Locklin on science

The problem with financial journalism: journalists

Posted in finance journalism by Scott Locklin on March 22, 2009

I’ve always had a problem with journalists. It probably dates from a traumatic experience being photographed while in a compromising position by the High School newspaper editor, but then, the fact that they do that sort of thing is the root of the problem. Journalists don’t give a fig for the truth. Journalists as a group seem to have no interest in educating the public; their only apparent interest is gossip and scandal mongering. If the High School newspaper editor had taken a picture of me reading a book, or hanging with friends, or working on an engine, it would have been an accurate portrayal. Instead, she took a picture of me sleeping in class. That’s what journalists do. That’s what they’ve always done.

Today, let’s consider the gossip mongering in the Wired magazine article on finance that everyone has been passing around.

Loud headlines bleat: “Recipe for Disaster: The Formula That Killed Wall Street.”

The author, Felix Salmon, then proceeds to retell Frankenstein’s monster with the villain’s name changed to David X. Li. David X. Li is the scientist who brought the models associated with Gaussian Copulas to the pricing of CDOs. Salmon then proceeds to give a hand-wavy explanation of how these gizmoes work in Finance and the places in which they fail. The explanation is not at all fishy: I can’t fault him on his explanations, and may even praise him a little. What I fault him with is the idea that they had anything to do with anything. The entire story revolves around the premise that, had that arrogant Doctor Li not come up with his evil formula, our houses would have remained inflated in price, and our banking system would seem as rock solid and praiseworthy as it did in, say, 2006. This is so abysmally wrong, it makes my head spin. Yet, that’s what the reader is left with at the end of the article. The reader is flattered that he understands the basic concept of the impressive sounding words, “Gaussian Copulas.” The reader is further flattered by the idea that he is now among the enlightened: someone who knows much better than all those brainy quants, and the wealthy, arrogant bankers who are ruining the world. The reader’s self esteem so-boosted, he will smugly send it to, well, me, presumably expecting me to do something besides become annoyed. By the way, this is the formula for selling middlebrow “popular science” books. Flatter the reader that he is a smart monkey privy to the secrets of the universe; so much smarter and better informed than those people who actually work in the field. Popular science writers don’t sell actual popularizations of science like they did when Asimov used to write them; modern popular science writers now sell smugness. Modern upper middle class over-educated people love smugness, and use it as a sort of barter currency in social interactions with the fellow enlightened.

"Look how big my brain is!"

"Look how big my brain is!"

“look at my big brain!”

While this is the flawed modus operandi of science journalism, the real problem I have with Salmon is, he’s telling you a deceptive story. Why blame Li’s formula? The actual failure of his formula was that the use of the formula for correlation, which was more or less invented by Gauss. For that matter Gauss also discovered the Gaussian statistical distribution Li used in the copula approach. Why not get out the pitchforks and torches and disinter the conveniently teutonic Herr Doktor Professor Gauss from his tomb? Of course, Gauss is dead, and we need a convenient villain, so, enter the hapless fall guy done up as Dr. Frankenstein: Dr. Li. One can almost hear the music rising to a crescendo as it did at the sanctimonious end of 1930s horror movies, and the sepultural refrain, “the punishment that befell a mortal man who dared to emulate God…”"Last known photo of Dr. David X. Li at work"

“Last known photo of Dr. David X. Li at work”

The thing is, whatever the problems with the pricing model: the invention of the CDO isn’t the problem. The problem is, houses cost too much because money was too cheap. That’s the financial crisis in one line. It’s not any more complicated than that, and it has dozens of historical precedents you can examine where the same thing happened without the help of CDOs. Markets blow up from time to time, usually when money is cheap. It’s a form of self correcting inflation, I guess. There are scientists Felix Salmon could have talked to about this phenomenon. One of them, Didier Sornette understands them well enough he actually told all of us about the oil bubble and the housing bubble years before they popped. Sornette is a true scientific prophet; an actual financial Isaiah who called it properly, and for all the correct structural reasons. His research is interesting, original, relevant, and worthy of being trumpeted to the skies. Yet, I’m willing to bet most of you have never heard of him, because when reporters feed “finance” or “CDO” into google, his name doesn’t come up the way it does with Paul Wilmott. I hope to correct this in the future; Sornette is too important a thinker to labor in obscurity.

