Legal Commentary

Matt Bodie wants to know whether I think "modern financial theory is more like the theory of evolution, Newtonian physics, or the Ptolemaic universe." (I was stumped by the Ptolemaic bit at first, but he explains it well.) Matt also figures that I'd probably say Newtonian physics?that is, it delivers a lot of useful answers, but it fails to explain a lot of important phenomena. Sounds about right.

This happens to be the parallel that people in academic finance prefer, too. So I do worry that maybe it's a little too generous. Modern finance and economics seem to be quite useful in answering small, focused questions. They don't do so well on big-picture stuff. That means somebody exclusively trained in mathematical finance or economics probably won't do a better job of predicting the course of the economy or the stock market than somebody with knowledge of history, politics, psychology, etc. Of course, a monkey throwing darts may outperform both?which would make the efficient markets guys happy. But models that make no room for business cycles or market bubbles maybe aren't the best models to use in trying to understand business cycles and market bubbles.

The most troubled aspect of modern financial theory is probably its approach to risk. Since the 1960s, the argument has been that while it's almost impossible to predict the future price of a stock or other financial instrument, it is possible to say something meaningful about the riskiness of that instrument (that is, the bounds within which that price will fluctuate). This is true, most of the time. It's just never true when it matters most?in times of crisis. And it's not just that financial risk models have a habit of failing to capture these fat-tailed risks. It's that the widespread adoption of risk-management techniques based on these models seems to bring on the very crises that invalidate those models. So in that aspect, modern financial theory seems worse than Ptolemaic. (Help me out here, people: what's a worse-than-Ptolemaic example from the history of science?)