Opinion

The Great Debate

The physics of an economic crisis

By Emanuel Derman
November 3, 2011

By Emanuel Derman
The views expressed are his own.

The great financial crisis has been marked by the failure of models both qualitative and quantitative. 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; ceaseless 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; companies that shorted stock for a living being legally protected from the shorting of their own stock; compromised yet unpunished ratings agencies; government policies that tried to cure insolvency by branding it as illiquidity; and, on the quantitative side, the widespread use of obviously poor quantitative security valuation models for the purpose of marketing.

People and models and theories have been behaving badly, and there has been a frantic attempt to prevent loss, to restore the status quo ante at all cost.

For better or worse, humans worry about what’s ahead. Deep inside, everyone recognizes that the purpose of building models and creating theories is divination: foretelling the future, and controlling it.

What makes a model or theory good or bad? In physics it’s fairly easy to tell the crackpots from the experts by the content of their writings, without having to know their academic pedigrees. In finance it’s not easy at all. Sometimes it looks as though anything goes. Anyone who intends to rely on theories or models must first understand how they work and what their limits are. Yet few people have the practical experience to understand those limits or whence they originate. In the wake of the financial crisis naïve extremists want to do away with financial models completely, imagining that humans can proceed on purely empirical grounds. Conversely, naïve idealists pin their faith on the belief that somewhere just offstage there is a model that will capture the nuances of markets, a model that will do away with the need for common sense. The truth is somewhere in between.

Widespread shock at the failure of quantitative models in the mortgage crisis of 2007 results from a misunderstanding of the difference between models and theories. Though their syntax is often similar, their semantics are very different.

Theories are attempts to discover the principles that drive the world; they need confirmation, but no justification for their existence. Theories describe and deal with the world on its own terms and must stand on their own two feet. Models stand on someone else’s feet. They are metaphors that compare the object of their attention to something else that it resembles. Resemblance is always partial, and so models necessarily simplify things and reduce the dimensions of the world. In a nutshell, theories tell you what something is; models tell you merely what something is like.

Intuition is more comprehensive. It unifies the subject with the object, the understander with the understood, the archer with the bow. Intuition isn’t easy to come by, but is the result of arduous struggle.

I wasn’t surprised by the failure of economic models to make accurate forecasts. Any assurance economists pretend to with regard to cause and effect is merely a pose. They whistle in the dark while they write their regressions that ignore the humans behind the equations. I was similarly unsurprised by the failure of financial models. Sensible people don’t forecast with financial models; they use a model to transform one’s forecasts of future parameters into present value. Everyone should understand the difference between a model and reality and no one should be astonished at the inability of one- or two-inch equations to represent the convolutions of people and markets.

What did shock and disturb me was the abandonment of the principle that everyone had paid lip service to: the link between democracy and capitalism.

Capitalism’s problems will not be solved by models. But in the meanwhile, financial models are not going to disappear. Data alone doesn’t tell you anything, it carries no message. Theorizing and modeling are what humans do and will continue to do. So how do we use models wisely and well?

First, one must recognize that there are no genuine theories in finance. In physics, Newton’s laws and Maxwell’s equations are facts of nature, entirely equivalent and identical to the phenomena of mechanics and electromagnetism that they describe. In finance, the Efficient Market Model’s assumption that stock prices behave like smoke diffusing through a room is not even remotely a fact. It is a metaphor, entirely approximate and limited, as are all financial models.

Wise practitioners know that the point of a model in finance is not the same as the point of a model in physics. In physics one wants to predict or control the future. In finance one wants to determine present value and goes about it by forming opinions about the future, about the interest rates or defaults or volatilities or housing prices or prices per square foot that will come to pass. Models are used to interpolate or extrapolate from the current known prices of liquid securities to the estimated values of illiquid securities—relating the unknown value of a Park Avenue penthouse to the known prices of smaller apartments in Battery Park City, for instance, using one’s opinion about the price per square foot.

The Right Way to Use Models

Given the inevitable unreliability of models and the limited truth or likely falseness of the assumptions they’re based on, the best strategy is to use them sparingly and to make as few assumptions as possible when you do. Here are some other observations I’ve found useful in modeling:

Avoid Axiomatization

Axioms and theorems are suitable for mathematics, but finance is concerned with the real world. Every financial axiom is pretty much wrong; the most relevant questions in creating a model are how wrong, and in what way?

Sweep Dirt Under the Rug, but Let Users Know About It

Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper. It doesn’t fit without cutting off some essential parts. Financial models, because of their incompleteness, inevitably mask risk. You must start with models, but then overlay them with common sense and experience.

