When Math Misleads

iStock_stock monitors.jpg
For complexity mavens, the current financial mess is a bonanza. If we set aside the painful crunch that is affecting so many, we might see that complexity is moving up in importance and acceptance. Complexity is a world view that argues that systems like the environment or the financial system are not describable or understandable by reductionist scientific methods. Sustainability is very closely related to such systems and their capability to provide health, security, beauty or, flourishing (the term I use in my book), far into the future under all sorts of changing conditions. The suddenness and huge scope of recent events has raised many question about the ability of conventional analysis to inform our key societal decisions.

Mainstream economists are, by and large, grounded in mathematics and use systems of equations to predict the future of economies. But a recent column in Resilience Science points to the failure of just these economists and their models to predict the crash and further implicates the use of mathematical financial risk models as setting up the conditions that led to it. The near bankruptcy of AIG exemplifies the dangers of ignoring complexity.

Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them. Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy. In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

The same column in Resilience Science quoted selections from another New York Times article on the economist Nouriel Roubini. Roubini has been uncannily close to predicting all the recent events, but for some time was mostly disregarded because he did not use mathematical models to ground his prognostications. Instead, he came to understand what was happening. Understanding is more than having a bigger computer and more equations linked together. It is rare, and should be respected rather than discounted simply because it does not follow the normal methodologies.

One final word. Without computers to run the endless calculations necessary to design the derivatives, this whole class of securities would have never seen the light of day. One might then say that the financial mess can be traced to a technology universally seen as beneficial. Ironic, perhaps, but not a valid claim. One can often pinpoint an event or part of the structure that acts as a trigger for a drastic change in a complex system, but it is always the whole web of relationships and interdependent parts that underlies its behavior. In this case one might say that economic systems use capital as food to keep them healthy. If they grow faster than the food supply grows, they will eventually lose resiliency and the ability to adapt to sudden perturbations. The explosion of derivatives using mythical capital though leveraging did exactly this.