Seismologists, economists and the crisis

Only yesterday, I was asked by BBC Radio 4 to produce a short comment on how seismologists differ from economists. The idea originated from a comment I made some time ago that both disciplines are terrible at making predictions but economics is, in fact, worse  (in another important regard). The piece will be broadcast on Radio 4 as part of the World at One program. As soon as I have the link, I shall post it here. Meanwhile, here is the transcript:

For some, science is as good as its predictions. On that account, seismology and economics are comparable failures. Neither has ever managed usefully to predict a major ‘event’. Back in 1980 my statistics supervisor offered me this wise counsel: “Give them a magnitude or give them a date. Never both at once!”

He was right. Seismologists and economists alike are on safer ground when predicting that, for instance, a great earthquake will hit California or that the Eurozone will be consumed by some crisis. But if we try to pinpoint a date, a magnitude and a place, we are bound to end up with egg on our faces.

Then again, there is more to serious science than mere prediction. Seismologists are undoubtedly the right people to explain an earthquake after the event. No one understands the laws governing the shifting tectonic plates better than seismologists do and, moreover, as a profession they tend to converge on similar explanations after the quake has struck.

If only we, economists, were even a little like that! First, it is clear that we agree on nothing. Not even with ourselves! Indeed, consensus among economists is either impossible or bogus. Natural scientists share a broad range of commonly held theories about their subject-matter and only disagree when it comes to cutting edge, unsettled issues: black holes in faraway places or the whims of quanta in the microcosm; places where our powers of observation fade.

In sharp contrast, we economists do not even agree on the definition of economics; on simple things like what happens when government implements budget cuts in the middle of a recession; on whether large corporations are a terrible scourge on competitive markets or a source of splendid innovations.

Even worse, and there’s the rub, whereas seismologists can never be blamed for having caused the earthquake, economists are open to this charge. A charge that may be proven beyond reasonable doubt in the court of public opinion. Am I being too harsh on my profession? Not in the slightest.

In 1997 the Economics Nobel Memorial Prize went to Robert Merton and Myron Scholes for developing, in the Nobel Committee’s own words: “a pioneering formula for the valuation of stock options.”  “Their methodology,” continued the Committee, “… generated new types of financial instruments and facilitated more efficient risk management in society.”

If only the hapless Nobel committee had known that in a few short months the lauded “pioneering formula” would cause a spectacular multi-billion dollar debacle and a massive bailout by the reliably kind American taxpayer of Long Term Capital Management, the hedge fund set up by the Nobel Prize winners…

That failure was a test run for the larger 2008 meltdown. Why did it happen? Because of huge investments that relied on the untestable assumption that economists can estimate the probabilities of events which our own model assumes un-theorisable.

To adopt a logically incoherent assumption in one’s theories is bad enough. But to convince others to base the fortunes of the world economy on such an assumption is bordering on the criminal.

So, how did we economists get away with it? How did we convince the world and the Nobel committee that we could estimate the probabilities of a string of defaults on mortgages; events which our own models assumed to be inestimable?

The answer lies more in the realm of mass psychology than in economics itself: We re-labelled ignorance and marketed it successfully as a form of provisional knowledge. The financiers then built new forms of debt on that re-labelled ignorance and erected pyramids on the assumption that risk had been removed. The more investors were convinced, the more money everyone involved made, and the better placed we economists became to silence anyone who dared doubt our underlying assumptions. In this manner, a mutually reinforcing process evolved between toxic finance and toxic economic theorising.

As a Greek economist, my story has an additional wrinkle. For years, we have been telling the world that the eurozone will bind together our disparate economies into some form of commonwealth. Our monetary union was based on economic models that suited our politicians’ purposes more than the edicts of truth-seeking. So, when the Crash of 2008 shook the world, our own little edifice, the euro, cracked and started to unravel. Greece was the weakest link, the part of the architecture from which the unravelling began. The result is that here in Greece, in Dublin and Cork, in Oporto and Valencia countless people will go to bed tonight anxious, terrified – worried about how they will make ends meet tomorrow.

To conclude, what started as a tongue-in-cheek story seems to have evolved into a sad tale. After 2008, we economists have been trying to present ourselves as part of the solution, when in reality we had a hand in creating the problem. Our toxic theories underpinned the financiers’ toxic derivatives.

Our science was no more than a series of motivated delusions in search of theoretical justification; fundamentalist tracts that acknowledged facts only when they could be accommodated to the demands of our bosses, or of our political masters.

I am sure, one day, seismologists will develop good predictive models. We, economists, will not. Our analytical thinking may be crucial in helping organising public debate on matters of economic policy. But to tap into this potential, society must develop ways of subjecting our impressive narratives to rational, critical scrutiny. You need to keep us in check! To prevent our powerful mathematical superstitions from arming, once again, the hand of spivs, unscrupulous politicians, and assorted financial villains.

18 Comments

  • Yani…there have been numerous articles pointing out the deficiencies in the Black Scholes model, but LTCM’s position were in fact good….Buffet tried to buy them when it all went sour. LTCM went bust because they didn’t have the capital to support their paper losses. Eventually, those positions were in the money.

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