Emanuel Derman

Having been a scientist, one of my major pet peeves is the naïve use of science. Let me give you several examples.

The influential biologist and evangelistic atheist Richard Dawkins wrote in the Los Angeles Times several years ago about what he called the scientific “vandalism” involved in hanging Saddam Hussein:

“Hussein’s mind would have been a unique resource for historical, political and psychological research, a resource that is now forever unavailable to scholars. … Psychologists, struggling to understand how an individual human being could be so evil … would give their eye teeth for such a rich research subject. Political scientists … have now lost key evidence forever.”

Elsewhere, Dawkins has also opined on the pernicious effect of fairy tales on children:

“So many of the stories I read allowed the possibility of frogs turning into princes and I’m not sure whether that has a sort of insidious affect on rationality.”

This reminds me a bit of the practical nursery rhymes taught to the alphas in Huxley’s Brave New World:

Orgy-porgy, Ford and fun,
Kiss the girls and make them One.
Boys at one with girls at peace;
Orgy-porgy gives release.

To me, there is something stunningly unimaginative about these remarks. How little you must understand of the complexities of human nature if you think we can learn to avoid the creation of monsters by questioning Saddam, Hitler or Stalin. People aren’t easily investigable objects.

More recently a neuroscientist, David Eagleman, wrote an Op-Ed suggesting that we base the legal system on neuroscience. In it he wrote:

A brain-based approach (to the legal system) can be more cost-effective, humane and successful. If we desire our medical treatments to be biologically informed, shouldn’t we demand the same from our courtrooms?”

Eagleman blithely assumes that crimes are unambiguous objective things, like physical illnesses. Doesn’t he notice that even illnesses themselves are ill-defined, that treatments go in and out fashion? When I was a child tonsillectomies and lobotomies were fashionable. Now stomach banding is in.

I invented the word pragmamorphism for this attitude. Anthropomorphism is the attribution of human characteristics to inanimate objects, that is giving inanimate objects the shape of humans. I use pragmamorphism to refer to attributing to humans the properties of inanimate things, to giving human minds material qualities. The Greek word pragma means a material object, and pragmamorphism is naïve materialism.

The World of Physics
I began my professional life as a physicist, excited by science, filled with a heady mixture of idealism and ambition, aspiring to be another Einstein or Schrödinger who intuited the way the universe works.

Physics is wonderful at this. Newton almost 400 years ago wrote down short one-inch principles and corresponding equations that described nature to an astonishing degree of accuracy. So did Einstein, Schrödinger and Dirac in the last century. Dirac’s equation describes the behavior of electrons in atoms to eleven decimal places. Ernest Rutherford, the New Zealand experimentalist who discovered the hard tiny nucleus at the center of atoms, captured the wonder of this when he said: How can a fellow sit at a table and calculate something that would take me 6 months to measure in the lab?

So, how did Newton write down his laws that explained the motion of planets?

John Maynard Keynes studied Newton’s long-lost cryptic papers and then wrote a speech to be delivered at the tercentenary of Newton’s birth in 1942, from which I quote:

Newton came to be thought of as the first and greatest of the modern age of scientists, a rationalist, one who taught us to think on the lines of cold and untinctured reason. I do not see him in this light. Newton was not the first of the age of reason. He was the last of the magicians, the last of the Babylonians and Sumerians, the last great mind which looked out on the visible and intellectual world with the same eyes as those who began to build our intellectual inheritance rather less than 10,000 years ago. …

I believe that Newton could hold a problem in his mind for hours and days and weeks until it surrendered to him its secret. Then … he could dress it up … for purposes of exposition, but it was his intuition which was pre-eminently extraordinary. His experiments were always, I suspect, a means, not of discovery, but always of verifying what he knew already.

Maxwell later said the same about Ampere’s discoveries in electricity, calling him “The Newton of Electricity,” and Einstein commented similarly about Maxwell’s own grand equations. All of them wrote down one-inch equations that absolutely described the physical world.

Finance
In late 1985 I left physics research and took a job at Goldman Sachs, doing financial research, which in my case meant building physics-style models of options and markets. I was one of the early so-called POWs  – Physicists on Wall Street.

