The economic crisis

After all these years, I am still curious about what caused the financial crisis that enveloped the world seven years ago.

Procol Harum were in no doubt. Their 2003 album The Well’s On Fire, several years before the crunch, included a song “Wall Street Blues”, with the line “They couldn’d have done it without your greed/They only satisfied a need.” But was there a more direct cause?

The most recent issue of Oxford Today has an article by Michael Black that made me think. He is well qualified to speak about this: nephew of Fischer Black (of the Black–Scholes equation), classmate of Michael Milken, and former director of the American Stock Exchange.

His conclusion is unequivocal:

In the Wealth of Nations in 1776, Adam Smith insisted, “It is fear of losing employment which restrains fraud and corrects negligence.” But this was before the rise of the corporation. Today the inverse is more probably true: fear of failure promotes fraud and deceit.

I have been under the impression that mathematical economics carries some of the blame. I thought that, although a theorem cannot be false, it can be applied carelessly without checking that its hypotheses are satisfied. In the case of theorems of mathematical economics, the hypotheses usually include some form of independence, which is very unlikely to be satisfied if everyone is using the same software to make their decisions.

In his article, Black suggests another, very plausible, problem: loss of liquidity. He says

The freezing of markets – illiquidity – is the financial equivalent of the existence of black holes in astrophysics: all the normal rules are suspended; theory fails.

Indeed, I now think it is not that “theory fails” but another unsatisfied hypothesis.

Consider the St Petersburg paradox: you can always beat the bank. In the simplest case, betting at evens on the toss of a fair coin, you follow the rule: if you lose, you double your stake; if you win, you collect your winnings and quit. If you lose d times before the coin favours you, you have invested 1+2+4+…+2d−1, and then you get back 2d, so you are ahead by precisely your original stake. Of course the problem is that, if you get a run of the coin against you, you will run out of liquidity, and lose a huge amount!

This seems to be precisely what happens in the case of “rogue traders” who have driven their employers into bankruptcy. Although the total worth of the institution seems vast in comparison with a single trade, a few doublings bring about the inevitable disaster.

Perhaps it is more general. If you are a large trader following what the Black–Scholes software tells you to do, you are fine as long as you can cover what you are required to spend. But this may not always be the case. Is it true that these financial instruments do not have the boundary condition of illiquidity built in?

On this subject, one of Kurt Vonnegut’s novels (I think Hocus Pocus, but I am not quite sure) is set in a world whose economy has been brought to ruin by “microsecond arbitrage”, where all stock trading has been left to computers, and the resulting system turns out to behave chaotically. Maybe not so far from the truth either!

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About Peter Cameron

I count all the things that need to be counted.
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5 Responses to The economic crisis

  1. Jon Awbrey says:

    I’ve been thinking about these questions quite a bit over the last decade or so, ever since I started paying attention to the outside world again, and one thing I’ve learned is that you have to look at a somewhat wholier system than your typical economyst is wont to do. I’m pretty sure the most recent economic crises was an engineered event, and if you ask your Qui Bonos it’s pretty easy to figure out who engineered it and who ingenued it. But I’m deep in the middle of a Memorial Day Spring Cleaning Marathon right now, so I’ll cut this short and just pass along the following quip:

    Grabitational Singularity

    • Well, maybe. If offered a choice between a conspiracy theory and a cock-up theory, I almost always trust the cock-up theory. I am not at all sure that most of those bankers and traders were smart enough to understand the system they were (mis)using,

      • Jon Awbrey says:

        The two are not mutually exclusive, of course. I think the truth is more like a “cocking up all the way to the bank” theory.

        I have always subscribed to the Platonic doctrine that there is no evil, only ignorance, but It’s a theory that changes nothing, neither in the phenomena nor in the policies we must use in practice.

        If you look to the causes, there are always powerful interest groups using their massive wealth to push governments in directions that provide themselves with obscene profits at the expense of everyone else. They know enough about the system they are pushing to know what policy changes will give them even more of what they want in the short-term, and they don’t really care about the long term or the harm they do to the poor and the powerless. Indeed, they do everything in their power to render the powerless even more powerless. So maybe they are not evil, they are merely ignorant that the system they fashion to their heart’s desire is inherently unstable and will eventually recoil against their own larger interests in the long run. But that is just a different description of what is going on all around us. Their ignorance continues to hurt others as much as any crime does.

  2. Nick Sparks says:

    «Che fai tu in questa fossa?

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