Of market and math

Remember the neocons after the Iraq war went bad? Many long-standing critics of mainstream economics — they are getting a large audience now — are arguing that the financial crisis has placed economists close to the same position.

To be more specific, a subset of mainstream economics is in the dock. This subset, microeconomics, studies economic actions of individuals and firms in a market. The financial crisis, as should be obvious, is at one level an outcome of individual/firm market actions. There’s a macroeconomics (study of economic variables in the aggregate; Government spending, total private investment, central bank policy) aspect to the crisis, too. Questions like whether interest rates were too low or whether government policy helped misallocate credit are among the macroeconomic debates going on. But post-crisis, mainstream macroeconomics is not being charged with having a theoretical framework that’s “fundamentally useless”.

That description came recently from James Galbraith, well-known economist son of the hugely more famous John Kenneth Galbraith. Galbraith Jr was speaking for many who have a deep suspicion of microeconomics that, roughly put, loves market and math.

Most economists will dismiss his statement as being as wrong as it is strong. But that would be a sub-optimal strategy. True, the framework is not useless. It is extremely powerful, in fact. But these economists owe a few explanations.

Of the many questions being asked by serious people who aim to improve mainstream economics, two are critical. One question is on market, the other on math.

The Market Question. Everyone who has read something on the financial crisis knows that at the heart of it was widely distributed risk that came from widely distributed financial assets that were created — engineered — from simpler financial assets. Mainstream economics has provided brilliant theoretical proofs that distributing risks is a smart thing in a market.

The basic idea is that different people have different risk tolerances. Therefore, if some financial assets (say, bank loans) can be bundled and bits of it sold to buyers with varying appetite for risk, it will free the primary lender (the bank) from the obligation of carrying all the risk. So risk will be borne more efficiently and the bank’s ability to lend will increase.

Don’t sneer at this just because jokes about investment bankers outnumber jokes about lawyers today. Distributing risks is at the heart of such plain vanilla financial products like insurance or company shares. Issuing shares allows a company’s business risk to be spread widely between shareholders.

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CRASH OF 2008 by sanjiv on 2008-11-24 15:57:22.501299+05:30
Definition of Risk as Standrad Deviation around Mean, Beta, the EMH Concept in fact the foundation of Modern Finance has been repeatdely proven wrong over last 20-30 years. VaR, another holy mantra was criticised as a "single digit magic number produced by pioneers of pecuniary perils to mislead the senior management in believing that market risk is properly controlled" BLACK-SCHOLE-MERTON model the magic formulae for option valuation was proved to be a disaster within a year of its authors getting Nobel award. The mathematical disasters, weapons of mass destructions, toxic assets all are well documented and known facts. In spite of this historical perspective, the genius of Wall Street invited the disasters. Irrationality and herd mentality plagues not only the common folks but also the corporate honchos and double doctorate in Maths, Physics dominating the Wall Street.

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Of market and math by Rajaram B on 2008-11-24 11:30:00.103987+05:30
Well written- finally the innocent assumption that market plays straight and it is only a matter of assuming normal distribution with low standard deviation which did not prove to be right is right... but solution has to factor in correcting the asymmetrical information where the credit rating agencies should have been more honest while the bundling the risks for re-sale, will remain. It is a matter of honesty and integrity. So long as fees become important, both auditors and the credit rating agencies are liable to be seduced at one point or the other. The trick is to become cautious when some groups of people without creating real physical wealth or service , start becoming stinkingly rich, that is parasites' income falling outside the normal distribution curve for incomes, monitored stochastically, for rate of change, warning bells should ring that a Ponzi's game is on.

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