Undercover Economist

April 5, 2013 6:26 pm

Rich pickings for scientists

Should we feel queasy about the growth of abstract, deeply technical thinking in finance?
illustration by Raymond Biesinger of a framed diploma©Raymond Biesinger

Amidst all the glories of belle époque Paris, the troubles of an aspiring physicist can’t have amounted to much. In 1888, Louis Bachelier had graduated from school with excellent grades and high hopes of studying at the elite grandes écoles – until both his parents died suddenly, leaving Louis responsible for his sister and his three-year-old brother. He ran the family wine business for a while, was drafted into the army, and by the time he extricated himself from that and sold up, he was too old to do anything but study at the less-prestigious University of Paris. With his siblings to support, his study of physics had to be nocturnal. By day, he worked at the Paris Bourse.

Bachelier’s enthusiasm for physics quickly spilled over into finance, and he began to ponder the processes that governed the price of government bonds. He developed the idea of the random walk; he wrote up his ideas and defended a dissertation on the physics of financial speculation. He was almost laughed out of academia, and only secured a PhD at all with the help of a powerful mentor, Henri Poincaré.

Bachelier was ahead of his time even as a physicist. His research anticipated by five years a hugely important paper on Brownian motion by a young chap called Albert Einstein. But as a financial thinker, he was more than half a century ahead of the curve. His early research was discovered by the mathematician Leonard Savage and economist Paul Samuelson in 1955, a decade after Bachelier died. The first person to improve upon his ideas was arguably the physicist Maury Osborne, fully 59 years after their publication.

The sad story of Bachelier is told in an excellent new book, The Physics of Wall Street, by James Owen Weatherall. The role of physicists in finance is now a commonplace, even if financial physics is, like its founder, not quite academically respectable. But modern financial physicists – the “quants” – differ from Bachelier in one respect: some of them have made an awful lot of money. The most successful is Jim Simons. He was once a serious player in the high physics of string theory. Now, as founder of Renaissance Technologies and its flagship Medallion fund, he is one of the richest men on the planet.

Should we feel queasy about the growth of abstract, deeply technical thinking in finance? Weatherall is a cheerleader. For one thing, he says, Medallion returned more than 70 per cent in 2007 and 80 per cent in 2008. That proves quantitative finance can be privately profitable –but not that it is profitable in general, or socially desirable.

A more convincing defence of financial physics, and the sophisticated statistical analysis it deploys, is that it provides fresh perspective, revealing patterns that had been missed. A famous example is Didier Sornette’s use of stress analysis to predict not only earthquakes and failures of pressurised fuel tanks, but also severe crises in financial markets.

Still, physics alone will not be enough. Understanding the financial crisis, or the economy itself, should be a multidisciplinary effort. Unpicking the flaws behind stinky structured finance products required somebody to take an interest in messy real-world details. No purely academic approach would have delivered that.

Unfortunately multidisciplinary work remains difficult. Even the physicists have trouble being taken seriously by economists, despite the latter’s respect for mathematical sophistication. As for psychologists, sociologists, anthropologists … It’s a tough thing for any self-respecting economist to swallow advice from disciplines that appear to deploy such vague theories.

Still, nothing concentrates the mind like the potential to make money. And nothing fosters interdisciplinary work like a problem that scorns boundaries. Finance offers both the problem and the potential. Watch this space.

Tim Harford is the presenter of Radio 4’s ‘More or Less’

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