to an irrotational region outside you pretty much get what is shown in that link above. It can be refined to allow for rotation of the earth and other important effects. But this first stab at the problem is basic, second-year undergraduate hydrodynamics.

So what did the financial consultant do? Working in finance, all he knew about was probability theory. And so he looked through his big book of probability distributions and picked out one that had the closest fit to the empirical shape. What?!?! Airspeed has little to do with probabilities! He may just as well asked which constellation of stars gave the best fit! I was so shocked by this and embarrassed for the man that I stupidly did not ask him whether he had the slightest inkling of what he was doing. He clearly didn’t, but then his audience equally did not have a clue. (Aside: More often that not I find myself in the position of watching the blind leading the blind. I’ve blogged on this before here. Quant conferences can be highly amusing, until you realize that people take their models seriously and so do others and, most importantly, they have an enormous impact on the rest of us.)

And that’s where we are now, as governments try to solve the current crisis…so that they will be re-elected.

Unfortunately they are somewhat constrained by also having to keep their chums happy, by making sure they get their big bonuses, while also maintaining the banks as private sector so that when they fail to get re-elected they will have well-paid City Directorships to step into.

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