Finance was exciting, and at first it seemed a lot like physics. The traders were the experimentalists, and I was a theorist working with them. The mathematics was similar to what I’d grown up on. Soon I began to believe it was possible to apply the same methods successfully to economics, perhaps even to build a grand unified theory of securities. Along the way I published many papers and built many models, several of which are still widely used today.

Nevertheless … after 20 years on Wall St I’m a disbeliever in grand financial theories.

Theories and Models
In my forthcoming book, Models.Behaving.Badly I carefully distinguish between theories and models.

Theories first. I hope you remember the story of Moses and the burning bush in the book of Exodus. Moses, tending the flock of sheep of his father-in-law in the desert, saw a burning bush whose flame would not consume it. God, from within the bush, declared himself to Moses and commanded him to deliver the Israelites from Pharaoh.

Whom shall I tell them sent me? asks Moses, trying to play for time.

Tell them: EHYH ASHER EHYH, said the voice in Hebrew. It means I am that which I am.

God was punning on his true name: EHYH means I will be but it is also similar to God’s ineffable name Yahweh. Yahweh is declaring himself to be the irreducible substance out of which everything else is constructed. He is exactly what he is, he says, nothing more, nothing less. You cannot compare him to anything on earth. He is not a metaphor or analogy. Hence, no graven images please.  About Yahweh you cannot ask ‘Why?’; you can only accept him as a fact.

That’s a good metaphor for how successful theories of the natural world work. Newton’s Laws for matter, Maxwell’s equations for light,  Quantum Mechanics  and Relativity for electrons – these theories are facts. They describe how the world works. You can discover them, but you can’t ask why they are true. As Goethe once wrote, The ultimate goal would be: to grasp that everything in the realm of fact is already theory.

Models are different. Models are metaphors or analogies. Calling the brain an electronic computer is a model. Calling a computer an electronic brain is a model too. These are analogies, based on similarity, not identity. They are graven images, useful but not very accurate.

Models tell you only what something is more or less like. Theories tell you what something actually is.

In economics one can make only models. The Efficient Market Model that has gone so badly awry  compares stock prices to smoke diffusing through a room, and models them with the physics of diffusion. But those are flawed analogies, not theory or fact.

Therefore the similarity of physics and finance lies more in their mathematical language, their syntax rather than their semantics. There is no grand unified theory of everything in finance.

The world is not a model.

The Great and Ongoing Financial Crisis
About thirty years ago I worked with a friend who told me that his elderly parents used to fight each other tooth and nail, ceaselessly, trading insults and offenses. After listening to his blow-by-blow accounts of their battles, one day I asked him why his parents didn’t just divorce each other? They’re waiting for the kids to die, he said to me.

I’m reminded of this when I watch the world trying to come to grips with what has happened to economies and markets. During the past two decades the United States has suffered the decline of manufacturing; the ballooning of the financial sector; that sector’s capture of the regulatory system; stimulus whenever the economy has wavered; taxpayer-funded bailouts of large capitalist corporations; crony capitalism; private profits and public losses; the redemption of the rich and powerful by the poor and weak; compromised ratings agencies; government policies that tried to cure insolvency by branding it as illiquidity (Greece); and the widespread use of obviously poor economic models.

What Can Be Done?
The internecine arguments by economists in the daily papers show that a good part of economics is really about what is good for society and how to get it. Years ago Economics was part of what was called PPE – the triple fields of Politics, Philosophy and Economics. Economics was grouped with the moral sciences.

Nowadays Economics is grouped with MPNE – Mathematics, Psychology, Neuroscience and Economics. Economics is put with the traditional value-free sciences.

There’s nothing wrong with these fields on their own. But, if economics is about what’s good and how to get it, it can’t be value-free. It’s mathematical models are poor metaphors that are obviously and vastly inadequate. Its papers read like Euclid, with axioms and theorems, their faux rigor is inversely proportional to their minimal efficacy.

No model yet invented can tell you whether anything at all will go up or down tomorrow. The invisible worm at the heart of economics has been its dark secret love of inappropriate scientific elegance and scientism.

