Thursday, 22 December 2011

The Girl with the Dragon Tattoo, and why we can't solve the Euro crisis

I, like a lot of technically minded-people it seems, like a good crime thriller.  Having spent a year mesmerised by Sara Lund's sweaters I picked up The Girl with the Dragon Tattoo.  It's a good story, but a bit contrived with the plot being resolved by unexplained and unbelievable computer hacking.

So why write about it on a blog about science and finance?

The plot is set in the context of our hero, a journalist, Blomkvist and his relationship between two businessmen,  Wennerström and Vanger.  Blomkvist publishes a story claiming Wennerström was involved in a fraud, which he failed to corroborate and the novel begins with his conviction for libel.  This makes him vulnerable to an approach from Vanger to investigate the mysterious disappearance of his niece in the 1960s, which is the central mystery in the novel.

What I find interesting is how the different businessmen are presented.   Wennerström has become a billionaire from nowhere, building his wealth by participating in such unsavoury activities as options trading and currency speculation.  Vanger, on the other hand, is old-money - a traditional industrialist whose family had arrived in Sweden with Napoleon's puppet king, Jean-Baptiste Bernadotte, and was granted land holdings on which they developed paper mills that spawned a firm involved in manufacturing, technology and the media.  Within this setting the message is clear:  Vanger may be an unpalatable capitalist but Wennerström is beyond the pale.

The sub-text is physiocratic, the Vagner's are legitimate capitalists because they hold land.  Wennerström, who has made his own money through speculation, by judgement and foresight, is corrupt.  The irony that the hero Blomkvist becomes rich by speculating,  that Wennerström is a crook, is passed by.  A second irony is that if the events described in the book had actually occurred in England, they might have become of interest to the Leveson Inquiry, looking at actual cases of the relationship between journalists and private detectives involved in phone hacking. 

The theme of the corruption of finance is not new, but the novel ignores St Augustine's observation that if a merchant was a cheat, the fault was with the individual, not the profession. What is disturbing is the deep conservatism of the books' sub-text:  if some thug in history had not given your ancestors land, you do not deserve to be rich.

I finished reading this book the weekend that France and Germany looked to solve the Euro crisis and impose tighter regulations on financial services.  The French President, commenting on the UK's withdrawal from the process, went on to say that "a good part of the world's problems come from the deregulation of financial services". 

Both the UK's FSA's, in their recent report on the collapse of RBS, and the US's Financial Crisis Inquiry Commission (FCIC) observe that the regulations existed, but they were not effectively implemented.  The UK-US crisis was a failure of government agencies, at the behest of politicians, to enforce rules.  The Euro crisis has similar roots in a failure to enforce rules on sovereign debt ratios.   The crises seem to have less to do with bankers and more to do with the profligacy of politicians.

Much of the narrative of the ongoing financial crises has been about the imbalance, particularly in the UK, between manufacturing, represented by Vanger, and financial services, the Wennerströms.  Implicit is that manufacturing, creating physical objects, is something more real than financial services, moving money around, and moreover, more reputable.

This bias seems to be reflected in UK government science policy.  In the recently published Innovation and Research Strategy, the government identifies the following, key, technology based sectors: life sciences, high-value manufacturing, nanotechnology and digital technology.  Financial services, while contributing around 10% of UK's GDP, is not mentioned.  This approach ignores the advice from the Royal Society in their 2009 report Hidden Wealth.

I would argue that the recent financial crises are about a general lack of understanding of modern finance that enabled institutions to behave irresponsibly.  It is hardly surprising that this situation has arisen given the blindness to policy-makers to investing in fundamental research into finance and its underpinning technologies, whether they be the contracts traded, the mathematical models and their computational implementations.  This aversion to understanding finance will persist as long as popular culture is dominated by the Vanger=good, Wennerström=bad model.

Thursday, 8 December 2011

... but what about the South Sea Bubble...

David K Waltz has made a comment on my last post, I realised my response was going to be a bit longer than a "comment".

David raises the spectre of the South Sea Bubble and Tuplipmania.  I am not an expert on the Tulip Bubble, but I am aware that there is a question as to whether it was a significant as popular imagination suggests (i.e Dumas's The Black Tulip).

The South Sea Bubble (1720) can tell us a lot.  In the aftermath the British constitution was completely overhauled - the introduction of the position of Prime Minister (held by Walpole,still the longest serving Prime Minister) was the most obvious impact.  In addition, British public finance was put on a firm footing that laid the foundation of successive military victories and the Empire.  France's response to the Mississippi Bubble (1719) was less dramatic (they blamed the financier Law) and the consequence was a succession of military defeats.

