Itís not the theory, stupid

Financial journalism in the past few months has been dominated by two catch-all phrases. For the less trendy, we have 'unprecedented', as seen in 'unprecedented crisis', 'unprecedented turmoil', 'unprecedented credit crunch' and such. Those with a taste for the slightly more exotic use the term 'black swan', as popularised by the best-selling author Nicholas Nassim Taleb (come to think of it, a black swan sighting would, in most parts of the known world, be unprecedented). Their argument, available in several variants, can be broken up into three main parts. First, economists with their theories failed to predict the oncoming crisis. Second, the size and scope of this crisis suggests that economists' macroeconomic and financial theories are plain wrong. Third, in this era of 'black swans', these theories must necessarily be jettisoned in favor of common sense and good judgment.

I would argue that our trigger happy friends are about half right. On the first part, I agree wholeheartedly. Clearly, almost no one saw this coming ó and the few who did were either drowned out by the eternal optimists, or had cried wolf often before. The latter claims have less weight to them. Admittedly, this crisis is the worst seen in over a generation. It isn't my preferred approach to reduce the job losses, bankruptcies, lost retirement savings and such to a collection of numbers, but even if one grants me that liberty, the numbers by themselves will be mind-numbing. The point to be made, however, is that at first brush, there appears to be nothing new occurring here. Sure, the instruments were new: raise your hands if you've heard the terms collateralized debt obligation (CDO) or credit default swap (CDS) as a result of this crisis. But the underlying story is the same old one. People got sloppy (and greedy), and as the rest of the world discovered the extent of the mess over the next few years, we lost confidence in our financial institutions, leading to the same bank runs seen in the roaring thirties. Even if the circumstances underlying it were unforeseen, the consequences were well within the realms of possibility.

The trouble is, economic theories are never (and I dare say cannot be) built to the same level of accuracy or robustness as engineering or physics. Economists on television mostly understand this, hence their predilection to predict either a time or an event, never both. The last few global economic crises: Black Monday in the 80's, the South East Asian crisis, the dot com boom and the current mess all root to the same basic fallacy-ópeople forgot their models were just models, not the real deal. Of course, once you've committed that mistake, and the model predicts a profitable strategy, you're tempted to magnify the strategy, in an attempt to get supercharged gains. The trouble with this perpetual money train is that if your model is even slightly wrong, your losses can be just as amplified. This particular incidence is not, in this author's opinion, a 'black swan' or even 'unprecedented', it's the same old story on a bigger scale.

At the end of the day, for all the mathematical wizardry and revered geniuses involved, theories are only as good as their assumptions. In the words of Nobel Laureate Roger Myerson, the usual 'garbage in, garbage out' caveat applies. The rumour mills buzz with stories about how mortgage backed securities were priced under the assumption that real estate prices will only go up, and how lenders tried to extrapolate the behavior of people with poor credit from the data on people with good credit. Bosses with an eye on the bottom line, and a poor understanding of the underlying products, scaled up so that the eventual problem went from a small glitch to a massive meltdown. Ratings agencies, by all appearances, bought into the models and rubber stamped them with their highest ratings. Swamped regulators went along, though it is hard to imagine how regulators can try and control trillions of dollars. Put together this unholy mix, and we find ourselves where we are today, a few missteps away from a return to the barter system.

However, I would argue that even this crisis does not justify jettisoning our theory of the markets. The same alchemy that over-reached to create these toxic products also helped corporates control risk and become more efficient. Tata's takeovers of Jaguar and Corus Steel that are so the pride of our media could well have been nigh impossible with the financial instruments available two decades ago. Our 25-odd billion dollars of FDI this year, which will create much needed jobs around the country, are possible in these scales because MNCs can hedge their currency risk with the tools available today. Glitches, anomalies and (even) crises should be seen as an opportunity to refine and improve our understanding, not as excuses to call for all previous foundations to be suspended. Till such enlightenment, I would submit that the only lessons to date from this crisis are ones the human race should have learned a long time ago: greed kills, poor oversight makes it worse and a little knowledge is a dangerous thing indeed.

The writer is a PhD candidate at the Kellogg School of Management, Northwestern University

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