Scientific American says the quant revolution in finance bears part of the blame for the crisis and it’s time for new and better models of the way the world really works (via Mark Thoma).
These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them… Without the formal requirement to maintain debt ceilings and capital reserves, the commission had freed these firms to police themselves using risk tools crafted by cadres of quants … For its part, the quant community needs to undertake a search for better models—perhaps seeking help from behavioral economics, which studies irrationality of investors’ decision making… These number wizards and their superiors need to study lessons that were never learned during previous market smashups involving intricate financial engineering…
Maybe. Adding behavioral assumptions is a nice tweak, but it won’t remedy the fundamental flaw of this kind of approach. The number wizards need to do much more than read and quantify history. The problem is that that quants and much of modern economics for that matter have neglected the systematic study of economic transformation. What’s needed goes far beyond more historical and behavioral data points. Concretely this would mean building on the fundamental insights of Darwin, Marx, Schumpeter, and Jacobs to create a real scientific understanding of how economies grow, evolve, generate crises, and restore themselves. There are very, very few economists or social scientists that are willing to take on these big questions. And to build these models will not only take big thinkers, but reasonably large and stable teams of theorists, economic and financial historians, computer scientists, data-base experts, and others. It’s what we’re trying to do here at the Prosperity Institute, and I’d encourage others to join in.
Tags: Prosperity Institute, quant community
November 17th, 2008 at 11:20 pm
Fascinating. When the quants failed in August of 2007, they showed two failures in a week that had been deemed statistically impossible except once every 1,000 years or something equally improbably. Again, they failed twice in one week. The quants have a lot to do with how Wall Street got so over-leveraged but, like you say, fail to address the fundamentals underpinning the current realities.
November 18th, 2008 at 1:09 am
Darwin? Huh, wouldn’t have thought of him. I read “Beak of the Finch” last year, about scientists in the Galapagos studying how creatures with slightly different characteristics have better or worse chances of survival when the environment changes. I guess thats a fruitful area for looking at how people, companies, economies survive when the we undergo a transformation.
November 18th, 2008 at 6:43 am
Go ahead. Keep trying. But don’t make the mistake again of believing you’ve somehow figured “it” out. In financial markets where each participant is supposed to have a fundamental understanding of the instruments of finance, complicated instruments are very dangerous.
Wall Street’s job is to satisfy a financial demand. The demand most recently came from huge amounts of liquidity looking for a lucrative place to “park.” Hello, property. Bundle it, insure it, slice it up, and give it all to a well paid salesforce. Demand sated. Property bubble created. A tried and true story, with same old, inevitable ending.
If there’s no dynamic improvement in production, no new discovery that impacts economies favorably, then bubbles in some form are inevitably created as a poor substitute. They at least have the positive effect of working off excess liquidity. Money is literally destroyed. Has to be destroyed. That’s what you do when excess money ends up sitting “over there” somewhere in a bubble.
November 18th, 2008 at 10:11 am
Beezer is absolutely right. There is no end to the business cycle. The free market is in natural operation when it explodes.
George Bush articulated a stunning paradox at the recent G-20 to the press - “I am a free market-oriented guy except when there is a global meltdown.” Understanding these resonances of opposites is fundamental to seeing through the bubbles and troughs in our world. The words ‘free’ and ‘market’ are a contradiction of words on the surface, as are ‘democracy’ and ‘capitalism’ as well as ‘globalism’ and ‘capitalism’.
The quants are a necessary part of the new economy but they will never eliminate all the uncertainty. Even a simple grade 9 physics table-top experiment has uncertainty.
The tragedy is the socialization of risk and the ordinary people who are maimed by the excessive greed when the bubbles peak. ‘Freedom’ and ‘equality’ are two other paradoxical words. Right now we need less freedom and more equality. A maximum wage - hampering executive pay - would be a good next step.
November 18th, 2008 at 1:56 pm
Most of the heavy lifting in the financial markets happens at investment firms, big and small. Very little work has been done on the organizational dynamics that amplify the behavioral errors of individuals.