The world of markets never matches the ideal circumstances a model assumes. Whenever one uses a model, one should know exactly what has been assumed in its creation and, equally important, exactly what has been swept out of view. A robust model allows a user to qualitatively adjust for those omissions.

Use Imagination

The perfect axiom or model doesn’t exist, so we have to use imperfect ones intelligently. When someone shows you an economic or financial model that involves mathematics, you should understand that, despite the confident appearance of the equations, what lies beneath is a substrate of great simplification and—only sometimes—great imagination, perhaps even intuition. But you should never forget that even the best financial model can never be truly valid because, despite the fancy mathematics, a model is a toy. No wonder it often breaks down and causes havoc.

Beware of Idolatry

The greatest conceptual danger is idolatry: believing that someone can write down a theory that encapsulates human behavior and thereby free you of the obligation to think for yourself. A model may be entrancing, but no matter how hard you try, you will not be able to breathe life into it. To confuse a model with a theory is to believe that humans obey mathematical rules, and so to invite future disaster. Financial modelers must therefore compromise. They must decide what small part of the financial world is of greatest current interest to them, describe its key features, and then mock up only those features. A successful financial model must have limited scope and must work with simple analogies. In the end you are trying to rank complex objects by projecting them onto a scale with only a few dimensions.

In physics there may one day be a Theory of Everything; in finance and the social sciences, you have to work hard to have a usable model of anything.

Excerpted from Models.Behaving.Badly by Emanuel Derman. Copyright 2011 by Emanuel Derman. Excerpted by permission of Free Press, a division of Simon & Schuster. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.”

Comments
23 comments so far | RSS Comments RSS

Wise words indeed!

I am a meteorologist. We have models of our own, for which we actually know the governing equations. Nonetheless, complexity and sensitivity to initial conditions mean that these same cautions apply. I paricularly like “Avoid Idolatry”.

Posted by LYSANDER_0 | Report as abusive
 

I would edit the heading, “Sweep Dirt Under the Rug, But Let Users Know About It” to include the admonition, “And Never, Ever Forget About It.”

Once a caveat is given, most users wade into the complexity of analysis forgetting about what’s been swept under the rug. I’m reminded of something my business school finance professor said the first day of class, ‘Are markets rational and efficient? Of course not. We assume that they are because without that none of our models work.’

And after that little tidbit was swept under the rug it was almost never mentioned again.

Posted by PapaDisco | Report as abusive
 

As a quantum physicist I am amazed every day by the utter ignorance of the vast majority of economists, social and political “scientists” etc.

For some reason, most humans think that societies and human thought is exempt from natural laws. In the above article the author writes this unbelievable quote: “Axioms and theorems are suitable for mathematics, but finance is concerned with the real world.”

He either has no idea what an axiom is or he is confusing it with a dogma. Of course we should be avoiding dogmatization but axiomatization is the basis of any solution that is using the scientific method.

Economy, society, relationships and everything else in nature are subject to the laws of nature. If we ever start thinking of them as part of physics and not as independent and closed systems, then we will finally solve some of our problems

Posted by Peripeton | Report as abusive
 

I would add one extra requirement – get of your backside, out of the office and talk to as many and as varied people you can in the country / market concerned! I visit Greece and Ireland regularly and it has been obvious for a long time that the apparent prosperity had no basis in sound economic growth and was built on credit or a ponzi scheme of property. If you look around and wonder ‘where is all this wealth coming from’ then go back and look at the business / economic models and see where they are going wrong. The trouble is we always want to think that some how this time it’s different and that somewhere, someone has discovered the economic equivalent of the philosopher’s stone.

Posted by paulos | Report as abusive
 

Great article and great comments, it does make me want to read his book.

Posted by M.C.McBride | Report as abusive
 

Good grief.

It doesn’t take a rocket scientist to understand that you can create any type of society you want by the rewards and penalties you build into the system.

Take the tax system. America obviously wants more and more of the poor, uneducated, and unmotivated who fundamentally have no place in today’s society because we reward them for each baby with more and more goodies “for the sake of the children” that are, in the main, unneeded and unwanted. If they ever DO get a job, all those kids are wonderful tax deductions to make sure that society is never repaid their cost from their wages.

Add to that our “open borders”, legal aid, special benefits, etc. for illegal aliens. We obviously don’t want to burden illegal aliens with the task of learning the language of their chosen nation so as to assimilate, so we provide bilingual education, ballots, etc. This also assures that the great majority of the fence-jumpers are uneducated with few skills but amazingly fertile, so as to clog up our schools, hospitals and food banks.

