ttp://www.ritholtz.com/blog/2008/11/new-hope-for-financial-economics-interview-with-bill-janeway/
Link: New Hope for Financial Economics: Interview with Bill Janeway | The Big Picture.
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.
(....)
The IRA: And both regimes falsely assume that banks and dealers can actually construct a viable ratings methodology, even relying heavily on vendors and ratings firms. There are still some people at the BIS and the other central banks who believe that Basel II is viable and effective, but none of the risk practitioners with whom we work has anything but contempt for the whole framework. It reminds us of other utopian initiatives such as fair value accounting or affordable housing, everyone sells the vision but misses the pesky details that make it real! And the same religious fervor behind the application of physics to finance was behind the Basel II framework and complex structured assets.
Janeway: That’s my point. It was a kind of religious movement, a willed suspension of disbelief. If we say that the assumptions necessary to produce the mathematical models hold in the real world, namely that markets are efficient and complete, that agents are rational, that agents have access to all of the available data, and that they all share the same model for transforming that data into actionable information, and finally that this entire model is true, then at the end of the day, leverage should be infinite. Market efficiency should rise to the point where there isn’t any spread left to be captured. The fact that a half a percent unhedged swing in your balance sheet can render you insolvent, well it doesn’t fit with this entire constructed intellectual universe that goes back 50 years....
(((I remember when critics used these same harsh terms to diss
Communism. Maybe somebody should have given those physicists a big Supercollider to play with, to keep them out of trouble... let's see, for seven hundred bllion dollars you could probably have built seven of those.)))
