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!