How to evaluate a black box financial system
Evaluation methods are important abstractions that allow us to measure models based only on their output.
Using various metrics of success, we can contrast and compare two or more entirely different models. And it means we don’t care about their underlying structure – they could be based on neural nets, logistic regression, or decision trees, but for the sake of measuring the accuracy, or the ranking, or the calibration, the evaluation method just treats them like black boxes.
It recently occurred to me a that we could generalize this a bit, to systems rather than models. So if we wanted to evaluate the school system, or the political system, or the financial system, we could ignore the underlying details of how they are structured and just look at the output. To be reasonable we have to compare two systems that are both viable; it doesn’t make sense to talk about a current, flawed system relative to perfection, since of course every version of reality looks crappy compared to an ideal.
The devil is in the articulated evaluation metric, of course. So for the school system, we can ask various questions: Do our students know how to read? Do they finish high school? Do they know how to formulate an argument? Have they lost interest in learning? Are they civic-minded citizens? Do they compare well to other students on standardized tests? How expensive is the system?
For the financial system, we might ask things like: Does the average person feel like their money is safe? Does the system add to stability in the larger economy? Does the financial system mitigate risk to the larger economy? Does it put capital resources in the right places? Do fraudulent players inside the system get punished? Are the laws transparent and easy to follow?
The answers to those questions aren’t looking good at all: for example, take note of the recent Congressional report that blames Jon Corzine for MF Global’s collapse, pins him down on illegal and fraudulent activity, and then does absolutely nothing about it. To conserve space I will only use this example but there are hundreds more like this from the last few years.
Suffice it to say, what we currently have is a system where the agents committing fraud are actually glad to be caught because the resulting fines are on the one hand smaller than their profits (and paid by shareholders, not individual actors), and on the other hand are cemented as being so, and set as precedent.
But again, we need to compare it to another system, we can’t just say “hey there are flaws in this system,” because every system has flaws.
I’d like to compare it to a system like ours except where the laws are enforced.
That may sounds totally naive, and in a way it is, but then again we once did have laws, that were enforced, and the financial system was relatively tame and stable.
And although we can’t go back in a time machine to before Glass-Steagall was revoked and keep “financial innovation” from happening, we can ask our politicians to give regulators the power to simplify the system enough so that something like Glass-Steagall can once again work.