If there’s one guy in the entire financial world who is not only useless, but also extremely dangerous, it’s Nobel Prize-winning schmuck Myron Scholes. Scholes won the Nobel for his contribution to the Black-Scholes-Merton derivatives pricing model. In theory, that equation allowed financial actors to more easily calculate their risk and reward positions, and hedge accordingly. This led to the development of a variety of complex hedging and arbitrage strategies that have spawned the complex web of interconnected debt and derivatives that we see today, where huge parts of the global economy have become too interconnected to fail. And as we are slowly learning, being too interconnected to fail doesn’t prevent failure — it just makes its effects more poisonous.
Myron Scholes’ own ventures were very unsuccessful. He was the “brains” behind Long Term Capital Management, the ill-fated hedge fund that blew up in 1998:
Nassim Taleb put it better than I ever could:
This guy should be in a retirement home doing Sudoku. His funds have blown up twice. He shouldn’t be allowed in Washington to lecture anyone on risk.
Yet lecturing the world on risk, as well as financial stability and the international financial system is exactly what Scholes is doing.
So the question arises, should the rest of the world take over management of Europe to prevent or mitigate disaster? Specifically, should the US Federal Reserve assume leadership as a monetary superpower and impose policy on a paralyzed ECB, acting as a global lender of last resort?
In essence, the US would do for EMU what it did in military and strategic terms for the Europe in the 1990s when Washington said enough is enough after squabbling EU leaders had allowed 200,000 people to be slaughtered in the Balkans. The Pentagon settled matters swiftly with “Operation Deliberate Force”, raining Tomahawk missiles on the Serb positions. Power met greater power.
Personally, I have not made up my mind about the wisdom of a Fed rescue. It is fraught with dangers, and one might argue that resources are better deployed breaking EMU into workable halves with minimal possible damage.
However, debate is already joined – and wheels are turning in Washington policy basements – so let me throw this out for readers to chew over.
Nobel economist Myron Scholes first floated the idea over lunch at a Riksbank forum in August. “I wonder whether Bernanke might not say that we believe in a harmonised world, that the Europeans are our friends, and we know that the ECB can’t print money to buy bonds because the Germans won’t let them. And since the ECB will soon run out of money, we will step in and start buying European government bonds for them’. It is something to think about,” he said.
Now, I don’t believe that an idea is necessarily discredited because its author is stupid. But this is another very bad idea from the author of many very bad ideas.
Bernanke’s copying of the failed Japanese response to a burst bubble — print money and avoid liquidation — has already doomed the United States to over two years of zombification, lowered employment, weak lending, biflation, and a lack of new growth or creative destruction. Does Europe — and the globe — deserve to be subjected to the same horrendous zombified state? I don’t think so.
Bernanke’s approach is deeply reactionary — it puts systemic stability above everything else — and will take any measure necessary to ensure it. But is systemic stability really worth anything if the system that is stabilised — encumbered by excessive debt, malinvestment and fragility — stinks? In my view, the bad debt, bad investments, and bad companies need to liquidate. The recapitalisation comes afterwards.
The best way to “save” a bad system is to let it fail, and help rebuild it. Clearly, neither Europe, nor America, nor the globe are working. Policymakers need bolder policy — they need to start looking at allowing what is failing to fail — and then facilitating rebuilding. If stern teutonic monetarism allows for the kind of global failure that can allow the junk to liquidate, then I am all for it. Yes — it undermines the Federal Reserve’s reactionary money printing policies. But that’s the cost of a system as fragile as the one Myron Scholes has helped build, where American stability is threatened by crisis in Europe, etc.
It is my theory that the real disaster in economics in the last half century was its takeover by mathematicians like Myron Scholes. These people never seemed to care much about reality, or empiricism. They have been lost in their imagined abstractions, drunk on maths, drunk on the beautiful, idealised, linear models that they create — but which merely resemble reality. Models are not real. That was the problem at Long Term Capital Management — their statistical arbitrage models worked perfectly at a theoretical level, but crashed and burned in complex, messy reality — at cost to the taxpayer, the investor, and the financial world at large. I can’t help but think that this is the problem here too — the ideal of a highly liquid, hugely interconnected and truly global financial system is seductive to idealist mathematicians, and therefore its preservation has become central to the Fed’s policies (the FOMC is dominated, of course, by mathematical economists and econometricians). In messy, non-abstract reality, the fragility of such a system makes it absolutely unsustainable. The mathematicians will keep pumping liquidity and trying to save their paradigm. But it won’t work.
azizonomics 
Very well put.
“It is my theory that the real disaster in economics in the last half century was its takeover by mathematicians like Myron Scholes.”
A corollary to that disaster is that the majority of the discipline is actually very critical of this mathematicization of economics, but always views the answer as more mathematicization. It’s quite amazing to see just how much criticism has been written about the problems with the math and the modelling, and how all the critics end up doing is, basically, tweak the models, producing new ones that suffer from the same fundamental problems as the old ones.
