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Beyond False Predictions - We Need to Fix the Math, for the Economy to Get Well

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The economic crisis our world is now slowly recovering from has received a lot of attention, but some of the underlying causes and factors necessary for a complete recovery or a fully-functioning world economy have been largely ignored by the media. What is worse; similar problems can be seen as the underlying cause of other man-made disasters, such as the oil spill in the Gulf of Mexico. Am I talking about rampant greed? No; everyone else is talking about that. The real culprit is stupidity, compounded by the unwillingness of those who were the most ignorant to admit their mistakes, which prevents problems with the system from being addressed. Mostly; it is a false belief in determinism, or perhaps a false application of deterministic rules, which is at fault. In some cases, events which have a small chance of occurring are re-defined as impossible. Common practice, in the world of Business and Finance, has been to treat these "black swans' as though they do not exist. This has produced a broad gap between accepted risk estimates, and actual risk.

And it has also put the world into a financial condition where we need to fix the Math, for the Economy to get well. At this point; there need to be repairs to both the mathematical models used in the Finance sector and to the way those models are applied. And what people don't seem to grasp is that there can be no transparency, in the Finance sector, until some of those repairs are made. Even the best model will fail to represent reality, if we fudge the data overmuch - to show the desired result. Now economists are beginning to re-examine past market data to include a broader time segment, as well as using the full extent of variations as a guideline, in order to properly include catastrophic events in their assessment of what is normal or characteristic. In the past, it was considered sufficient to use a segment of time and range of variations when the market was well-behaved, to determine its normal behavior. This approach treats all rangy or catastrophic events as impossible, rather than merely unlikely, promoting a kind of false determinism that allows lies to appear factual.

So; if we want to have real accountability, we need to fix the Math to an extent where it more accurately reflects reality. Mathematician Benoit Mandelbrot correctly pointed out several flaws in financial Math in common use, and predicted there would be problems down the road if the errors were not fixed, but he was looked at as a "Chicken Little' telling people "the sky is falling" rather than an honest mathematician, trying to save people some grief. People were all too eager to believe another mathematician, David X. Li, when he devised something called the Gaussian Copula Function, which became the basis for credit-swap derivatives trading. Li cleverly knitted together two risk-estimation formulas, one used in engineering for equipment failures, and the other from actuary for attrition rates due to disease or death. He included plenty of caveats in his paper, about the need to use all the data, but also made a convincing case for the illusory notion that precisely estimating risk allows us to reduce it, and thereby create financial instruments with zero risk.

Of course; the claim of zero risk seems rather absurd after the fact of a market crash fueled in large measure by trading in such instruments. But at the time Li's paper came out, it was hailed as a major advance in financial Math, and there was even talk of a Nobel Prize for his contribution to Economics. Well; it turns out Mandelbrot was nearer correct, but we now have trading in financial instruments (credit-swap derivatives) whose founding premise was discovered to be faulty. Yes; there must be greater transparency and some form of regulation of CDOs is necessary, in order to assure fairness. But I wonder if the economists and quants have really addressed some of the basic problems caused by bad Math, which allow for greedy and devious people to play both sides without it being apparent. It is as though the numbers, and the Mathematics itself, were used as a shield or weapon instead of an instrument of the truth. Math is used in finance because of its capacity to represent complex transactions accurately and transparently. But one has to use the right Math for the job, and though Mathematics as a whole has continued to evolve, much of the Math used in Finance is outdated.

The good news is that there are better models being evolved. The bad news is that we can't cling to the illusion of predictability afforded by determinism, if we really want to fix things. People like Mandelbrot have laid a groundwork, and created tools for economists to model financial markets - and to estimate both risk and the potential for reward - far more accurately than has been possible in the past. In order to earnestly adopt better models, however, we need to abandon the idea that everything which happens in the world of finance can be predicted or controlled, and the illusion that marginal risk is the same thing as no risk at all. The reason why both the financial crisis and the oil leak got as bad as they did is that nobody prepared for the worst-case scenario as though it could really happen. So; if we are looking to reform the world of Finance, let's fix some of the bad Math first. If we do that; it will help to restore confidence like nothing else. When there is transparency and accountability, then people will know it's safe to go back into the water.

2010 Jonathan J. Dickau - reproduction for non-commercial purposes is allowed

 

www.jonathandickau.com

Jonathan is a modern Renaissance man. He is a Grammy award-winning engineer, a performer, a writer and lecturer, and a scientific researcher. Since recording "At 89" Jonathan has worked on other projects with Pete Seeger, including a 300 song (more...)
 

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Howdy Folks,This one is my first article for Op Ed... by Jonathan Dickau on Thursday, May 20, 2010 at 8:25:53 AM
This article provided a different look at the root... by Taylor on Friday, May 21, 2010 at 10:40:09 AM
Thanks V.It is gratifying to be able to contribute... by Jonathan Dickau on Friday, May 21, 2010 at 1:38:08 PM
Greetings folks,Since I failed to include any refe... by Jonathan Dickau on Thursday, May 20, 2010 at 10:06:49 AM
Thank you for providing this.... by Taylor on Friday, May 21, 2010 at 10:43:14 AM
There is a deliberate avoidance of including land ... by David Chester on Sunday, May 23, 2010 at 5:13:51 AM