Also, the popular response included Defoe's Complete English Tradesman where he writes (1726)

A tradesman's books are his repeating clock, which upon all occasions are to tell him how he goes on, and how things stand with him in the world: there he will know when it is time to go on, or when it is time to give over; and upon his regular keeping, and fully acquainting himself with his books, depends at least the comfort of his trade, if not the very trade itself. If they are not duly posted, and if every thing is not carefully entered in them, the debtor's accounts kept even, the cash constantly balanced, and the credits all stated, the tradesman is like a ship at sea, steered without a helm; he is all in confusion, and knows not what he does, or where he is; he may be a rich man, or a bankrupt-for, in a word, he can give no account of himself to himself, much less to any body else.
This contrasts with  the Rape of Lady Credit by stock-jobbers that Defoe described in 1709
The first Violence they committed was downright Rape ... these new-fashion'd thieves seiz'd upon her, took her Prisoner, toss'd her in a Blanket, ravish'd her, and in short us'd her barbarously, and had almost murther'd her
Much of the political and public rhetoric in recent years has been focused on criticism of financiers (but, unlike Defoe, not before 2006).  However, given the performance of Europe's politicians since 2008 is terrifying (for a European citizen) in that they seem to refuse to take responsibility (which countries were the first to break Euro rule, was it Germany and France?) and prefer to see the crisis as an opportunity to score political points (the Conservative party in the UK).

The British, between around 1688 and 1728, seem to have recognised the democratic nature of markets. Something that Aristotle commented on, and was discussed by scholastics that influenced the development of science through the likes of Bradwardine and Oresme.  Napoleon was scornful as Britain as a nation of shopkeepers, but that is precisely where its strength lay. And it is not simply a financial strength, how different is Defoe's description of a Tradesman from Hume's empiricism?

Its not just science that can learn from the markets.

Tuesday, 6 December 2011

Does finance need a scientific revolution or science need a revolution inspired by finance

Nature, the British version of Science, rarely makes forays into exploring issues in finance. They invited me to talk at a meeting in September 2009 and I get the sense that they would like to do more but are a bit perplexed by the subtleties of finance. The mind is willing but the body is weak.

In October 2008 Nature published a piece, Economics needs a scientific revolution, by the French econo-pysicist Jean-Philippe Bouchaud, which argued that the fault was with the academic discipline of economics: "Classical economics is built on very strong assumptions that quickly become axioms" where as "Physicists, on the other hand, have learned to be suspicious of axioms. If empirical observation is incompatible with a model, the model must be trashed or amended". More recently they have published a broader article, reflecting the diffusion of the financial crisis into society at large, Science's attitudes mustreflect a world in crisis, by the science writer Colin Macilwain.

Physicists are never slow to criticise the short-comings of other disciplines, but the truth is physics, with its never changing laws, is simple. While physicists are paddling in the play pool, economists are hanging on to a rubber ring in the middle of a North Atlantic gale. It is not surprising they don't look like good swimmers. That said, economists are well aware of the limitations of their discipline. From the mathematician Cournot's criticism of the economists' use of mathematics in the 1830s to the contemporary economist's criticism of the wholesale adoption of the ergodic hypothesis by Paul Davidson, economics could do better.

Since the Second World War, economics has transformed itself from a relatively minor discipline to a dominant field. It is ironic that in the 2008 "Research Assessment Exercise", UK economists judged their work to be "excellent", just as the tsunami of the credit crisis was crashing on the shore. This dominance was built, substantially, on "positive" economics, adopting the ideals of the logical positivists that emerged in central European maths and physics in the aftermaths of the First World War. The authority that these scientist had rested on the fact that they had defeated Germany and Japan.

It was not square-jawed commandos that defeated the Axis, but mathematicians and physicists (like  Turing, von Neumann, Kolmogorov, Weiner, Shannon, ... the list is not short) working in Operations Research, the Manhattan Project and code-breaking, that won the war. In particular the code breakers were able to transform streams of random letters into meaningful messages. This analogue seems to have driven economic research through the fifties and sixties: given the right algorithm the randomness of asset prices can be read. Then, just as the idealised economic order of Bretton Woods collapsed under the reality of people and politics, Black-Scholes-Merton and financial mathematics (apparently) emerged to save the world from random chaos.

The financial crisis of 2007-2009 was a demonstration of limitations of the science that emerged out of logical-positivism and in particular the ergodic hypothesis placed at the core of positive economics. It was not a failure of maths and science in general, but a particular type of science that emerged in the 1920s and dominated society between 1940 and the present.

Macilwain is concerned with he fact that many science policy gurus, generally wedded to the tenets of  positivism,  are "clearly more comfortable discussing the planet's ecological crises than the economic ones currently alarming the general population" and that there is "great danger is that scarce funding will consolidate around single-discipline research". More Big Physics like the LHC, or repeating Tony Blair's "betting the house"on genetics - a bet that has not paid out.

Financial markets are manifestations of random, non-ergodic phenomena, as such they can hardly be amenable to deterministic techniques. Specifically, a single approach to understanding them, whether rooted in analogues from the Olympian disciplines of mathematics, physics or biology, will fail. Scientific revolutions have historically been based on the inter-disciplinary interaction, such as between financiers, lawyers (Bacon, Descartes, Fermat, Huygens) and mathematicians. If society stops to think about the current financial turmoil and what it can tell us, we would surely be at the dawn of another scientific revolution.