I recently came across several fascinating articles that point out to an overlooked, yet fundamental cause of the current credit crisis — Wall Street’s blind faith in math as a tool for understanding finance.
For instance, take David X Li’s Gaussian copula function, the key mathematical formula used by financiers to calculate the triple-A ratings of the pools of mortgages known as “CDOs,” which turned into financial toxic waste as soon as the American real estate bubble burst.
As Felix Salmon points out, Li’s formula simply wasn’t able to capture the enormous complexity inherent in calculating the risks of such Frankenstein pools of assets. This seems all too clear and evident in retrospect, to the point that Wall Street’s infatuation with the formula has been qualified by some pundits as sheer stupidity — the nature of CDOs and similar securities was so complex that people dealing with them at all levels simply didn’t understand what they were doing.
But what was the cause of this fatal error in judgement that lead financiers to enshrine a flawed mathematical formula? This was surely not a problem of low IQ’s — that’s not the sort of stupidity that can be blamed on Wall Street too easily. As a matter of fact, the root cause of the problem could lie in that the financial industry is pervasively dominated by people with very high IQ’s.
People with high IQ’s are in general very rational types that rely heavily on logic, analysis and mathematical reasoning to solve problems and make sense of the world. That’s why they excel in professions such as the physical sciences, engineering, computer programming and finance. And because these abilities are controlled by the left hemisphere of the brain, people good at them are usually referred to as left-brained. Right-brained people, on the other hand, are good with intuition, processing qualitative information and seeing the big picture.
In his book “A Whole New Mind,” Daniel Pink argues convincingly that right-brain skills will be indispensable for economic survival in the developed economies of the 21st century due to the importance of emotion, beauty and spiritual meaning as consumption attributes of the modern marketplace, all of them controlled by the right hemisphere of the brain. And equally important, left-brain jobs are easier to delegate to robots or outsourced to low-cost developing countries.
This argument’s relevance for understanding the credit crisis goes beyond what Pink himself recently hinted in a blog post.
Because left-brain thinking has been the driving force of scientific discovery in the physical sciences and the backbone of the Information Age, it’s been enshrined by our culture as the only true form of knowledge. Therefore, left-brain thinkers are sometimes too eager to find clear-cut, elegant mathematical solutions to problems that are not well suited for mathematical treatment. I dare to speculate that this cultural prejudice is exactly what led financiers to embrace the Gaussian copula function as the risk-assesment Holy Grail.
In an essay published in The American magaizne Jerry Z. Muller gives another good example of left-brained bias in our business culture that he calls the “the cult of accountability” — the ideological belief in rewarding business performance by ostensible measures of objectivity (the emphases are mine):
“The cult of “accountability” was related to diversification. As companies grew larger and more diverse in their holdings, new layers of management were needed to supervise and coordinate their disparate units. From the point of view of top management, the diversity of operations means that executives were managing assets and services with which they have little familiarity. This has led to the spread of pseudo-objectivity: the search for standardized measures of achievement across large and disparate organizations. Its implicit premises were these: that information which is numerically measurable is the only sort of knowledge necessary; that numerical data can substitute for other forms of inquiry; and that numerical acumen can substitute for practical knowledge about the underlying assets and services.
Attaching a number creates a belief that the information is more solid than is actually the case. That is what I mean by “pseudo-objectivity.” In each case, it is a response to what (to recoin a phrase) one might call alienation from the means of production, the attempt to substitute abstract and quantitative knowledge for concrete and qualitative knowledge.”
The depth of economic crisis has revived interest in the writings of Karl Marx. But while Wall Street’s capitalist greed was part of the problem, it wasn’t the whole story. One can be tempted to think that financiers knew all along that their mathematical models were flawed and unscrupulously kept using them as intellectual legitimizers of what turned to be a massive fraud. Surely, conspiracy theories of all sorts will emerge as variations of this argument.
