Putting the “U” in Blue

Given the research destroying the applicability of the bell curve in financial markets, and the recent research from agency-based models suggesting that extreme volatility is triggered by excessive leverage, the worrying danger is that the normal distribution is the WORST possible model to use in financial markets.  If there is a correlation between increased volatility and debt, the probability distribution during periods of high debt is likely to be a “U” shape – with the least likely outcome the long-term mean and the most likely outcomes either deflation or high inflation (the extremes on the returns distribution).

The tragedy is that this mindless, zombie-like application of an inapplicable theoretical model materially contributed to Iceland and the sub-prime bust.

There is a cartoon where Lenin is talking to his advisors as he sees a row of academic economists walk by him in parade. The advisors ask “Where are the parades of nuclear warheads and missiles and the Soviet tanks?”.

Lenin replies “We discovered that Western academic economists are cheaper than nuclear warheads and do much more damage!”

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