Myron Scholes' pathetic response to Nassim Taleb

Myron Scholes finally responded, in a pathetic manner, to Nassim Taleb's criticism. With Taleb now being the leader in revolt against the Modern House of Finance and Mathematical Models adopted to measure risk, had this to say about Myron Shcoles: "we have to unmask the charlatans of risk like Myron Scholes".Taleb was quite furious on Scholes. He considers Scholes as the Great Oz because his work on options and derivatives allowed the whole of the financial system to adopt poorly understood products-like the ones that brought AIG down-that hide risk. To Taleb, Scholes' academic work, which enabled the widespread use of complex derivatives, was like 'giving children dynamite.' 'This guy should be in a retirement home doing Sudoku,' Taleb says. 'His funds have blown up twice. He shouldn't be allowed in Washington to lecture anyone on risk.'" Michael Lewis too commented on hazards and harms that the use of Black Scholes Model has brought upon the financial health- "Black-Scholes didn’t work; trillions of dollars’ worth of securities may have been priced without regard to the possibility of crashes and panics. But until very recently, no one has bitched and moaned about this problem too loudly. Lay folk might harbor private misgivings about the clergy, but as lay folk, they are reluctant to express them. Now, however, as the subprime market unravels, the beginnings of a revolt against the church seem to be taking shape".

I had expected that the fathers of Financial Horoscope Models would come up with some decent answer or better still would admit the flaws in their Models with open heart. But, it looks like they dont have the gut and unfortunately still continue to live in fool's paradise. Still sticking to their guns they are not even sophisticated to give a decent reply. All Scholes could say to Taleb's criticism was " If someone says to you, “Go to an old-folks’ home,” that’s kind of ridiculous, because a lot of old people are doing terrific things for society. I never tried sudoku. Maybe he spends his time doing sudoku".

Nassim on Reuters

Nassim Taleb Long Talk on Econ Talk

Link to Podcast: http://www.econtalk.org/archives/2009/03/taleb_on_the_fi.html

Excerpt fromt the Interview with Russ Roberts:

complexity cannot tolerate leverage, since no room for error. Since 1980, tripling in leverage, in U.S. and in Europe, ratio of leverage to GDP. High exposure to errors. Commodity prices, similar argument: can have rise in wheat prices in response to very small imbalance in demand, followed by rapid collapse. Not long ago talking about inflation, now talking about deflation. Speculative issue in commodity prices: how much comes from similar mistakes to Greenspan. Globalization has side effects; produces fat tails. In competition, consider two banks, one robust and one not. With globalization, everybody pushed to do outsourcing; concentration of U.S. and German firms outsourcing to, say, Bangalore. Probability of failure low because only one source of randomness. But suppose there is a problem in Bangalore--political, storms--that disrupts communication there? What happens to all these firms? French bank, lost money on a rogue trader. If you had 10 small banks each with 5 billion, wouldn't have a problem because easy to liquidate. With one bank, should a rogue trader happen, his position will be 10 times the size. Assume no linearities in execution cost. Liquidating $50 billion is more costly than 10 times liquidating $5 billion. Lumping makes you more vulnerable to large events. One large error is a lot worse than 10 smaller errors.

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Nassim Taleb & Daniel Kahneman: Reflect on Crisis