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'The Physics of Wall Street': The Most Arrogant Book in the World? Part 13

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How to fix the financial system.

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Editor's note: The following column is the 13th part of an ongoing series of articles by Aaron Brown examining the claims made in The Physics of Wall Street: A Brief History of Predicting the Unpredictable, a new book by James Owen Weatherall. Click here to read Part 1.

Physicist James Weatherall's The Physics of Wall Street contains what may be the greatest collection of errors about finance ever assembled in one book. Last week we looked at his fabulously overheated account of the quant equity crash of August 2007. This week we'll look at his solutions for it, and indeed, for all financial problems. It comes in three parts.

Weatherall's first solution is more regulation. This is curious because the largely unregulated quant equity crisis was over in three days with no bailouts, no bankruptcies, and no damage to the economy. The same underlying problem was hidden for months by large regulated financial institutions, every single one of which either failed or would have failed absent huge government bailouts, bailouts that may have bankrupted the governments of the world. It's not a question of good or bad regulation because every type of regulated institution in every developed country failed.

How did relative freedom from regulation help quant equity? First and perhaps most important, it meant quants were in charge rather than lawyers, regulators, or bank executives. Quants have their faults, but they deal in reality. When prices go down, they admit it, and take protective action. They have superstitions and ego like anyone else, but these are subordinated to reality. Regulated institutions deal in accounting and legal fictions that make things appear to be much less volatile and more predictable than they really are. Huge salaries to managers and huge power to bureaucrats and politicians can only be justified if they are able to predict and control events, at least a little bit. The pretense makes things seem safer and more solid most of the time, but when messy reality intrudes, the complex and expensive superstructure of regulated entities is far more fragile than the simple, robust hedge fund strategies run by quants.

Also, lack of regulation means hedge fund investors insist on sensible protections. The investors know the government isn't looking out for them, so they look out for themselves. Agreements are structured with the right incentives, accurate information is required, and business models are very transparent. Customers of regulated financial institutions are willing to deal with complex and opaque businesses run by people with murky incentives and little objective evidence of ability because they figure the regulators (in complex, opaque agencies and with murky incentives and even less objective evidence of ability) are making sure it's all safe.

This doesn't prove that all regulation is bad. My point is that comparing the quant equity crisis of August 2007 to the global regulated financial system meltdown that sprang from the same root causes (but is still unresolved) is a point in favor of less financial regulation, not more.

The second way Weatherall would prevent future financial crises is for everyone to think like physicists. He gives no details on how this mind control is to be effected. He actually does mean something by this, and it's not completely wrong. What is completely wrong, and staggeringly arrogant, is to think any one style of thought is better than diversity. There are times when you want a physicist in charge, and times when that would be a poor choice. But no one should want a World Council of Physicists to run everything.

It is Weatherall's third solution that wins him the all-time arrogance crown. He wants the government to pay him to study the problem and come up with solutions, in a "financial Manhattan project." At the end of the book, after explaining how stupid everyone in finance except Jim Simons is, he lets slip that he doesn't know any answers either. He's just sure that because he has a PhD in physics, he could figure them out with the help of massive government funding.

If he really believes this, I have a suggestion for him. People become billionaires with the ideas he finds incredibly stupid. His ideas should have no problem producing far more income than any government job will provide. So rather than wait for a subsidy from taxpayers, why not get started now? If he doesn't want the extra billions for himself, I'm sure he can find some good use for them. So start trading and either fix the world for everyone, or learn some humility. It's a win-win.

Or he could take another obvious route. The US government is uncounted trillions of dollars in debt, and not particularly knowledgeable about finance (some might say, "is spectacularly misinformed about finance," or even, "is defined by denial of financial reality"). But Jim Simons, Weatherall's hero, has a positive net worth in the neighborhood of $10 billion. Why not ask him for money to study finance? Surely Jim is in a position to appreciate the extraordinary good a physicist like Weatherall could do, and also he is an exceptionally generous guy.

But Simons has not attempted to fund a financial Manhattan project. Instead his two main charitable concerns are paying mathematicians to teach high school, and paying physicists to do physics. This seems to indicate a plan to train everyone to use math to figure stuff out for themselves, rather than to pay physicists to do math so they can tell everyone else what to do. The other inference we can draw from this is Jim thinks if there are useful insights from physics to apply to finance, they are best achieved by improving the state of physics knowledge. There will always be lots of people willing to make a profit translating physics discoveries into investing; there's no need to subsidize that.

Next week we'll examine the deeper lessons in the quant equity crash of August 2007.

Links to previous stories in this series: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, Part 8, Part 9, Part 10, Part 11, Part 12.
No positions in stocks mentioned.
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