Everybody is citing the article in Wired on the Gaussian copula function.  Apparently, everybody had been applying some clever maths to finance decisions so they thought they had a mathematically valid way of making accurate predictions while eliminating most variables.  It probably was mathematically valid.  But was it ever economically valid?

The Austrian economics folks at the Mises Institute are basically saying that it’s difficult to imagine an Austrian economist, a reader of Human Action: A Treatise on Economics, to fall for the idea that a simple formula can predict the future.  Boingboing, similarly, has suggested that the moral of the story is ‘STOP MATHS NOW!’  Which isn’t to say maths is bad – it’s just that it’s not really economics.

My take is that the Misians are right (again) and this is a failure in the understanding of economics, not a failure in maths or the creator of the formula.  But I don’t have to make any comments on this because ‘Andrew’ has already said all I want to say in his comment on Boingboing:

#7 posted by Andrew, February 24, 2009 1:19 AM

Economics is not formulas. Economics is not higher math. Economics is not experimental science. Economics is not even quantitative. Economics is logic applied to the choices that people, and business, make constantly. The logic of marginal value, opportunity cost, uncertainty, and all the rest is as good as it’s ever been — it’s universal as long as time and resources are finite. It’s when you start to say that the demand elasticity of natural gas times the velocity of money, minus the consumer price index, is correlated to the relative humidity in china with r^2=.83, that you’ve fucked up irrevocably.

What’s this got to do with management?  In management terms, applying a formula is never the basis of a capability.  Like another great ‘Andrew’ said in a comment to my last post, the banks appear to have been saying ‘yes’ to anybody who asked for money – and now they are saying ‘no’.  This itself is the simplest of all formulas – and it doesn’t in itself give you that all important capability of being able to differentiate between good and bad risk.  And if you use a formula long enough you’ll loose the capability itself (if you ever had it).

I’m becoming convinced that the financial system is completely broken.  One of the reasons that managers didn’t put the breaks on use of the formula is sighted in the Wired article:

In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn’t understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop.

(See also comment here)

Note that they were ‘making too much money to stop’ and yet you might ask the intelligent questions raised here:

And one question:
I’d like for the knowledgeable people here to tell me what would have the banks done with all the money they had to lend if they wouldn’t have gone for the bad risk? Isn’t everybody so loaded with debt right now that there is very little good risk left? Was this crisis even avoidable?

These raise an interesting point – what do you do with ‘too much’ money?  How, or why can there even be ‘too much’ money?  If you are expected to make a certain return, to create a certain level of growth in any market conditions, then you need to spend or lend your spare money.

This is the obsession with growth that I think must end.  We even define a recession in terms of a lack in growth – why does there always need to be growth?  Also, if the government is fiddling with interest rates and indirectly providing cheap loans how do you as a business deal with sort of price eroding competition?  Your forced to make dumb / risky decisions I guess – but perhaps you also start getting the wrong signals making it hard to make the right decisions.

The other point it raise is the different between earning money and creating value.  The money that was risked on risky loans is now gone.  Never mind the details but that value has been whipped from the economy.  But the destruction of value coincided with the making of money.  Again, something is wrong here.  In this sense people were being paid for taking risks.  This shouldn’t ever be the case – people should be paid for either creating value or because the risks they take paid off.

But there is more than one agent here.  There are the employees of the banks and the banks themselves.  Of course, you have to pay employees for turning up – even if they are risking money and eventually driving your business into the ground.  So it’s not the financial folks themselves that are taking the risks.  It’s the organisation.  It’s the bank itself.  It’s the process, structure, culture – in short, all the capabilities that make the organisation what it is – that by its very design choose the wrong people, had the wrong controls, gave incentives for the wrong behavior.

And yet – it’s the Banks that are getting bailout money!  I can’t understand this.  People don’t appear to realise that the institutional structure is temporary.  The exact nature of who owns banks, who runs banks, the boundaries between banks, and the intermediation of different agents (existing or potential) is all we have when it comes to a financial industry.  The only way a solution can possibly exist for any financial crisis is for the institutional structure that is overlaid over value to change.  The only process that will cause universal (or at least, on average) improvement is to change this institutional and agent structure so that it works more effectively and so that more capable ownership and control exists.

Bailouts to banks will effectively allow the current owners of banks to continue to own the assets -despite- the fact that they have proved they can’t managed them effectively.  This doesn’t stop at direct ownership – it also include the investors.  If people have invested in banks that are not managing value correctly they have failed to invest wisely.  A bailout helps them retain ownership -despite- making bad investment decisions.

If investors are investing in the wrong things, and if owners or corporations are managing assets ineffectively, or if risk is not being managed by a corporations capabilities the investment needs to not provide a return, the assets need to be moved (naturally, through sales) to somebody who can manage them, and different capabilities need to be engineered or given resources.

But – what is the magic formula for deciding all of this restrucing?  Well there isn’t one – it just has to be allowed to happen doesn’t it?

PS.  I’m not an economists so I don’t really know what I’m talking about.