Reason & Financial Markets

1. The fact that the top students of science and mathematics have since the mid 1980s chosen a career in Wall Street finance and investment banking cannot be remarked upon enough. The danger of staking Western life on a debt-based financial system constructed upon the models of scientific men is just now coming into view.

2. The financial engineers have over the course of decades developed masterful innovations to extend and hide debt. They have at the same time endeavored to make the financial system reasonable and predictable. They have re-engineered the system basing it upon Reason, rather than upon men.*

3. By remaking the financial system as ‘systematic;’ subjecting it to, as well as structuring it upon, certain models--making it rational--the system is undermined and made fragile. The clear rationality and beauty of the model then justifies a significantly higher level of leverage. The crowd following the model continues to grow, with still more leverage applied. But with the growing crowd an even greater leverage is required to make the model profitable, and systematic risk is pushed to extreme levels (see the carry trade, LTCM, etc.).

4. Any human system that can be modeled, with a significant proportion of its systematic participants following those models, is a weakened system. Any tiny breakdown or failure is felt system-wide, particularly in overleveraged systems (the mortgage-backed securities market, MBS, for example, represented less than 3% of the GDP of the United States in 2008, yet the breakdown of this market nearly brought down the world’s financial system).

5. A system that does not hold up well under the scrutiny of Reason, is difficult to model, and that is opaque to many of its participants, is a strong system, not prone to failure. Within such a system crowd behavior will be limited along with leverage. Any market breakdown will be limited in scope among market participants, without far-ranging effects.

6. Crowd behavior as it pertains to the belief in the men of science and Reason has perhaps built up to its most dangerous level in the financial markets. Whereas the belief in Reason had formerly been contained to the sciences and mathematics--not affecting the daily lives of men in a significant way--its spread into finance--with the concomitant buildup of leverage based upon the models of financial engineers-- puts society as a whole at risk, with any breakdown felt by all men through the banking system and money supply.

7. With interest rates at the zero-bound it would appear that a 30+ year cycle of debt growth (Bernanke’s “Great Moderation”) has come to a close. It would seem that without the expansion of the debt base the financial markets will be less ably modeled, will be more human. Verily, a particular model has worked for a time, not because financial markets can be comprehended by a rational scientific approach, but predominately as a result of structural changes to the market (derivatives), pro-banking legislation (leverage increases, repeal of Glass-Steagall), pro-debt growth government subsidies (FNM, FRE among others), and the continuing assistance of the Federal Reserve in lowering rates and increasing the money supply. Now there are few new grand structural changes to be undertaken and interest rates can hardly be taken lower without disastrous inflationary consequences. The human component of the system, long marginalized as the models flourished and the financial system was made reasonable and ‘systematic’, is preparing its return. Irrationality, built up in the system over decades, is set to be released.

8. What sort of system-wide horrors are set to be unleashed as the models break down? Perhaps a period of irrationality and unpredictability in markets as long as the 30 year period of stability that proceeded it?

*Computer programs have replaced the day trader. I know. I myself was of the replaced. No human can process price data on a screen and act upon it with a click of a mouse faster than the trade execution of a computer program.

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