November 18, 2008
the physics of failure
Finance & Economics, Financial Crisis, In Other Words
(Faith in the underlying mechanics of portfolio theory and market efficiency has certainly contributed to humanity’s greatest leap forward in wealth, productivity, private innovation, and global integration. But that same numerology has since crippled our aging financial system and triggered the worst global recession in nearly a century. Perhaps it’s time to reassess the value – and the logic – of bleeding edge finance.
As Professor Janeway points out in the following interview, treating securities like molecules, subject to the same variable distributions, “random walks”, differential equations, and reductionist math simply compounds the short-sighted actions of a few scientists-turned-gamblers. Not only does it greatly overstate the predictive power of econometric analysis, but it also understates the tremendous dangers of financial engineering.
Having studied the basic principals of both the capital markets and the broader macroeconomy at the peak and trough of our latest business cycle, these basic investment theses simply reek of oversimplification. Worse still, the theories have become irrefutable “laws” of finance and their creators knighted as Nobel prophets – names like Black, Scholes, Merton, Miller, Modigliani, and Markowitz – as balance sheets swelled and derivatives became increasingly complex.
As Janeway suggests,”It was a kind of religious movement, a willed suspension of disbelief.” For those interested in how so many bright people could make such bad decisions for so long, this is definitely worth the read…)
New Hope for Financial Economics: Interview with Bill Janeway
To continue our search for understanding as to the antecedents of today’s financial mess, we turn to one of the smartest private equity investors on Wall Street, William H. Janeway. Bill is a Managing Director and Senior Advisor of Warburg Pincus, and now a lecturer at Cambridge University, where he received his doctorate in economics as a Marshall Scholar. The youngest son of Elliot and Elizabeth Janeway, Bill’s friendship and advice are highly valued by his clients and associates. We asked him to put the current financial crisis in context based upon his nearly two decades as a professional money manager, banker and economist. We spoke to Bill in his office in New York several weeks ago as the financial markets were tumbling.
The IRA: So Bill, you picked an interesting week to be back in New York. We actually started posting equity volatility numbers on our web site just for kicks. They are mostly in triple digits. How did we get into this mess?
Janeway: It took two generations of the best and the brightest who were mathematically quick and decided to address themselves to the issues of capital markets. They made it possible to create the greatest mountain of leverage that the world has ever seen. In my own way, I do track it back to the construction of the architecture of modern finance theory, all the way back to Harry Markowitz writing a thesis at the University of Chicago which Milton Friedman didn’t think was economics. He was later convinced to allow Markowitz to get his doctorate at the University of Chicago in 1950. Then we go on through the evolution of modern finance and the work that led to the Nobel prizes, Miller, Modigliani, Scholes and Merton. The core of this grand project was to reconstruct financial economics as a branch of physics. If we could treat the agents, the atoms of the markets, people buying and selling, as if they were molecules, we could apply the same differential equations to finance that describe the behavior of molecules. What that entails is to take as the raw material, time series data, prices and returns, and look at them as the observables generated by processes which are stationary. By this I mean that the distribution of observables, the distribution of prices, is stable over time. So you can look at the statistical attributes like volatility and correlation amongst them, above all liquidity, as stable and mathematically describable. So consequently, you could construct ways to hedge any position by means of a “replicating portfolio” whose statistics would offset the securities you started with. There is a really important book written by a professor at the University of Edinburgh named Donald MacKenzie. He is a sociologist of economics and he went into the field, onto the floor in Chicago and the trading rooms, to do his research. He interviewed everybody and wrote a great book called An Engine Not a Camera. It is an analytical history of the evolution of modern finance theory. Where the title comes from is that modern finance theory was not a camera to capture how the markets worked, but rather an engine to transform them.
Filed by The Editor on November 18th, 2008
In recent weeks, our mounting economic woes have sent financial experts, journalists, and average citizens running to the history books in search of clues about the causes and potential fixes for our present mess. Many are seeing disturbing parallels between today’s state of affairs and the period that preceded the Great Depression of the 1930s. Not surprisingly, the onset of the Great Depression provoked a similar spate of economic soul searching. A series of Atlantic articles published in the aftermath of the 1929 stock market crash captures that era’s collective grappling with the situation—and reflects a broad range of thinking on the future of our economy, politics, and society.
The following 
We all know of the extraordinary turbulence still roiling the world’s financial markets and the broader economy. The downturn is widely seen as the most serious in decades, and each day’s headlines remind us that heightened volatility and persisting uncertainty have become our new economic reality.
The 2008 U.S. Presidential election was historic itself owing to the candidates’ profile. But the timing of the elections as the U.S. and global economy are in the midst of the worst financial crisis and recession in decades reminds us of the Great Depression era and the 1980s recession when incoming Presidents Roosevelt and Reagan faced immense challenges to cure the economy’s woes.