Our children are taught, by and large, by union members. It would be heresy to fire the ineffective and replace them with the productive. This assures a good fundamental indoctrination of socialist principles from first school day through graduation. It is an incnonvenient truth that for everyone that is “above average” there is someone that is “below average. Everyone DOESN’T get a trophy in life.

Many can’t balance a checkbook and it is almost universally agreed that profit only results from greed. Capitalism, the engine that fuels our economy, is regarded as antisocial and outmoded.

It’s really pretty simple from the personal to the international stage: Find a need and fill it, economically and in a timely manner for those that can and will pay. Everyone else scrambles for the crumbs surrounding this essential function.

Posted by OneOfTheSheep | Report as abusive
 

Your first paragraph was a multifaceted gem. It should be made required reading for all of those politicians who want their memos to be a page or less long (we still remember you George II.) I would also like to see it read by regulators and economists of all kinds.

The question is, how do we get the people responsible for changing things, some of whom are as poorly educated as the general populace, to accept what you are saying?

Posted by IntoTheTardis | Report as abusive
 

I’d add one more: Don’t trust a model that can’t be prototyped and tested in a spreadsheet in a way that is intuitive and grounded in reality.

Posted by RiskMan | Report as abusive
 

Markets and how they move are influenced by human nature, which no one has ever quantified. In this respect, I understood what he meant when he said that the market is not based on the real world, i.e., something that can be quantified by mere numbers and formulas. It works for hard science, but finance is not hard science (nor is anything else that deals with human behavior).

The comments by the scientists display this very nicely; while being technically right, these are the very sort of “right” that produce invalid or incomplete algorithms that don’t work when attempted in the “real life” of day to day market happenings.

Posted by stevedebi | Report as abusive
 

@ Peripeton

I agree with your general feeling that the social sciences could use a swift kick in the scientific method.

(A personal anecdote: I once knew a deliberately inscrutable anthropology phd who was existentially stunned that all his work learning obscure theories and puffed up opinions had been undone by a mere decade’s worth of biology, mainly in genetics. It seemed that nothing he’d learned was true anymore. I admit to great schadenfreude when I would ask him about the latest genetic discoveries. He began avoiding me.)

I have always thought that the best way for a physicist, and thus any scientist, to approach economics is the same approach used by physicists to study meteorology. There was a time, not so many decades ago, when meteorologists confidently predicted that soon they would be able to make absolutely accurate forecasts far into the future, which was only the first of many subsequent forecasts to fail.

Why don’t we have long-term foolproof weather forecasts yet? The calculations to describe the interactions between the molecules are all available. I’m sure you already know the answer; it is because there are simply far too many calculations involved. We can’t even imagine today what a computer powerful enough to crunch those numbers would look like, never mind how to collect and manage the data in the first place. And then there’s the oft misquoted butterfly effect, wherein a change anywhere in the simulation, even as little as that of adding an amount of wind equivalent to one flap of one butterfly wing, on one hemisphere, is theoretically capable of setting off a chain of events that could radically alter the weather on an opposite hemisphere.

So trying to calculate the trillions upon trillions of causes and effects that go into creating the weather of the moment is like the job an economist must do in trying to calculate not only the actions of 7 billion humans, but also the movements of trillions of currency units, multiplied by the total number of currencies, plus commodities, random events, and yes even the weather itself. Even more difficult, economists must predict the activity of human brains, for which no precise calculations yet exist.

This is why the state of the field remains an art, and not a science…although it aspires to be a science. It would be very interesting to know how much cross pollination already exists between the methods and approaches used by meteorologists, who are considered after all to be actual physicists, and economists.

Posted by BajaArizona | Report as abusive
 

@ OneOfTheSheep

Your post soils what would otherwise have been that rarest communal achievement, a comment board filled with an intelligent, respectful, and non-ignorant discussion of the topic of the article.

Your thinly veiled bigotry may not be obvious to you, but it is painfully so to everyone else. They’re ignoring you just like they would ignore a shouting, inappropriate drunk person on the street. You’re not worthy and it’s best to just step around.

I’m not trying to insult you for insult’s sake. I’m just not going to let you think your diatribe is acceptable simply because none have bothered to clue you in.

Posted by BajaArizona | Report as abusive
 

It seems to me that it’s not models which have failed, rather it is reality which is failing. Put another way, “failure is the hallmark of our current reality.”

In an attempt to divine the future models must first look backward, and then hope that the future behaves like the past.