Markets and prices are generated by human behavior. The greatest conceptual danger in modeling human behavior is idolatry, which is a kind of pragmamorphism, imagining that someone can write down a theory that encapsulates human behavior and relieves you of the difficulty of constant thinking. A model may be entrancing but no matter how hard you try, you will not be able to breath true life into it. To confuse a limited flawed model with a theory is to embrace a future disaster driven by the belief that humans obey mathematical rules.

Economists think that matter is simple and that people can modeled similarly.

I want to conclude by quoting from a wise as well as brilliant nonpragmamorphic physicist, Schrödinger, the father of the quantum mechanical wave equation that bears his name. He knew that the apparent solidity of matter disguises the mystery that lies beneath. In 1944, summarized his personal views, he wrote:

My body functions as a pure mechanism according the Laws of Nature. Yet I know, by incontrovertible direct experience, that I am directing its motions … in which case I feel and take full responsibility for them.

Schrödinger didn’t shy away from the essential duality: the apparent conflict between scientists’ ability to discover nature’s mechanical laws and the autonomy that must nevertheless lie beneath any attempt to discover them. He concluded:

Every conscious mind that has ever said or felt ‘I’ … (is) the person, if any, who controls the ‘motion of the atoms’ according to the Laws of Nature.

The world is complex and you lose a lot by insisting that the things you don’t understand already fit into the boxes you imagine you do. Don’t be pragmamorphic.

On my way to New York from South Africa in the Sixties, I stopped in Israel. It was midsummer, and in Ramat Gan where I stayed for a few weeks, people sat out at night on their breezeless balconies and played cards till late. Food vendors sold sunflower seeds on the street; people popped them into their mouths and then split them with their teeth, swallowed the core and spat out the shell through the bus window in one continuous mouth-teeth-tongue movement, no hands. Streets, apartment and balconies merged into a kind of shared outdoorsiness. I’d never seen it before and I liked it.

When I came to New York a few weeks later, I was taken aback. The ride from JFK to Manhattan was ugly and bumpy (though probably still better than today). It was globally dramatic (the skyline) but locally dispiriting (the disrepair in front of you). New York was nice from far but far from nice. I lived in a dormitory on the Upper West Side at the edge of Harlem. There were no telephones in rooms and no AC. The corridors looked prison-like,  green lower half and white upper half, and the guards at the entrances confirmed that view. I was UNimpressed.

The first thing that struck me after I got over my shock at being 10,000 miles from everything I knew was how foreign everyone was. New York was a polyglot city of immigrants. People around me spoke Spanish and Yiddish and Italian and German. Middle-aged men and women with concentration camp numbers on their arms ran local luncheonettes. The deli store run by immigrants nearby on Broadway and 123rd Street sold chocolate-covered ants. The pizza store we refueled at late at night right next to it was run by real Italian-speaking Italians, an enormously large Mama on a metal folding chair scowling at her dapper grey-haired flour-dusted husband who combed his hair as he eyed the girls. Puerto Ricans sat out on their stoops till late at night smoking and talking. Though it didn’t look like it, New York reminded me of the Tel Aviv I’d just left, a city of immigrants who lived out on a street that encompassed the entire city. New York was a Mediterranean or Caribbean town, the only American one like that, at least at that time.

Every other place I’ve been, you feel a bit out of it if you’re an immigrant or foreigner. But New York is a foreigner’s town in its own brash and unfriendly way that is quintessentially American. Maybe people here care too much about money, but it’s better than caring about class or family or the other accoutrements that take a long time to accumulate. Here, it’s what did you do for me lately. That’s not all bad.

_____

When I graduated I didn’t want to leave NYC. I feared the bland non-immigrant cities that didn’t have a street life, where existence was conducted behind closed doors. In New York if you’re lonely you can walk down the street and be surrounded by people and have interactions. When I thought (in those days) about going somewhere in the heart of the country, I feared cold winters and hemmed-in living. I liked being able to walk the streets, even if they looked like the grim ones outside the diner in Hopper’s Nighthawks, because inside there were people who were still part of the public to exchange a word with. There was always the possibility of something happening.

