Understanding the credit crisis

In an earlier post (see here) I put a link to an online book that explains all the main concepts of economics in terms of the classic ‘Island Economy’.

If you think about it in theoretical terms, this book is a ‘proof’ that the Island Economy is a sufficiently rich model into which many important elements of economic life can be incorporated.

And like all good models, it is light and understandable.

Very importantly, this means that everyone can get involved in a healthy debate about its assumptions & simplifications, and any policy implications coming from it.

This is something that undermines the quality of our mathematical models of financial or economic processes: they require a very large amount of technical ability before you can even start to understand the terms of the model (for derivatives pricing this means stochastic calculus & arbitrage-free pricing theory; for systematic trading this means advanced statistical analysis; for economics this means advanced calculus and plenty of background reading of fragmented economic theories).

Experience tells me that the more technically ‘perfect’ we make our models, the less able the users become of giving an informed critique of the theory’s assumptions and main features.

The lesson I draw from this is that it is the responsibility of the model builders to work even harder to make our theories and models accessible to an averagely intelligent user.

What does this hard work look like?

Well here are four examples:

  1. Irwin Schiff’s book on economics (see my post here).
  2. Ray Dalio’s paper on why economies rise and fall (see my post here).
  3. A series of articles by Isabella Kaminski from FTAlphaville that present the credit crisis in terms of a felt cartoon story about water gathering and storing (see here).
  4. My work on understanding the Black-Scholes formula for out-of-the-money options (see my post here).

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