No mention of the present financial apocalypse should be made without referring to the previous financial disasters which it resembled. The Dutch weren’t ruined by Gaussian Copulas when they started pricing single tulip bulbs at more than entire households full of goods and livestock. Isaac Newton didn’t create equations which caused the South Sea Bubble. Nor did we need CDOs to get taken to the cleaners by the Florida Real Estate Craze of the 1920s. A 27 year old Scotchman named Charles Mackay wrote about this phenomenon in the mid-1800s. It isn’t something mysterious and new; volatility and bubbles are a feature of capitalism and life in general. Understanding the financial bubble is important, but talking about Gaussian Copulas doesn’t help anyone understand financial bubbles.

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one!”
“Money, again, has often been a cause of the delusion of the multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. “
-Charles Mackay

Whew, that made me feel a lot better. I’ll be fine until someone sends me another piece of nonsense by Nassim Taleb, at which point, as my favorite wrestler, the Iron Sheik likes to say, “I will make him humble; old country way.”



4 Responses

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  1. Andreas Yankopolus said, on March 31, 2009 at 8:38 pm

    “The problem is, houses cost too much because money was too cheap. ”

    To what extent do you think money becoming too cheap was due to banks trading MBS at 40:1 leverage? That provided the backing for a tremendous mortgage lending spree, which put a tremendous amount of money in circulation.

    • Scott Locklin said, on March 31, 2009 at 9:58 pm

      Well, it certainly helped inflate housing prices in NYC for a while. Mostly though, the leverage is what helped deflate the bubble. Banks were 12:1 until 2005 or so. It only took 2 years at insane leverages for the entire lot of them to explode. I blame the MBS itself for printing all the cheap money. As long as clowns in Germany and China would buy them, Mariachi band clowns here could buy houses they couldn’t afford. Since they were competing with people could afford houses, even though they don’t really have the money, houses cost more. I don’t have a good solution for this. I think MBS are a good idea. I just think people should think about pricing them a little better.

      When this is studied 100 years from now, it will probably be some kind of case study in how inflation works. Usually, houses are cheaper because it’s harder to get money to buy them.

  2. Kralizec said, on August 13, 2009 at 3:11 am

    I found your blog post because Felix Salmon, who certainly lives up to his first name, cheerfully provided a link to it in his own blog post of July 21, 2009. Here, you said, “The problem is, houses cost too much because money was too cheap. That’s the financial crisis in one line. It’s not any more complicated than that….” Did I not already have other information and some critical acumen of my own, I might have read your hand-wavy explanation and gone away flattered that I’m among the enlightened.

    Assuming that we know what it means for money to be too cheap, that we know when it is too cheap, and that on the given occasion it really was, we’re still faced with the circumstance that housing suffered a bubble this time, while tulip bulbs and companies trading in South America were more or less spared the insane run-up. We must also try to account for the circumstance that house prices didn’t rise at all uniformally across the United States, as one learns from even a little time spent examining the histories of the twenty cities in the Case-Shiller index. Moreover, in order to accept your opinion that “cheap money” was the cause of the housing bubble, we have to assume that hand-wavy quantitative financial analysts, complacent risk managers, authors of legal restrictions on land use, and supposedly powerful members of Congress such as Barney Frank and Chris Dodd are all actually non-causal. So I do think the matter is more complicated than that. Oddly, for one who is so sensitive to others’ simplifications, it appears you may even have made a habit of simplifying. Consider that in this same blog post, you gave us the formula for popular science-writing, then immediately allowed that Isaac Asimov had a much different way of going about it.

    • Scott Locklin said, on August 13, 2009 at 3:30 am

      I’m not real sensitive to over simplifications; I’m more sensitive to bullshit. Sure, things are more complicated than “money is too cheap,” however, that was the ultimate cause. Cheap money makes for inflation. It would be interesting to look at why inflation manifested itself in things like houses and market equity: probably this has much to do with who had access to the cheap money.

      Asimov, who has been dead for almost 20 years now, was a completely different beast, writing for completely different audience than modern “science” writers, who rarely write about science at all. He actually explained things, an idea which seems to be outdated somehow.

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