The financial crisis has been a great leveller: We now know that the priests of high finance have been as clueless as the lay people whose money they manage.
Poor American households are defaulting on their subprime loans even as con artiste Bernard Madoff managed to get powerful investment banks, sovereign wealth funds and high-profile charities to invest in what now looks like a Ponzi scheme. Ordinary investors saw their fond hopes of stock market wealth wilt this year even as Alan Greenspan admitted that his entire intellectual edifice had been demolished. It is either infuriating or amusing—take your pick—to remember the advice dished out by self-styled stock market experts in India to buy on dips through 2008.
Is it time to bury the myth of the omniscient financial expert? And of the economist who can predict everything to the second decimal point? They haven’t done too well, have they?
Many of these experts are ducking for cover by claiming that what has hit them is a Black Swan, trader-writer Nassim Nicholas Taleb’s term for rare events that create a huge impact. They are merely using a fashionable term to repeat what Goldman Sachs’ chief financial officer said in August 2007, with dollops of exaggeration: “We were seeing things that were 25-standard-deviation events, several days in a row.” In plain English, it means that the financial markets were facing problems that visit us once every 100,000 years.
We know that this is a rubbish claim. There is not even any data on financial prices that go all the way back to the early years of mankind. There were no economies and financial markets around at that time.
Financial crises such as the present one are not Black Swan events. They recur every now and then. Economists Carmen Reinhart and Kenneth Rogoff note that these crises are a constant feature through what they term 800 years of financial folly. And economists at the International Monetary Fund, in a November working paper, counted 124 systemic banking crises between 1970 and 2007. Nobody should be surprised at what has happened. This is not a Black Swan event.
The problem is not the arrogance of the individual investment banker or trader, but the wider belief that they have the intellectual tools to predict the future with unerring precision. Both economics and finance suffer from what some have described as “physics envy”—the fond hope that social events are as predictable as physical events.
Our knowledge of the future is inherently limited and no amount of fancy mathematical modelling can overcome this fatal flaw. “The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made,” John Maynard Keynes wrote in 1936. Keynes’ ideological sparring partner—F.A. Hayek, winner of the 1974 economics Nobel—wrote something similar in a book titled The Pretence of Knowledge: “I confess I prefer true but imperfect knowledge, even if it leaves much undetermined and unpredictable, to a pretence of exact knowledge that is likely to be false.”
The use of mathematics in theoretical economics and finance helps strip long arguments and constructs down to their essential core. My grouse has been more about the practitioners in the finance industry who believe regressions on recent data can help them unerringly peer into the future. It is this almost religious worship of such forecasts that pushes everybody to make the same bets at the same time, further inflating asset bubbles.
Is there an alternative? Massimo Pigliucci, a professor of ecology and evolution, says in a blog post, “Economics can learn a thing or two from evolutionary biology.” He adds: “There is another lesson to be learned from evolutionary biology that will not make economists, or the public at large, particularly happy: When complex systems evolve over time, the paths they take is contingent on historical accidents... Sociologists, psychologists, ecologists and evolutionary biologists will readily tell their economic colleagues that it is certainly possible to explain past events (the extinction of the dinosaurs, the dot-com bubble) by the use of sufficiently complex causal-historical models. What seems to be out of reach, however, is precisely what economists want most: predicting the future, the hallmark of ‘good’ science.
“The moral of the story is that all of the above is not a failure of economics, sociology, psychology, ecology or evolutionary biology. It is the predictable outcome of the fact that these sciences deal with complex, historical systems unlike much (though not all) of physics.”
The road ahead should be paved with more modest claims about the ability of economic and financial experts to tell the rest of us exactly where the world is headed. That should be the big lesson of 2008.
Your comments are welcome at cafeeconomics@livemint.com