Physics to Economics -- possible?

[sakky]

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Its really stretching it to say that the current crisis is caused by “dodgy models.”

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<p>Uh, what? Go and re-read the links in my previous posts. All of them blame the crisis on dodgy financial models. After all, why did the banks pile into mortgage-backed-securities and derivatives that only later turned out to be sketchy? Because their models told them that these were supposedly good bets. It is now a general consensus that the financial industry relied on poor models, hence causing the crash. If their models had actually been accurate, we wouldn’t be in the situation we are in. </p>

<p>Here are a few more:</p>

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Hundreds of hugely complex products based on hugely complex mathematic financial models were created and sold around the world—without first being tested out. There was little or no real-world iterative process. Commercial ankers, hedge fund managers and investment bankers didn’t know what would work or not work in a troubled economic environment, such as one where housing prices fell sharply. In fact, the complex financial instruments were supposed to spread and reduce risk. In the end, they did the opposite. In short, the innovation process was flawed. New inventions were not stress-tested in a real enviroment. </p>

<p>Second, the new financial products were flawed. They were opaque—not transparent. They were sold to investors who didn’t really know what they were buying. Instead, they relied on the rating agencies to tell them the value of the products—if they were AAA or BBB. But that didn’t work. The rating agenices had mathematical models that didn’t work in a period of sharply falling housing prices. In the end, no one really knew what the new products were worth. Worse, when trouble came, those who sold them didn’t know how to fix the products.

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<p>[Did</a> Innovation Cause The Crisis on Wall Street? - BusinessWeek](<a href=“Businessweek - Bloomberg”>Businessweek - Bloomberg)</p>

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To make matters worse, the financial models underpinning many of the most sophisticated new products were largely based on trading patterns from a more tranquil time, at least by historical standards.

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<p><a href=“http://www.nytimes.com/2008/09/20/business/20crisis.html?ref=business[/url]”>http://www.nytimes.com/2008/09/20/business/20crisis.html?ref=business&lt;/a&gt;&lt;/p&gt;

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Recent events have revealed that the methodology of Wall Street’s financial models used for valuing securitized assets is entirely broken. Furthermore, the credibility of rating companies on assigning ratings that assess ultimate payouts for mortgage-backed and asset-backed securities is also bankrupt.</p>

<p>Hence, in contrast to the potentially generous mark-to-model valuations that banks are currently using, it is anyone’s guess as to what the value of Level lll assets sitting on bank balance sheets are worth

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<p>[Asia</a> Times Online :: Asian news and current affairs](<a href=“http://www.atimes.com/atimes/Global_Economy/JI25Dj02.html]Asia”>http://www.atimes.com/atimes/Global_Economy/JI25Dj02.html)</p>

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Duration mis-matches are responsible for much of the failed financial models that led to the crisis

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<p><a href=“http://www.mortgageintroducer.com/mortgages/231845/219/Yesterday’s_news/You_can’t_solve_problems_you_don’t_understand.htm[/url]”>http://www.mortgageintroducer.com/mortgages/231845/219/Yesterday&#37;27s_news/You_can’t_solve_problems_you_don’t_understand.htm&lt;/a&gt;&lt;/p&gt;

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In any case, you seem to think that people only study economics for the sake of making money and have no real interest actually coming up with theories, which is just complete idiocy.

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<p>I never said that people only study economics for the sake of making money. Of course there are some people that want to try to figure out what is going on without actually trying to make money. Don’t put words in my mouth. </p>

<p>On the other hand, what is clearly inevitable is that somebody will try to use your ideas to make money. Maybe you will not personally try to use your own ideas. But somebody will try. Regardless, whoever ends up trying, the point is that economic modeling holds tremendous potential to damage the world, as we are seeing now. </p>

<p>Which gets to my central objection to what you have said. You seem to think that economics is a science, when the truth is, it is not. To be a science is to first make careful observations about the real world, ideally through controlled experiments, and only then do you devise potential hypotheses which may eventually be turned into a true scientific theory. That theory then is probed for predictions that are either confirmed or falsified through more experimentation. </p>

<p>But economics, and especially financial economics, doesn’t really do that. Since you invoked Black-Scholes, let’s use that as an example. What experimental data did the authors use to devise Black-Scholes? The fact is, they used none. They derived the Black-Scholes equation from initial assumptions in a purely deductive style similar to a mathematics proof. But that’s not scientific, because pure mathematics is not a science. Furthermore, has anybody used Black-Scholes to generate predictions which are then experimentally tested on the data to attempt to confirm or falsify? Again, no. Any real-world options prices that are found not to conform with Black-Scholes would be interpreted as a problem with those prices rather than a problem with Black-Scholes itself. In other words, nobody really knows whether Black-Scholes is true, and nobody really seems to be interested in finding out through experimentation. Black-Scholes, like other financial models, is now taken to be an axiom, and that’s clearly not scientific.</p>