Mad Math

The only viable response for a financial wizard whose been gulled is denial.

One can be gulled in a variety of ways. There’s the old fashioned con game in which the perpetrator knows he’s trying to cheat the mark out of his money. Then there’s the sincere gull in which a group of individuals convince themselves that a given methodology or approach is so sound that there are no alternatives.

It was the latter that snookered our financial wizards, and the methodology that suckered them in was the belief that risk could be mathematically predicted. According to Martin Hutchinson, the mathematical modeling was based on the mistaken assumption that market movements were random. Were this the case, then future movements of the market could be predicted using linear mathematical equations.

Unfortunate, it wasn’t true.

As Hutchinson points out, randomness only applies in situations in which “tiny variations cause a discrete change in results. Since tiny physical variations are themselves unpredictable, their results are truly random.” Examples are the fall of the ace of spades when the deck is shuffled or the drop of a ball on a roulette wheel.

That isn’t how the market behaves. Hutchinson tells us:

This true randomness almost never holds for economic activities. Some of them are governed by complex underlying equations, impossible for mediocre mathematicians to solve, which produce pseudo-random “chaotic” behavior, in which prices or other variables appear to move randomly but are in reality mostly determinate.

In other words, it is another classic example of fools trying to force the nonlinear movements of the market into linear equations that look good on a computer screen, but don’t tell you shit about what’s going to happen. (It was a situation similar to nineteenth century medicine’s belief in the curative power of magnets which, “draw off the noxious electrical fluid that lay at the foot of suffering.”)

It was a these mathematical models that led Bernanke to pronounce “the great moderation,” a utopian age in which risk had been brought under control, or so he said just before the economy entered “the great meltdown.”

Instead of randomness, chaos and the unknown drive the market, both of which don’t respond to linear, exponential or normal equations with which mathematicians are most familiar. Unknowns can never be expressed mathematically since mathematicians known none of the factors that go into them.

But, what the hell! When you’re dealing with guesswork, it makes your life a lot easier if you can justify your actions with a mathematical formula that is so complex it looks authoritative, even though it is dead wrong.

It is proprietary mathematical models such as these that the banks are using to market their toxic paper to model instead of to market. Of course their crap is worth sixty cents on the dollar, they tell us, because they have the mathematical models to prove it, even though you can’t see them because they are proprietary.

I must correct myself. The banks aren’t holding toxic paper; they’re holding toilet paper so gentle on our assholes we don’t even know we’re being reamed.

After all, numbers never lie. Do they?

--Case Wagenvoord