New models are precisely what are now needed. They should be constructed out of the failures that have and are occuring. They should thus be able to educate society on what precisely happened, and how and why. With that precise information society should be able to chart a course forward.

The failures are multiple, and are occuring across many accepted ways of doing things. These accepted ways will surely change, either by consequence, or preferrably by intelligent design.

Posted by jusguessn | Report as abusive
 

What’s needed simply, is an understanding of the incentives that drive people’s behavior. In the 1980s President Reagan eliminated Fed Tax interest deductions. Thus giving many folks the incentive to use home equity lines for large purchases. In the 1990s President Clinton pushed his homeownership initiative handing incentives to every business involved in Real Estate. So, with the Government’s blessing they quickly threw away their standards creating huge demand for their services. Then the clever folks on Wall St figured out how to bundle those serives into products. Rising demand meant rising home equity so home owners jumped on the bandwagon and either cashed-out and bought larger homes or tapped into the equity to make even more purchases. Things, as we know, didn’t end well and lot of finger pointing has gone on since. But the key factor in all this is, incentives. I think we should be careful about assigning blame to individuals for being human, because as long as we have this self-rightous streak we obfuscate the fact that humans are by nature incentive based creatures who will always do, to one degree or another, what benefits them in a given situation.

Posted by GLK | Report as abusive
 

Excellent article Mr. Derman, and @BajaArizona, I completely agree with you, for there was a wonderul flow of commentary until I came upon @OneOfTheSheep

Posted by mmcg | Report as abusive
 

This is one of many articles plugging this importnat book. I comment on them at http://djmarsay.wordpress.com/2011/10/21  /how-mathematical-modelling-seduced-wal l-street-ns/ . As a mathematician I note that financiers have tended to use mathematics as a computational tool rather than a forensic tool, to check for assumptions. Thus I maintain that Keynes’ more axiomatic approach was actually better at revealing risks than common sense unaided by logic or mathematics. The problem seems to be, not the use of mathematical models, but the lack of use of them to check the economists’ dogmas. This problem seems not to be confined to financial matters.

Posted by djmarsay | Report as abusive
 

Epistemology:

What is knowledge?
How is knowledge acquired?
How do we know what we know?

. . . physicists, social scientists, economists and the whole lot should realize that they are the children of philosophy (epistemology is a traditional line of philosophical inquiry). The lack of philosophical awareness and education in this country is unfortunate indeed.

Posted by effoff | Report as abusive
 

BajaArizona,

The “topic of the article” is the qualitative and quantitative failure of the U.S. gross national product to grow for a period in excess of two decades during which domestic manufacturing significantly decreased and the financial sector plundered the related ebbs and flow of capital without ethical or legal restraint. When he says that “People and models and theories have been behaving badly” he really means “unpredictably” or “in a manner with unacceptable result”.

He then discusses the “failure” of economic models and admits that “capitalism’s problems will not be solved by them. He then admits that there are no genuine financial theories, and that in the “real world” no one can write down a theory capable of reliably predicting human responses to infinite variables.

In essence, Mr. Derman shares with us some specifics as to what economists CAN’T do and admitting that this is pretty much everything they have attempted to do. They KNOW they don’t know what they’re doing. Duh?

No one will pay for what another can’t do. Money is made by knowing with some certainty what another will or must do. The challenge is for economists to become capable of doing the function they have yet to fulfill. My earlier thoughts are more “to the point” than useless academic musings. No offense intended, of course.

Posted by OneOfTheSheep | Report as abusive
 

I tend to agree with Peripeton.

The fact that global markets are not subject to simple linear maths does not mean they are not amenable to objective analysis, modelling and even prediction by the right tools.

In particular I find this statement:

“In physics one wants to predict or control the future. In finance one wants to determine present value”

just plain wrong. For many of us the present value is already perfectly well determined by the market and what we want to know is the most probable future value, e.g. any fool can tell it’s raining now but we want to know if it will be raining in an hour’s time when we have to go out.

Likewise this statement:

“Whenever we make a model of something involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper. It doesn’t fit without cutting off some essential parts”

seems to assume one always deals with neat cut and dried linear models rather than say ranges of possibility where nothing essential need be ‘cut off’ at all.

“you should never forget that even the best financial model can never be truly valid because, despite the fancy mathematics, a model is a toy.”

It beggars belief that this is sentence is actually being put forward as some sort of objective conclusion!

Finance models are nearer weather and quantum physics models than the simple linear models this author seems to be using as his model to berate them!

What we look for is not simple one answer certainty but statistically meaningful probability and that is achievable.

