Doug French

There's plenty of blame for the financial crisis being spread around. Those on the left say Wall Street wasn't regulated enough, while those on the right claim government mandates required lenders to make bad loans. The argument is made that the Federal Reserve was too loose, while the other side says Bernanke wasn't loose enough. Some blame greed. Others blame Wall Street's investment products. And then there's mathematics.

Wall Street has become a numbers game played at high speed by powerful computers trading complex derivatives utilizing even more complex mathematical modeling. Writing for the Huffington Post, Théo Le Bret asks the reader to

Take the Black-Scholes equation, used to estimate the value of a derivative: it is actually no more than a partial differential equation of the financial derivative's value, as a function of four variables, including time and "volatility" of the underlying asset (the derivative being a 'bet' on the future value of the asset). Differential equations are well-known to physicists, since such fundamental properties of nature as the wave equation or Schrodinger's equation for quantum mechanics are given in the form of differential equations, and in physics their solutions seem to be very reliable: so why is this not always the case in finance?

Mr. Le Bret quotes Albert Einstein for his answer: "as far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality."

Murray Rothbard put it another way:

In physics, the facts of nature are given to us. They may be broken down into their simple elements in the laboratory and their movements observed. On the other hand, we do not know the laws explaining the movements of physical particles; they are unmotivated.

Rothbard goes on to make the point that human action is motivated and thus economics is built on the basis of axioms. We can then deduce laws from these axioms, but, as Rothbard explains, "there are no simple elements of 'facts' in human action; the events of history are complex phenomena, which cannot 'test' anything."

Using the models that work so well for physicists, mathematicians on Wall Street got it spectacularly wrong in the mortgage and derivatives markets, just as mathematical economists can never predict the future with any accuracy. Motivated human behavior cannot be modeled.


Doug French

Doug French is is president of the Mises Institute and author of Early Speculative Bubbles & Increases in the Money Supply and Walk Away: The Rise and Fall of the Home-Ownership Myth

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