Musings on Prediction Under Asymmetric Loss

As has been known for more than a half-century, linear-quadratic-Gaussian (LQG) decision/control problems deliver certainty equivalence (CE). That is, in LQG situations we can first predict/extract (form a conditional expectation) and then simply plug the result into the rest of the problem. Hence the huge literature on prediction under quadratic loss, without specific reference to the eventual decision environment.

But two-step forecast-decision separation (i.e., CE) is very special. Situations of asymmetric loss, for example, immediately diverge from LQG, so certainty equivalence is lost. That is, the two-step CE prescription of “forecast first, and then make a decision conditional on the forecast” no longer works under asymmetric loss.

Yet forecasting under asymmetric loss -- again without reference to the decision environment -- seems to pass the market test. People are interested in it, and a significant literature has arisen. (See, for example, Elliott and Timmermann, "Economic Forecasting," Journal of Economic Literature, 46, 3-56.)

What gives? Perhaps the implicit hope is that CE two-step procedures might be acceptably-close approximations to fully-optimal procedures even in non-CE situations. Maybe they are, sometimes. Or perhaps we haven't thought enough about non-CE environments, and the literature on prediction under asymmetric loss is misguided. Maybe it is, sometimes. Maybe it's a little of both.

Models Didn't Cause the Crisis

Some of the comments engendered by the Black Swan post remind me of something I've wanted to say for a while: In sharp contrast to much popular perception, the financial crisis wasn't caused by models or modelers.

Rather, the crisis was caused by huge numbers of smart, self-interested people involved with the financial services industry -- buy-side industry, sell-side industry, institutional and retail customers, regulators, everyone -- responding rationally to the distorted incentives created by too-big-to-fail (TBTF), sometimes consciously, often unconsciously. Of course modelers were part of the crowd looking the other way, but that misses the point: TBTF coaxed everyone into looking the other way. So the key to financial crisis management isn't as simple as executing the modelers, who perform invaluable and ongoing tasks. Instead it's credibly committing to end TBTF, but no one has found a way. Ironically, Dodd-Frank steps backward, institutionalizing TBTF, potentially making the financial system riskier now than ever. Need it really be so hard to end TBTF? As Nick Kiefer once wisely said (as the cognoscenti rolled their eyes), "If they're too big to fail, then break them up."

[For more, see my earlier financial regulation posts:  part 1, part 2 and part 3.]

You Can Now Browse by Topic

You can now browse No Hesitations by topic.  Check it out -- just look in the right column, scrolling down a bit. I hope it's useful.

On Rude and Risky "Calls for Papers"

You have likely seen calls for papers that include this script, or something similar: 

You will not hear from the organizers unless they decide to use your paper.

It started with one leading group's calls, which go so even farther:

You will not hear from the organizers unless they decide to use your paper.  They are not journal editors or program committee chairmen for a society. 

Now it's spreading.

Bad form, folks.

(1) It's rude. Submissions are not spam to be acted upon by the organizers if interesting, and deleted otherwise. On the contrary, they're solicited, so the least the organizer can do is acknowledge receipt and outcome with costless "thanks for your submission" and "sorry but we couldn't use your paper" emails (which, by the way, are automatically sent in leading software like Conference Maker). As for gratuitous additions like "They are not journal editors or program committee chairmen...," well, I'll hold my tongue.

(2) It's risky. Consider an author whose fine submission somehow fails to reach the organizer, which happens surprisingly often. The lost opportunity hurts everyone -- the author whose career would have been enhanced, the organizer whose reputation would have been enhanced, and the conference participants whose knowledge would have been enhanced, not to mention the general advancement of science -- and no one is the wiser. That doesn't happen when the announced procedure includes acknowledgement of submissions, in which case the above author would simply email the organizer saying, "Hey, where's my acknowledgement? Didn't you receive my submission?"

(Note the interplay between (1) and (2). Social norms like "courtesy" arise in part to promote efficiency.)

The Black Swan Spectrum

Speaking of the newly-updated draft of Econometrics, now for some fun. Here's a question from the Chapter 6 EPC (exercises, problems and complements). Where does your reaction fall on the A-B spectrum below?

Nassim Taleb is a financial markets trader (and Wharton graduate) turned pop author. His book, The Black Swan, deals with many of the issues raised in this chapter. "Black swans"' are seemingly impossible or very low-probability events -- after all, swans are supposed to be white -- that occur with annoying regularity in reality. Read his book. Where does your reaction fall on the A-B spectrum below? 

A. Taleb offers crucial lessons for econometricians, heightening awareness in ways otherwise difficult to achieve. After reading Taleb, it's hard to stop worrying about non-normality, model misspecification, and so on.

B. Taleb belabors the obvious for hundreds of pages, arrogantly "informing"' us that non-normality is prevalent, that all models are misspecified, and so on. Moreover, it takes a model to beat a model, and Taleb offers nothing new.

The book is worth reading, regardless of where your reaction falls on the A-B spectrum.