Wednesday, April 1, 2009

The economic Pandora’s Box

pandora box In Greek mythology, Pandora’s Box was a large jar given to her by Zeus, along with instructions to keep it closed.  However, because Zeus had also endowed her with curiosity, she opened the box, releasing misfortune, disease, and burdensome labor into the world where it had not previously been known.  At the bottom of the box, though, was hope: belief that, in the end and despite adversity, what is wanted can be had and that events will turn out for the best.

This is the earliest instance of a recurring belief that, when curiosity couples with ignorance, mankind can inadvertently release evil into the world.  Thus, there are ‘forbidden secrets of nature’ that, if tampered with, can escape control to destroy their human creator and wreck havoc on the world. 

The popular worry remains that scientists will release mutants through gene manipulation or create black holes in accelerators.  However, there aren’t any actual scientific antecedents, just apocryphal stories like Shelly’s Frankenstein, Goethe’s The Sorcerer’s Apprentice, or Shakespeare's The Tempest.

Rather, to find a real-world example of Pandora’s Box, one has to look to the free markets.

I have been reading My Life as a Quant, an autobiography by physicist Emanuel Derman describing his work at Goldman Sachs to create financial models used to value options and predict derivative prices.

imageIt’s all very empirical.  He created statistical models of past trends, rationalized assumptions about  underlying factors that might drive trading psychology, and validated on limited independent samples.  There’s never a deep understanding of the equations beyond the fact that they correlate well with his data sets.

Despite this lack of understanding, Goldman rushed to capitalize on the equations and other firms built on the work.  It became a self-reinforcing delusion that they had insight and control over their creations. 

Sutton (2007) points out that social science theories become more accurate as they become more accepted because people act as though they are true.  Black Sholes pricing models didn’t predict options prices well at first, but as the theory became widely adopted, it fit people’s behavior better and better.

imageIt’s ironic that conservatives waged war on scientists and tried to limit work that they saw as potentially dangerous, yet gave the financial markets unlimited freedom to tamper.  Scientists self-censored, limiting research into genetic modification until experimental safeguards were created, but free-market capitalists set no limits or safeguards around their work.

The G-20 are now recognizing that there are “Pandora’s Box” risks associated with the economic sciences.  They are talking about regulations to set limits and to increase oversight, much as the Bush White House did with stem cells and climate change monitoring.

In truth, as natural scientists, we often pause to ask whether, just because we can do something, should we do it.

And, in truth, the financial scientists never did.


Textual Healer said...

Love this blog. Truth is many alpha scientits moved to working in the banking sector because they could add one if not two 0s to their incomes and left their morals and scientific ethics behind. Greed drove this collapse

Dave Hampton said...

You made my day (and then some), thanks!