The financial crisis and physicists

The financial crisis is all my fault. Or so David Smith from our friends REvolution seems to suggest in his post Physicists, models, and the credit crisis:

I remember working in The City in the late 90’s and Wall Street in the early 00’s and remarking then that just about every quant had a physics or engineering background. I met very few statisticians. […] Quantitative models have taken a hefty share of the blame for the credit crisis, but I wonder whether the blame lies more in their application, rather than the models themselves. Statisticians are trained on the limitations of models, and how to detect when models are breaking down, but statisticians were woefully underrepresented amongst quants. Do physicists and engineers get similar training?

I can only speak as a (ex-)physicist (I used to work on experiments at CERN) and the short answer is “yes”. Of course we do get this training.

I did experimental physics. What we are good at is testing a model (or a set of competing models) against data. Physics only really moves forward when (1) we find some domain where our previous models do not work or (2) we find a simpler model that consolidates several previously separate models or extends the domain of a previous model.

The quantum properties of particles would be an example of the first and general relativity might be an example of the latter.

The caveat is that it really helps if it is a “reasonable” model we are looking at. We are not primarily trained in statistics. We are primarily trained in understanding nature: cause and effect, the scientific method, and a mathematical apparatus for communication.

A statistician is primarily trained in statistics. He will run tests on the model against data. I firmly believe that no statistician should ever be allowed out in the wild unsupervised. A physicist is trained in a world-view, if you like. He will (first) try to understand the model. He will look for internal consistency and he will compare with other models in the same or adjacent domains. He will run thought experiments. Then he might run some statistical tests against data.

I worked as a quant in a bank back in the days before “banker” became a four-letter word. We did good models. But, and this is important, the focus was on modeling the high-volume trades better. That’s where the money is. If you could find an anomaly there you were set to make millions. If you could find a better model there you could make hundreds of millions.

If you could find an anomaly on the tail, you could write a research paper.

The average tenure of the people I was working with was less then three years. Nobody was interested in events that were not likely to occur within a three year time horizon. We knew and understood that the models were not valid on the tails, but there was no volume of trading on the tails so it wasn’t very interesting.

We knew that the tails didn’t fit. But that was not important. Making money is the business of business.

Quoting from the article that got David Smith started:

Quants say that they should not be blamed for the actions of traders. They say they have been in the forefront of pointing out the shortcomings of modern economics.

“I regard quants to be the good guys,” said Eric R. Weinstein, a mathematical physicist who runs the Natron Group, a hedge fund in Manhattan. “We did try to warn people,” he said. “This is a crisis caused by business decisions. This isn’t the result of pointy-headed guys from fancy schools who didn’t understand volatility or correlation.”

Business decisions. But before we go completely medieval on the bankers, let us understand that society is often expected to pick up the bill for tail effects. Houses built in flood plains, hurricane prone area, or earthquake zones? DDT? Space debris? Global warming? Even famines are probably mostly preventable, but at a cost.

And the challenge with with all of this is that the cost of prevention may be bigger than the cost of fixing it. Maybe. It is hard to say: both costs are typically highly uncertain, and in the (really) long run we are all dead and extinct anyhow: if you take the long view nothing is cost-justified. This universe will end.

The question is: for all the billions of (preventable) damage caused by the current crisis and for all the personal losses (everyone without a job) and tragedies (everyone without a pension or conned by Maldoff), did the banks create net value summed over both the good and bad years? Capitalism has allowed us to grow, albeit in fits and starts. The bankers made huge sums of money in the good years and not just for themselves but real money in real business and real growth and innovation. Ask the people who would not have been alive today if it was worth it: the poor who got additional aid and support (often squandered by their leaders but still) from the surplus wealth generated by all the elements of capitalism, including those bankers, and ask the people benefiting from new medicines developed by capital-intensive pharmaceutical research. Ask the people benefiting from capital investments in infrastructure projects: hospitals, hydroelectric dams, schools, etc.

We have the luxury to be angry with the bankers. I do not want to take that luxury away from us: it is wonderful that we can afford to indulge ourselves. But I would like to remind us that is is a luxury that we can afford, and that we can afford it at least in part due to those bankers.