[BPSDP]A fundemental axiom of science is that if the predictions made by your theory are wrong, the fault lies with your theory, not with reality. Somebody really should have told the Wall Street and City wbankers that the same applies to mathematical models of the economy.
As Rob Jameson pointed out in “The Blunders That Led to Catastrophe” (New Scientist 27 September 2008 pp 8-9), the world’s financiers assumed that models which described the behaviour of straightforward financial instruments such as shares would also apply to more complicated financial instruments which bundle up assets such as high-risk mortgages. This turned out not to be the case.
Ten years ago the hedge fund Long-Term Capital Management failed and almost precipitated a liquidity crisis of the kind currently afflicting world finance. LTCM had relied on their use of statistical models to keep track of the risks involved in their investments. Regrettably, the world’s financiers carried on using such models, despite the evidence that they did not work as advertised and that their predictive powers were hopeless when it came to extreme events.
To me, it appears that the modellers were – ironically – ignoring one of the major assumptions of modern capitalism, which is that we all behave as individuals pursuing our own selfish interests. If you read in the paper that the bank which holds your life savings has a liquidity problem (due perhaps to losing money on sub-prime mortgage lending) what is the rational thing to do? Clearly it is to get hold of your money while you still can. This excacerbates the problem, of course, so the movers and shakers of the financial world say that the account-holders are “panicked” rather than admit that they are making a purely rational decision as to where their own best interests lie.
It seems to me that the reason for so much sub-prime mortgage lending is that there was not enough of the traditional market to go round. And why was that? One reason was that banks had been allowed to enter the mortgage market by the financial deregulation introduced by Margaret Thatcher. Competition is good, regulation and red tape are bad, you see. As part of this same package, Building Societies were allowed to de-mutualise and become banks. All the Societies that went down this route no longer exist; Bradford & Bingley and Northern Rock went bust, the rest have been taken over by other banks. Sorry, what was that about competition?