Posted by PaulJWeighell | Report as abusive
 

Peripeton, would you say that the game of bridge is subject to the laws of physics? Would thinking of it as part of physics help us solve bridge problems?

How about chess?

Are you sure that the rules of the finance game are closer connected to physics than the rules of bridge or chess?

Posted by J_Thomas | Report as abusive
 

Economics can never be the science many want it to be because – as the article ably demonstrates there are too many moving parts, and too many of them are people, with the randomness that entails.

Economists will tell you that, in the main, people act in their own self-interests. But, that simple statement hides the fact that people often cannot see, or don’t realise, what IS in their best interests. Overlay that with the duplicity or ponzi-style delusion sometimes involved in financial dealings and it’s clear that economics can only ever be educated guesses informed by the past, not really a science.

I once called a radio phone in to ask a panel of economists “How can so many people have got so much wealthier, where has that wealth come from? Surely someone somewhere must lose wealth for others to gain?”. I got three different answers, none of which I really understood at the time, or subsequently. I looked for (and found) endless articles and papers on the fundamentals of wealth creation, but again, none made sense to me – most explained the mechanisms for getting wealthier (investment, risk taking, opportunity awareness etc) but none really addressed how that additional wealth was created.

My conclusion was that – like so many things – if it’s not susceptible of an easily understood, common-sense explanation, then there’s probably trickery, mass delusion or deception involved. I think reading this article has confirmed that conclusion for me. Thanks!

Alan T

Posted by AlanNewsMan | Report as abusive
 

@Alan T –

“I once called a radio phone in to ask a panel of economists “How can so many people have got so much wealthier, where has that wealth come from? Surely someone somewhere must lose wealth for others to gain?”. I got three different answers, none of which I really understood at the time, or subsequently.”

When the wheel was invented, that created a lot of wealth. Ditto when the lever was invented.

When the relay was replaced by the valve, the valve by the transistor, the transistor by the integrated circuit, each change massively increased the amount of wealth in the world.

Machine looms instead of hand looms. Sliced bread. Cars. Tea bags. Kidney dialysis. Electronic payment. Every time someone thinks up a more efficient, less wasteful way to produce more value with less resources and effort, it means that wealth is created.

Even every time a kid figures out a shorter route to walk to school, they have created a little bit of wealth (their shoes wear out more slowly, freeing up resources for other uses).

Does that help?

Posted by DanielEarwicker | Report as abusive
 

The solution of economic problem is Spiritual. To solve it, first all kinds of prejudice should be put aside whether national, political, language, culture, etc. There is no difference to build a hospital in a country other than yours. Spirituality is about serving humankind everywhere without any prejudice, in accordance with the law of God for this age. (see Baha’i faith at http://WWW.bahai.org). Once these laws are put in place, then you can be assured of sustainable prosperity everwhere.

Posted by shm | Report as abusive
 

The American economy is based upon my performing a service or producing a product that pleases others. It follows natural economic law. We see that every day when whatever we need is there waiting to be purchased. The natural economic law is not an equation. It can be modeled with equations, but, it cannot be duplicated with equations.

The most important action of the American economy is that it, just like the military, is ruled by representative government. The current economic crisis is due as much to our representative government as it is to many facets of the economy.

We work to fix the operation of the economy. Those efforts sometimes fix things and sometimes make things worse. We work to fix our representative government. Sometimes those efforts work and sometimes they do not.

However, there is something, among the goals of our system of government and its subservient, by law, economy, that continues so long as we retain our form of government. It has to do with liberty. We remain free. Freedom requires us to remain vulnerable.

We do not want police standing outside our doors, so, when we walk out of our doors we are vulnerable. We do not want leaders, or what sometimes seems almost the same, committees, telling us what we must do to earn our living. Or, what we must spend our money on. Or, that we will be better off if only we recognize the benevolence of our betters.

Our betters can take a hike. We are Americans. Some have had it easier than others. Many have had it challenging to advance themselves. Others have thrown away the opportunity that liberty offers them. Make this part very clear. We help one another. Social safety nets are not new to the American system of government. We care about one another. We help one another.

However, the leader or committee that tells me that I have to work longer days so that someone else who chooses to not be productive can sit around watching television can forget it.

We are a very productive people. We share a great deal of what we produce with others. We do without that which we share. We do without that which fails us whether by economic abuses or by governmental mistakes.

However, we must always keep in mind that when times are difficult, the most important property of the American system that must be preserved and never lost is liberty.

James Putnam

Posted by JamesAPutnam | Report as abusive
 

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