Bad Science and Bad Finance

[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?

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4 Responses to “Bad Science and Bad Finance”

  1. ben Says:

    As Keynes said, “the market can stay irrational longer than you can stay solvent”. The market is ultimately subject to laws as rigid as physical ones, but only in the long run — and, as Keynes also said, “in the long run, we are all dead.”

  2. Teek Says:

    quite. in the real world, if you make a prediction and it turns out to be spectacularly wrong, you suffer. on Wall St, if your predictions are wrong, don’t sweat it cos Congress will lend you $700bn!

    the problem is that because the US/UK economies depend heavily on the stock exchange, ordinary folks will (possibly) lose savings or (more likely) lose their jobs – whilst the banks are bailed out. and following the bailoit, will the models you mention change? fat (cat) chance…

    we need a latter-day Keynes or a Galbraith – someone to talk sense into the City.

  3. John The Geologist Says:

    I work in IT and worked in the finance sector from many years (still do with a few major retail banks on my client list – not that I am doing much with them at the moment !).

    That is a good post and I would like to add a few minor comments to it.

    Firstly the models were developed by seriously bright guys and are not necessarily understood by people using them. I know a metals trader who is led by his systems as he does not fully understand the way they work.

    Secondly it is only computers that are able to identify the “gaps” in the market and rush to fill them. So if in a three way exchange rate there is some discrepancy the trading systems can exploit this automatically.

    Thirdly it is the ability to do stuff rapidly that forces the short selling of stocks. Input parameters will say “sell if price > X” and sell automatically at this level. Ironically others will say the opposite and buy at a certain proce (based on a whole host of input parameters) – this was seen in the fluctuations in the Halifax share price.

    Fourthly the stock exchange seems in many ways remote and insulated from the daily experience of the broader economy (we still go to work and do the same amount of stuff etc). Unfortunately this is not the case if you are just about to trade in your pension fund for an annuity. On a macro scale there are implications for the valuation of companies and loans (and by definition debt).

    Fifthly the models are based on micro and macro economic parameters and ignore the (possibly) most interesting part of economics which is behavioural economics.

    Sixthly – you are absolutely right about the demutualised building societies. This process was driven by nothing other than greed and I hope the greedy bastards get their comeuppance. Unfortunately a lot of civilians will get killed by the collateral damage. They broke the old tradition of relating debt to equity and just jumped on the merry go round.

    Seventh – It is only the oiks who get it in the neck over these cock ups (OK and a few at HBOS got canned) along the lines of Nick Gleeson at Barings.

    Eighth – 6 years at the LSE has left me none the wiser as to where all the money has gone. I assume that like Barings and Societe Generale one banks loss is someone elses gain in the zero sum game of international finance. So where the f**k did it go ?

    Ninth – your final paragraph is spot on. ALL companies who have a solid presence in a given marketplace (say within global corporations) eventually end up moving “downmarket” into the SMB/SME marketplace.

    Tenth – and the real joke. Sales of Das Kapital have increased as many economists have realised that it actually provides a good understanding of what has happened here in terms of the accumulation of capital.

  4. Jesse Johannesen Says:

    Strange this post is totaly irrelevant to the search query I entered in google but it was listed on the first page. – It�s absolutely impossible, but it has possibilities. – Samuel Goldwyn 1882 – 1974

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