Robert Merton, Jr., and Myron Scholes were founding partners in the large speculative trading firm called Long-Term Capital Management, or LTCM, which I mentioned in Chapter 4. It was a collection of people with top-notch résumés, from the highest ranks of academia. They were considered geniuses. The ideas of portfolio theory inspired their risk management of possible outcomes—thanks to their sophisticated “calculations.” They managed to enlarge the ludic fallacy to industrial proportions.

Then, during the summer of 1998, a combination of large events, triggered by a Russian financial crisis, took place that lay outside their models. It was a Black Swan. LTCM went bust and almost took down the entire financial system with it, as the exposures were massive.

Since their models ruled out the possibility of large deviations, they allowed themselves to take a monstrous amount of risk. The ideas of Merton and Scholes, as well as those of Modern Portfolio Theory, were starting to go bust. The magnitude of the losses was spectacular, too spectacular to allow us to ignore the intellectual comedy. Many friends and I thought that the portfolio theorists would suffer the fate of tobacco companies: they were endangering people’s savings and would soon be brought to account for the consequences of their Gaussian-inspired methods.

None of that happened.

Instead, MBAs in business schools went on learning portfolio theory. And the option formula went on bearing the name Black-Scholes-Merton, instead of reverting to its true owners, Louis Bachelier, Ed Thorp, and others.
How to “Prove” Things

Merton the younger is a representative of the school of neoclassical economics, which, as we have seen with LTCM, represents most powerfully the dangers of Platonified knowledge.

Looking at his methodology, I see the following pattern. He starts with rigidly Platonic assumptions, completely unrealistic—such as the Gaussian probabilities, along with many more equally disturbing ones. Then he generates “theorems” and “proofs” from these. The math is tight and elegant. The theorems are compatible with other theorems from Modern Portfolio Theory, themselves compatible with still other theorems, building a grand theory of how people consume, save, face uncertainty, spend, and project the future. He assumes that we know the likelihood of events. The beastly word equilibrium is always present. But the whole edifice is like a game that is entirely closed, like Monopoly with all of its rules.

A scholar who applies such methodology resembles Locke’s definition of a madman: someone “reasoning correctly from erroneous premises.”

Now, elegant mathematics has this property: it is perfectly right, not 99 percent so. This property appeals to mechanistic minds who do not want to deal with ambiguities. Unfortunately you have to cheat somewhere to make the world fit perfect mathematics; and you have to fudge your assumptions somewhere. We have seen with the Hardy quote that professional “pure” mathematicians, however, are as honest as they come.

So where matters get confusing is when someone like Merton tries to be mathematical and airtight rather than focus on fitness to reality.

This is where you learn from the minds of military people and those who have responsibilities in security. They do not care about “perfect” ludic reasoning; they want realistic ecological assumptions. In the end, they care about lives.

I mentioned in Chapter 11 how those who started the game of “formal thinking,” by manufacturing phony premises in order to generate “rigorous” theories, were Paul Samuelson, Merton’s tutor, and, in the United Kingdom, John Hicks. These two wrecked the ideas of John Maynard Keynes, which they tried to formalize (Keynes was interested in uncertainty, and complained about the mind-closing certainties induced by models). Other participants in the formal thinking venture were Kenneth Arrow and Gerard Debreu. All four were Nobeled. All four were in a delusional state under the effect of mathematics—what Dieudonné called “the music of reason,” and what I call Locke’s madness. All of them can be safely accused of having invented an imaginary world, one that lent itself to their mathematics. The insightful scholar Martin Shubik, who held that the degree of excessive abstraction of these models, a few steps beyond necessity, makes them totally unusable, found himself ostracized, a common fate for dissenters.

If you question what they do, as I did with Merton Jr., they will ask for “tight proof.” So they set the rules of the game, and you need to play by them. Coming from a practitioner background in which the principal asset is being able to work with messy, but empirically acceptable, mathematics, I cannot accept a pretense of science. I much prefer a sophisticated craft, focused on tricks, to a failed science looking for certainties. Or could these neoclassical model builders be doing something worse? Could it be that they are involved in what Bishop Huet calls the manufacturing of certainties?

Let us see.

Skeptical empiricism advocates the opposite method. I care about the premises more than the theories, and I want to minimize reliance on theories, stay light on my feet, and reduce my surprises. I want to be broadly right rather than precisely wrong. Elegance in the theories is often indicative of Platonicity and weakness—it invites you to seek elegance for elegance’s sake. A theory is like medicine (or government): often useless, sometimes necessary, always self-serving, and on occasion lethal. So it needs to be used with care, moderation, and close adult supervision.



The Black Swan



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