Saturday, August 21, 2010

Complexity, Financial Markets, and Suspicious Graphs

As I mentioned in a previous post, I recently watched a DVD of Michael Crichton’s 2005 speech to the Independent Institute.

I’ve viewed the speech before several times, but this time something caught my eye. Crichton’s speech was accompanied by slides. About 43 minutes into the speech, Crichton said:

Here’s a financial market, and we all know that if you were to make one single change, say, increase the price of crude oil or charge a White House aide with a felony, you could not be sure how the financial system would react. Nobody knows in advance. People make their businesses out of trying to figure it out, but nobody knows except for inside traders. And that’s the same for financial systems all around the world.

The slide shown during this was a photograph Chicago Board of Trade by Andreas Gursky. This was one of the artworks owned by Crichton that was auctioned off at Christie’s in May 2010.

A short time later I was reading the book No One Would Listen: A True Financial Thriller by Harry Markopolos. It was Markopolos who discovered that Bernie Madoff was a fraud, and he warned the SEC several times, to great futility.

Markopolos was asked by his firm to replicate Madoff’s results, and in doing so, he realized the implausibility of those results:

At the bottom of the page, a chart of Madoff’s return stream rose steadily at a 45-degree angle, which simply doesn’t exist in finance…. Volatility is a natural part of the market. It moves up and down—and does it every day. Any graphic representation of the market has to reflect that. Yet Madoff’s 45-degree rise represented a market without that volatility. It wasn’t possible. (pp. 30, 35-36)

This made me recall not only Crichton’s speech, but also another infamous graph—the “hockey stick” graph. As Crichton explained in his speech “Science Policy in the 21st Century”:

In 1998, an American climate researcher named Michael Mann, along with his co-workers, published an estimation of global temperatures from 1000 to 1980….Mann's results appeared to show a spike in recent temperatures that was unprecedented in the last one thousand years. As a result, his report achieved immediate and world-wide fame. It also formed the centerpiece of the U.N.'s Third Assessment Report, in 2001, of the Intergovernmental Panel on Climate Change….The next chapter in the story began when two Canadian researchers, McIntyre and McKitrick, obtained Mann's data and repeated his study. They found numerous grave and astonishing errors in Mann's work, which they detailed in 2003.

Steve McIntyre, like Harry Markopolos, was skeptical when viewed the graph in question. From a 2010 interview:

In financial circles, we talk about a hockey stick curve when some investor presents you with a nice, steep curve in the hope of palming something off on you.

Just as Madoff’s return graph didn’t reflect reality, neither did Mann’s hockey stick.

Some useful links:

Climate Audit - Steve McIntyre’s blog

McIntyre and McKitrick Slide Show on the Hockey Stick

2004 Technology Review article on McIntyre and McKitrick

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