23 September 2008

Blame and Fixin's for the Financial Meltdown

An old Soviet joke goes like this.

Upon becoming Premier of the Soviet Union, Brezhnev finds two envelopes on top of his new desk. The handwriting on them is from his immediate predecessor, Krushchev. On the outside, one envelope says, "Open me during your first crisis." The other says, "OPen me during your second crisis."

In due time, Brezhnev faces his first crisis, opens the first envelope, and unfolds the paper inside. It reads simply, "Blame me." Naturally, Brezhnev takes the advice and weathers the crisis.

When his second crisis occurs, Brezhnev consults the second envelope. Inside it reads, "Prepare two envelopes..."

So now the world is in a deep financial crisis. There is plenty of blame to go around, and I'll let the usual pundits spread it. Here I note that quite a few physicists and mathematicians have got into analyzing the financial markets. They are the ones who invented all kinds of fancy and obscure classes of "derivative" investments, which are a big part of the current mess. They did it because they were being paid by investment houses to figure out how to make more money for them.

But there is something very big and very obvious (to a physicist) that they failed to do. I can prove it to you very simply. All you need do is go to Amazon.com and search inside the contents of Johannes Voit's The Statistical Mechanics of Financial Markets for the word, "stability."

You won't find it, because it's not there. Physicists, the people who can spend lifetimes studying the stability or instability of dynamical systems when perturbed by physical influences large and small, have largely neglected the stability or instability of financial systems.

Why? Because they were paid by investors, not regulators. All the while the investment houses were developing more intricate investments, the regulators were asleep at the wheel.

There are many things that must be done to stabilize the financial markets. Nationalizing parts of them and creating a US sovereign wealth fund may or may not be one of them. But surely, one of those things is for the regulators to hire physicists and mathematicians to understand what makes markets stable or unstable, and to help craft regulations to stabilize them.

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