How an equation contributed to the GFC

Ian Stewart is well known to anyone interested in mathematics - alongside Marcus du Sautoy, he is one of the great popularisers of the subject. His book, 17 Equations that Changed the World, lives up to its brief. Stewart not only gives insights into the mathematics of 17 disparate topics, but explains how they’ve affected our lives in ways we don’t see. I’ve read a number of books along similar lines, all commendable, but Stewart succeeds better than most in demonstrating how so-called pure mathematics has shaped the modern world that we all take for granted. (By all, I mean anyone who can read this via a computer and the internet.)

The book includes the usual suspects like Pythagoras, Newton, Maxwell, Einstein, Schrodinger and lesser known ones like Boltzman, Shannon, the Bell curve, chaos theory and the Fourier transform. In all cases he explains how they have affected what we loosely call civilization. But it is the last chapter in the book that covers the Black-Scholes equation, which is most relevant to the present state of the world, and what Stewart aptly coins ‘the Midas formula’. This is the Nobel-prize-winning formula that effectively created the GFC (global financial crisis).

I was lucky enough to see the movie, The Inside Job, which had a limited release in this country, but ran for well over a month in one art-house cinema in Melbourne, such was its morbid appeal. It’s a depressing yet illuminating film because, not only do you get a recent history lesson, but you realise that no one has learnt anything and it will happen all over again.

Stewart is a mathematician yet he explains the machinations that created the current economic catastrophe with remarkable clarity and erudition, and provides antecedents that teach us how we never learn from history.

Some quotable quotes:

The banks behave like one of those cartoon characters who wanders off the edge of a cliff, hovers in space until he looks down, and then plunges to the ground.

How did the biggest financial train wreck in human history come about? Arguably, one contributor was a mathematical equation.

He then goes on to explain what derivatives are and how they became monopoly money in the hands of the biggest financial institutions in the world.

As Stewart expounds:

In 1998 the international financial system traded roughly $100 trillion in derivatives. By 2007 this had grown to one quadrillion US dollars… To put this figure into context, the total value of all the products made by the world’s manufacturing industries, for the last thousand years, is about 100 trillion US dollars, adjusted for inflation. That’s one tenth of one year’s derivative trading.

Curiously, it was a mathematician, Mary Poovey, professor of humanities and director of the Institute for the Production of Knowledge at New York University, who rang alarm bells in August 2002, when she gave a lecture at the International Congress of Mathematicians in Beijing, titled ‘Can numbers ensure honesty?’ The lecture was subtitled ‘Unrealistic expectations and the US accounting scandal’.  She pointed out, amongst other things, that ‘by 1995 [the] economy of virtual money had overtaken the real economy of manufacturing.’ She argued that  ‘[this] deliberately confusing virtual and real money… was leading to a culture in which the values of both goods and financial instruments were… liable to explode or collapse at the click of a mouse.’ This, of course, was the year after the collapse of Enron, the biggest bankruptcy in American history (at the time) to the tune of $11 billion to shareholders.

Stewart’s major point is that people used the Black-Scholes equation routinely, with no appreciation of its dependence on key assumptions. Change the assumptions and the consequences could be dire as we have since witnessed world-wide. Its proliferation was guaranteed by its Nobel-prize-winning status and the simple fact that everyone else was using it. What’s more, it could be converted into a computer algorithm, ensuring its ubiquity.

Economics doesn’t follow natural laws like gravity, nevertheless I expect chaos theory could provide some insights. It’s the human factor that appears to be the element that people leave out or ignore. I’m not an economist – it’s the area I least understand – yet a mathematician can explain to me what went wrong in the past decade in a way that makes sense. If I can understand it, why can’t the people who run economies and financial institutions?

Stewart’s final comment:

The financial system is too complex to be run on human hunches and vague reasoning. It desperately needs more mathematics, not less. But it also needs to learn how to use mathematics intelligently, rather than as some kind of magical talisman.

Addendum 1: Stewart also explains how mathematics gives credibility to human-generated climate-change, although that’s another issue. In particular, he claims: Global warming was predicted in the 1950s, and the predicted temperature increase is in line with what has been observed.

Addendum 2 (6 Sep 2012): I've just seen the movie, Margin Call, a well-drawn fictional account of this issue, with some big-name actors: Kevin Spacey, Jeremy Irons, Demi Moore, Paul Bettany and Simon Baker, amongst others. There is a reference to this equation early in the film in a dialogue between the Demi Moore character and Simon Baker character, though its significance is not explained nor its title given. Demi's character says: 'I told you not to use that equation...' (or words to that effect) and Simon's character says: 'Everyone else is using it...' (or words to that effect). An intriguing piece of dialogue that only 'people-in-the-know' would pick up on.

Addendum 3 (3 Nov 2012): This interview with Greg Smith (formerly with Goldman Sachs) reveals the real story behind Wall Street, its culture, its hypocrisy (how it wants zero government interference in the good times and government bale-out in the bad times) and, most importantly, how nothing has changed since the GFC.

Addendum 4 (30 Jun 2013): I changed the title from 'Mathematics and the Real World'. I think it was misleading and the new title is more relevant to the discussion.