Friday, January 25, 2013

Solving for $

Solving for $ by Floyd Norris
The New York Times Book Review, January 6, 2013

This article is a critical review of James Owen Weatherall’s book The Physics of Wall Street: A Brief History of Predicting the Unpredictable.

“Ever since the financial crisis, James Owen Weatherall writes in his new book, “The Physics of Wall Street,” “words like ‘quant,’ ‘derivative’ and ‘model’ have taken on some nasty connotations.” He is out to change that.

What finance and economics need, he says, is more physics, not less. So what if the quantitative models that underlay such products as mortgage-backed securities blew up, nearly bringing down the world financial system in the process? Models always have assumptions; it is up to the users to pay attention to whether those assumptions hold.”

He describes that the first part of the book on the history of the use of quantitative modeling in economics is well written.

“But Weatherall has a grander aim. “The Physics of Wall Street” “is a book about the future of finance,” he writes in his introduction. “It’s about why we should look to new ideas from physics and related fields to solve the ongoing economic problems faced by countries around the world. It’s a story that should change how we think about economic policy forever.”

This is a lofty goal, made all the more ambitious by the blunders of physicists on Wall Street in recent decades, blunders he describes well but with an extremely generous view. Sure, he concedes, the crisis “was partly a failure of mathematical modeling,” but he declares that the real problem “was a failure of some very sophisticated financial institutions to think like physicists.””

Norris writes, “He has little use for Nassim Taleb, whose best-­selling book “The Black Swan” argues that the models used by traders disastrously underestimated the possibility of very negative outcomes — the black swans. To say that a model failed, Weatherall contends, is not to say that no models can work. “We use mathematical models cut from the same cloth to build bridges and to design airplane engines, to plan the electric grid and to launch spacecraft,” he writes. If you don’t trust them, why are you driving over the George Washington Bridge? “After all, at any moment an unprecedented earthquake could occur.””

This thought by Weatherall demonstrates his lack of knowledge of complexity science. His examples are certainly complicated but are far from being a complex system like a market or an economic system.

Norris ends his short article with, “The world’s economic problems are far too complex to be reduced to a matter of physics and mathematics. Reading this book brought to mind the adage that if all you have is a hammer, every problem looks like a nail.”

It is amazing to me how most economists consistently refuse to think that economic systems are complex systems in a state of criticality, and hence not subject to cause and effect rules we normally live by.

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