I have a romantic view of New York that’s never faded. Serge Gainsbourg, now being recalled in a movie at Film Forum, was a Russian-Jewish first-generation Parisian in the days when Paris welcomed foreigners, and he captures some New York’s iconic charm in his song ‘New York USA’ which requires very little knowledge of French; he simply professes amazement at the height of New York buildings as he recites their magical names. It’s dumb, but it’s charming because it recognizes reality and isn’t shy to say so. Here’s a video

and some of the lyrics.

… … J’ai vu New York

New York U.S.A.

J’ai vu New York

New York U.S.A.

J’ai jamais rien vu d’aussi haut

Oh ! C’est haut, c’est haut New York

New York U.S.A.

Empire States Building oh ! c’est haut

Rockefeller Center oh ! c’est haut

International Building oh ! c’est haut

Waldorf Astoria oh ! c’est haut

Panamerican Building oh ! c’est haut

Bank of Manhattan oh ! c’est haut

____

Even when you’ve been in New York for decades, you can still see it through immigrant eyes. You can be a foreigner and all-American at the same time. Because beneath the quotidian city the romance of an immigrant past in which everything is amazing and open to you is always lurking.  Mundane people have romantic stories in their past. And romantic people have to do mundane city things. You don’t have to choose between countries because you can be a citizen of New York, a magical realist country all by itself:

The Laboratorio at GROM

On Columbus Circle, in the Laboratorio behind the register
white-coated Dottoressas of  physiology and science
mix extracts of fruits and spices
harvested from their Sicilian orchards.
They combine them with organic milk
flown in from Tuscany
and add a few drops of San Pellegrino.
You can understand why even small amounts of GROM are expensive.
They say that late at night,
after they close,
the serious white-coated Dottoressas remove their horn-rimmed spectacles
and put aside their microscopes and loupes
and wet-and-dry bulb thermometers.
They empty their pipettes
and autoclave the tongs and spatulas
and apply a few drops of Princess Marcella Borghese from the nearby Sephora
to rid themselves of the smell of vanilla from Agrigento
and turn the Laboratorio into a spa to make extra money.
New York is expensive, even when you sell ice cream at $6 a scoop.
After cleaning the giant aluminum mixing tubs
with steaming jets of distilled Pellegrino
the Dottoressas
provide
health consultations
mineral baths
and exercise prescriptions.
They wrap customers in hot GROM sheets
as they cool down after immersion in the tubs.
The Dottoressas
have very advanced degrees from Bocconi
and say the traces of GROM
in the tubs
relieve pain and stress
and strengthen the immune system.
At 6am they shut the place and leave
tossing their lab coats into the common laundry bag.
They get a cup of coffee and a glazed at Dunkin Donuts
check their email at the 24hr Fedex Kinkos
and read about the latest advances in nutrition on the GROM server.
Then they go home and try to sleep
before their next shift.

For a couple of years now I’ve had a bad feeling about the field of finance. Though I often inveighed against the mechanical use of models, I didn’t damn the entire endeavor. I still don’t, but the other day, talking to a colleague who was much younger than me, I discovered that we had somewhat similar sentiments. Mine are summarized as follows. I hope it’s just a mood.

Neoclassical finance, the entire structure that includes the efficient market model, Brownian motion, stochastic calculus, the capital asset pricing model, and of course Black-Scholes-Merton, is a beautiful comprehensive far-reaching discipline. It describes a risky system and its consequences elegantly and sparely, and provides lots of insight. I like it. Unfortunately, the real world is more complicated.

One of the responses to that complexity is behavioral finance. This started out with prospect theory as an attempt to provide a comprehensive new foundation for finance and economics. It hasn’t turned out that way. That part of behavioral finance is by and large ignored. Instead, its proponents have streamed off into two directions. The first is neuro/psycho finance, filled with papers discussing brain scans of traders and their risk appetite, which isn’t really finance at all, but belongs (if it belongs anywhere outside of grant applications) in a psychology department. The second is the study of how people react to choice, a collection of mildly interesting statistical studies of CEOs and investors that mostly confirm what everyone knew before, and whose results are most useful in justifying various paternalistic social policies. None of it adds up to a comprehensive discipline; it seems to be mostly strategies for writing papers.

On the sidelines, people with an interest in computational finance work away at more rapid methods of computing the results of various models; they don’t care if it’s right or wrong, they just want it to be accurate. There’s nothing wrong with that and I’ve done it myself, but it’s not central.