Thanks. I had been thinking for a long time about how to explain my disgust at the mathematicisation of economics — and the world taking Myron Scholes seriously, a guy who has been completely discredited — gave me a chance to do so.
Here in England we teach economics as a cousin of philosophy and politics — a practical subject. In America, and most countries, I understand it is generally taught as a “science” or even as a branch of maths.
Thank God for Nassim Nicholas Taleb.
@azizonomics I could not agree more. My studies in economics were just another math class, devoid of psychology, sociology, philosophy or politics. It’s all cut and dry and fits into a nice set of equations so we can be considered a “hard” science.
The sad truth is that by attempting to mimic the hard sciences they relegated economics to pseudoscience in the most literal sense. Economics is so much deeper and richer than demand curves. For me, it is predominantly a historical subject — history (and not abstract models) is my laboratory. Through history we can deal with black swans. Through mathematics, we can only deal with the parameters in the model.
A friend was telling me about a tutor in college who was considering a PhD in economics but chose to go into mathematics. His reasoning was that he “didn’t like dealing with data”. I wish all the other abstract theoreticians would do the same thing and leave real economists alone.
I thought Nassim was God.
“The main function of economic forecasting is to make astrology look reasonable…” Apologies to John Kenneth Galbraith for mangling his quote.
“Theory and practice work great in theory, but not in practice….” maybe apocryphal, but ascribed to Yogi Berra?
Great post, Spruce.
About models vs reality – market is so effective because it is not a model, but real process. Obviously actors employ many models to help their entrepreneurship decisions, but its only preliminary. After all you have to set your price and when someone agrees to it and you shake hands – that’s the meaningful part. You cannot substitute it with prediction, there are just to many unknown factors, some of them deep in the minds of actors probably never to be fully quantifiable. All of this mathematical economics could be useful if it directly dealt with all this risk. Every step of the way there should be significant allowance for the unknown factors. Well, such a honest treatment would ruin many great models and “laws” – but rightfully so. After all it is not “national demand” or whatever you look at, but it is sum of many individuals (who in this case live in one country and want to buy).
There is also huge amount of unknowns on macro level. After all who know what technology will change witch process and when? Or what resources will be found? It would be very useful to develop even very sophisticated mathematical models, but only to use them as reference, with full knowledge of their limitations and a healthy level of insurance for their mistakes.
BTW If any one of you saw Zeitgeist: Moving Forward – neo-communists would actually like to substitute entire economy with… computer model. It would never work even if programmers actually tried to make it into a honest super-manager of all production and distribution. It would fail on the same principle (unless it was much faster corrupted and turned over to other ends than material justice to all…).
Absolutely, Piotr.
The market (mostly) works because it is real and not a simulation. It has more checks and balances, more feedback, and more information than any central planner or model. It does not have trouble with epistemology, either. The value in modelling is mainly as a conjectural (rather than a predictive) tool.
And yes Zeitgeist is a frustration to me. The notion of replacing the market with central planning by computer is completely crazy, and very arrogant, because it presumes humans and rationality know better than nature.
Let me just say how impressed I am with the level of understanding and intelligence from all commenters today. You guys really “get” it. I feel like my readers are smarter than me, and that is a good feeling.
Don’t forget most Mathemiticians have mild Aspergers Syndrome.
They just don’t get the full picture! This is why their models don’t work in the real world.
Taleb and I had a long argument about autism. Essentially, I see the problem as the institutions (corporations, the state, academia) imposing a kind of collective, bureaucratic autism:
1/ Epistemic arrogance and platonification
2/ Rigid acceptance of academic/bureaucratic/epistemic authority structures
3/ Wilful ignorance of the hard-to-quantify and apophatic
The key difference between this and real autism is that real autism is defined in terms of empathy deficit, and incomplete theory of mind. The key point I want to draw out of that is that many of the practitioners of bureaucratic autism are normal, empathetic, social beings — and that these are the ones who are most dangerous, because they can use their social and cultural nous to spread their creed. Examples of these people include Richard Dawkins, Walter Benjamin (and most of the Frankfurt school), and Paul Krugman.
Furthermore, many individuals with real autism actually can have genuine and useful insights — so long as they do not allow themselves to be sucked into the collectivist hive-mind of bureaucratic autism. Look at Einstein — the shy patent clerk, working outside of the system who turned the system on its head.
I feel far more kinship for Einstein — a man who really did have Asperger’s Syndrome — than I do for any of the non-autistic conformists working within the structures of the establishment.
The number one rule of investment is “past performance is no indicator of future performance”. How can you predict randomness? It takes serious hubris to think you can predict the economy with all its feedback loops and infinite causes and effects – someone well removed from the real world.
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