How destructive financial theories are embedded in the system

One of the key reasons why the world went through a gut-wrenching period for much of 2008, when markets were frozen and economies and institutions were destroyed, was ironically the very theories from financial economics that supposedly help companies raise money cheaply and make markets more efficient. This book shows how.

Pablo Triana is a professor, successful derivatives trader and an acolyte of Nassim Taleb. Taleb has made it his mission to go after the orthodoxy in finance and economics which pretends to be able to mathematically model financial markets and ends up as a highly destructive influence again and again. Taleb has vigorously argued for abolishing the Nobel Prize for economics because, unlike those practising physics, medicine, chemistry, literature and even peace, professors of economics don’t really have to practise anything. They are good at spinning theories with a dozen impractical assumptions. And these theories happen to be extremely harmful. Triana provides an elaborate exposition of this line of argument.

He lays out the origins of the baneful financial theories and mathematical dicta that have come to acquire a vice-like grip on academia. He follows them into Wall Street firms which became eager employers of financial academics, creating attractive models to bet on the markets. In the process, Triana exposes the dirty little secret of the quant crowd: most of them don’t really do much research or modelling; they do computer coding!

A large part of the book is dedicated to highlighting the nasty aspects of the applications of various financial theories such as Gaussian Copula which was used by banks and rating agencies to arrive at the credit-worthiness of the toxic structured securities that were at the heart of the credit crisis. Then there is the famous Value at Risk (VaR) tool, employed by everybody and sponsored by regulators, which “always fails to measure risks even half-accurately and, worse, decisively encouraged and sanctioned the wild risk-taking that brought Wall Street (and consequently the world) down.” VaR has been actively promoted in India by the stock exchanges, mainly the National Stock Exchange, and has always accelerated a market crash as brokers rushed to sell investors’ shares in a falling market as the NSE raised margins sharply because VaR dictated so.

However, financial economists have never admitted that their theories have caused havoc. Even though markets have proved to be complex systems that are prone to fail ever so often, the theorists have persisted with their assumptions about the market being a rational and normal system. This makes another crisis perfectly possible.

Triana, like Taleb, advocates dumping mathematical decision-making for good, old-fashioned, commonsensical decision-making. But there is no chance that this will ever happen. The academic world is a sclerotic system where one writes papers to please one’s superiors and works the system to get a ‘tenure’ even if it perpetuates false beliefs and faulty knowledge. It will never turn against the orthodoxy that nurtures it. The practitioners, too, have a vested interest in ignoring that rare negative events are not so rare. They can take refuge under the ‘Who knew that there would be a crisis of such epic proportions?’ argument to explain their poor performance. This book is worth reading but the writing style is verbose and repetitive. It could have been cut by one-third.

Here is one of the most egregious examples which appears as the last sentence of the book: “Deliciously paradoxically, the Nobel could end up diminishing, not fortifying, the qualifications-blindness and self-enslavement to equations-led dictums that, fifth-columnist style, pave the path for our sacrifice at the altar of misplaced concreteness.” The other irritating aspect of the book is that it is peppered with comments that are unattributed. While some are sourced from insiders, many others simply hang there, italicised and within quotes.