There are many things worth doing — studying price formation and the behavior of underlyers, to give just one example. I hold, perhaps sentimentally as a result of my background, some hope for the econophysicists and the builders of agent-based models. They’re most likely not going to find the absolute truth with these cellular automata  — these are still models, not theories — but at least they seem to understand what they are doing, and why.

C’est la vie
Feel free
To disagree

If God had only had a committee of business writers to help him, I think he could have done a better job:

I grew up in a post-WWII world where, temporarily, because of their capacity to create devices that wreak destruction, physicists had lots of influence in government. Think Einstein, Oppenheimer, Teller. By the time I went to graduate school at Columbia, the U.S. was involved in Vietnam, and a new bunch of much younger physicists were active in JASON, a Government advisory group. There were many protests against JASON at Columbia in the Sixties, as a result of mild-mannered physicists writing reports with titles (I recall)  like “Interdiction of Trucks By Night,” apparently to do with bombing the Ho Chi Minh Trail. Recently someone claimed that JASON stood for “Junior Achiever, Somewhat Older Now” which captured the hubris of scientists at the time. Influence and power is seductive.

Those days are over. The Cold War is faded, and the Superconducting Collider is dead.  No one cares too much about physicists any more, and won’t, unless the string theorists can come up with a doomsday weapon. (Actually, there’s a 2005 Herman Wouk novel about the political consequences of a Higgs boson gap between the U.S. and China.)

Physicists had only  indirect political  influence; their ability to accurately harness nature’s powers via pure science and accurate engineering based on that science gave them power over presidents, and made people think they might be smart about other things too. Biologists are the real 21st Century physicists in that sense, and, like them, in the long run have the larger influence on the future. As Feynman wrote about Maxwell, “From a long view of the history of mankind — seen from, say, ten thousand years from now, there can be little doubt that the most significant event of the 19th century will be judged as Maxwell’s discovery of the laws of electrodynamics. The American Civil War will pale into provincial insignificance in comparison with this important scientific event of the same decade.” There are biologists like Darwin and Watson and Crick for whom the same is true.

Meanwhile, day to day, administrations are filled with economists of all stripes who have direct influence and the power to do good and harm in the short run.  But economics is not a pure science; it’s closely linked with philosophy and politics. As Keynes wrote:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.

The consequences of errors are severe.

My son, who did his PhD thesis on Max Weber, soon to be published as a book, showed me Weber’s essay on Politics as a Vocation. Weber has many interesting remarks about the responsibilities of people who get involved in politics, among them this:

Well, first of all the career of politics grants a feeling of power. The knowledge of influencing men, of participating in power over them, and above all, the feeling of holding in one’s hands a nerve fiber of historically important events can elevate the professional politician above everyday routine even when he is placed in formally modest positions. But now the question for him is: Through what qualities can I hope to do justice to this power (however narrowly circumscribed it may be in the individual case) ? How can he hope to do justice to the responsibility that power imposes upon him? With this we enter the field of ethical questions, for that is where the problem belongs: What kind of a man must one be if he is to be allowed to put his hand on the wheel of history?

One can say that three pre-eminent qualities are decisive for the politician: passion, a feeling of responsibility, and a sense of proportion.

The last two are especially important when you can’t be sure of the consequences of your theories.

_____________________________________

Addendum: One interestingly relevant paragraph from the same essay, my italics:

In America, the spoils system, supported in this fashion, has been technically possible because American culture with its youth could afford purely dilettante management. With 300,000 to 400,000 such party men who have no qualifications to their credit other than the fact of having performed good services for their party, this state of affairs of course could not exist without enormous evils. A corruption and wastefulness second to none could be tolerated only by a country with as yet unlimited economic opportunities.

Capitalism depends on lending and borrowing, and hence on banks. In that sense banks are a utility, like Water Works or Electric Company.

Utilities have to be protected from collapse.

Banks borrow from depositors and have to earn a spread by lending or investing.

How do you set a sensible limit, individually or as a group, on the activities borrowers can lend to or invest in, so as to avoid future economy-shattering disasters?

I don’t think the answer should involve advanced statistics or mathematics.