But people simply don’t behave that way. Even the perpetrators behind the most atrocious genocides in history think that they have good reasons for what they do. And invariably, their terrible moral reasoning can be traced back to an ideology. The cult of accountability and the bias towards pseudo objectivity pointed out by Muller, fit nicely as component elements of a taylor-made ideology for a profession dominated by left-brained people.
While there is surely a lot to learn from Marx to make sense of the current crisis, it was economist Friedrich von Hayek who foresaw most clearly the terrible consequences that an intellectual bias towards mathematical reasoning as the fundamental condition for scientific knowledge, and a blind faith in the powers of science, could have on the economics profession and on society at large. What follows are quotes from his 1974 Nobel Prize Lecture (the emphases are mine):
“…Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones… And while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated as important which happens to be accessible to measurement. This is sometimes carried to the point where it is demanded that our theories must be formulated in such terms that they refer only to measurable magnitudes…
…It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world. This view, which is often quite naively accepted as required by scientific procedure, has some rather paradoxical consequences. We know: of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant…
…The progress of the natural sciences in modern times has of course so much exceeded all expectations that any suggestion that there may be some limits to it is bound to arouse suspicion… Yet the confidence in the unlimited power of science is only too often based on a false belief that the scientific method consists in the application of a ready-made technique, or in imitating the form rather than the substance of scientific procedure, as if one needed only to follow some cooking recipes to solve all social problems…
…The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men’s fatal striving to control society – a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.”
There are concrete lessons that can be derived from acknowledging the left-brain bias of finance as a fundamental cause of the economic mess we are into.
Muller’s most important policy insight in this regard is that injecting capital into financial institutions will not by itself solve the problem. In order to fix the financial system, he recommends reducing the size of the current gigantic American financial institutions by the reformulation of something like the Glass-Steagal act, which would separate savings banks, investment banks, insurance and brokerage from one another. This would reduce the level of complexity of their operations, increase the ability of executives to truly understand what they are doing, and reduce the incentive to recur to pseudo-objectivity.
Furthermore, private individuals and firms should make decisions based on these considerations: “…avoiding firms that are ‘too complex to manage’ in Amar Bhidé’s memorable phrase. Companies should not expand beyond the ability of top management to comprehend the firm’s actual activities. That will mean smaller and less diversified firms. Investors may want to ask the question: is this firm so big, or engaged in such diverse activities that its management doesn’t understand the activities in which it is involved? (And by understand, I don’t mean simply the ability to read a current balance sheet, but rather to understand the underlying dynamics of the products or services being provided.) If not, decide to invest elsewhere.”
To these lessons, I would add a few more, in line with Daniel Pink’s philosophy of infusing our world with a dose of right-brain vitamin. These are examples of how to encourage the birth of Whole New Mind for finance:
- Reform the educational institutions in finance, business administration and economics, giving at least equal importance to history and non-quantitative forms of reasoning and research methods as to mathematics, statistics and econometrics.
- Encourage more women to join careers in in these fields. Finance is still a profession that is particularly dominated by males, but it is a well established fact that women’s brains are the ones wired to use the right-hemisphere predominantly.
- Create corporate cultures that accept ambiguity and fuzziness, comfortable with not having a clear-cut “right” answer for all problems. Embrace the fact that in business, as in social problems in general, fundamental complexity is the rule, and imperfect knowledge an inescapable reality.
Following these guidelines would at least make the financial world less akin to mechanically applying mathematical formulas to problems that simply don’t lend themselves for mathematical treatment. And the cult of accountability would have a less fertile ground to grow from. Encouraging the creation of a Whole New Mind for finance would be a nice complement to the institutional and regulatory reforms that the industry badly needs.
UPDATE: On April 27th 2009 Felix Salmon wrote a blog post that sheds further light about how the Gaussian copula function got adopted by rating agencies.
UPDATE: On June 25th 2009 I came across a New York Times Op-Ed piece by Richard Dooling written in October 2008 that is tremendously relevant for understanding the disastrous consequences that the seductive power of mathematical models can have in finance, and science in general. Hat tip: Blogless and Robert Blinn.