<http://www.wired.com/techbiz/it/magazine/17-03/wp_quant>
As I've many times pointed out, Keynes claimed that:
"The vast majority of those who are concerned with the buying and selling of securities know almost nothing whatever about what they are doing. They do not possess even the rudiments of what is required for a valid judgment, and are the prey of hopes and fears easily aroused by transient events and as easily dispelled. This is one of the odd characteristics of the capitalist system under which we live, which, when we are dealing with the real world, is not to be overlooked." (Keynes, Collected Writings, vol. VI, p. 323)
In particular he claimed conventional forecasting methods were both mistaken and irrational.
He claimed this was also true of the treatment of expectations in "classical economic theory". In particular, this treatment was a psychological means of "hiding from ourselves how little we foresee" and, through this denial, escaping the intolerable anxiety conscious acknowledgement of such "uncertainty" would provoke.
"I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future." (Collected Writings, vol. XIV, p. 115)
The "pretty, polite techniques" were inapplicable mathematical and statistical techniques.
"it was, I think, an ingredient in the complacency of the nineteenth century that, in their philosophical reflections on human behaviour, they accepted an extraordinary contraption of the Benthamite School, by which all possible consequences of alternative courses of action were supposed to have attached to them, first a number expressing their comparative advantage, and secondly another number expressing the probability of their following from the course of action in question; so that multiplying together the numbers attached to all the possible consequences of a given action and adding the results, we could discover what to do. In this way a mythical system of probable knowledge was employed to reduce the future to the same calculable status as the present. No one has ever acted on this theory. But even today I believe that our thought is sometimes influenced by some such pseudo-rationalistic notions." (Collected Writings, vol. XIV, p. 124)
He associated the psychology involved with obsessional neurosis understood psychoanalytically. It was the link between this psychology and the mentality dominant in physics that made this mentality inappropriate for the study of economics.
This link is pointed to explicitly in his psycho-biographical essays on Newton, essays that attribute to Newton an extreme form of obsessional neurosis.
In his essay on Alfred Marshall, to whom he attributes a "profound" understanding of the limits placed on the use of mathematical and statistical methods by the nature of social phenomena, Keynes says, in a footnote to criticism of conventional uses of axiomatic deductive including mathematical reasoning in economics, that:
"Professor Planck, of Berlin, the famous originator of the Quantum Theory, once remarked to me that in early life he had thought of studying economics, but had found it too difficult! Professor Planck could easily master the whole corpus of mathematical economics in a few days. He did not mean that! But the amalgam of logic and intuition and the wide knowledge of the facts, most of which are not precise, which is required for economic interpretation in its highest form is, quite truly, overwhelmingly difficult for those whose gift mainly consists in the power to imagine and pursue to their furthest points the implications and prior conditions of comparatively simple facts which are known with a high degree of precision." (Collected Writings, vol. X, p. 186)
Elsewhere he associates the "foolish consistency" - axiomatic deductive arguments that end in "Bedlam" - to which this mentality, when applied to economics, leads with "sadistic Puritanism", i.e. with character traits expressing the same repression of instinct to which psychoanalysis traces obsessional neurosis. His favorite example here is Hayek.
Since Keynes, the obsessional mentality he claimed was a barrier to insight in economics has become even more dominant.
One indication of this is the development and coming into dominance of the absurd ("Bedlamite") "efficient market hypothesis" as the foundation of financial market theory.
In contrast to what Keynes claimed about the "extraordinary contraption of the Benthamite school", however, many individuals in financial markets have "acted on this theory".
In particular, the theory has played a very significant role in creating the financial market conditions that have issued in the current financial crisis.
Over on Pen-L, I recently pointed to a paper by Donald MacKenzie and Yuval Millo, "Constructing a Market, Performing Theory: The Historical Sociology of a Financial Derivatives Market", in the July 2003 issue of the American Journal of Sociology documenting the influence of economics, as represented initially by Malkiel, Quandt and Baumol and later by Black, Scholes and Merton, on the explosive growth of derivatives markets.
The article pointed to by Charles provides further confirmation of this role.
It is an account of how a "formula" - a "Gaussian copula function" - for measuring "default risk" developed by David Li influenced the growth of the CDS and CDO markets.
The "efficient market hypothesis" underpinned this formula; it was based on the "implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly."
"When the price of a credit default swap goes up, that indicates that default risk has risen. Li's breakthrough was that instead of waiting to assemble enough historical data about actual defaults, which are rare in the real world, he used historical prices from the CDS market. It's hard to build a historical model to predict Alice's or Britney's behavior, but anybody could see whether the price of credit default swaps on Britney tended to move in the same direction as that on Alice. If it did, then there was a strong correlation between Alice's and Britney's default risks, as priced by the market. Li wrote a model that used price rather than real-world default data as a shortcut (making an implicit assumption that financial markets in general, and CDS markets in particular, can price default risk correctly)."
According to the article, this had the following influence on the CDO market.
"The effect on the securitization market was electric. Armed with Li's formula, Wall Street's quants saw a new world of possibilities. And the first thing they did was start creating a huge number of brand-new triple-A securities. Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche —no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was.
"As a result, just about anything could be bundled and turned into a triple-A bond—corporate bonds, bank loans, mortgage-backed securities, whatever you liked. The consequent pools were often known as collateralized debt obligations, or CDOs. You could tranche that pool and create a triple-A security even if none of the components were themselves triple-A. You could even take lower-rated tranches of other CDOs, put them in a pool, and tranche them—an instrument known as a CDO-squared, which at that point was so far removed from any actual underlying bond or loan or mortgage that no one really had a clue what it included. But it didn't matter. All you needed was Li's copula function.
"The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.
"At the heart of it all was Li's formula. When you talk to market participants, they use words like beautiful, simple, and, most commonly, tractable. It could be applied anywhere, for anything, and was quickly adopted not only by banks packaging new bonds but also by traders and hedge funds dreaming up complex trades between those bonds.
"'The corporate CDO world relied almost exclusively on this copula- based correlation model,' says Darrell Duffie, a Stanford University finance professor who served on Moody's Academic Advisory Research Committee. The Gaussian copula soon became such a universally accepted part of the world's financial vocabulary that brokers started quoting prices for bond tranches based on their correlations. 'Correlation trading has spread through the psyche of the financial markets like a highly infectious thought virus,' wrote derivatives guru Janet Tavakoli in 2006. ...
"For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.
"His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.
"Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril."
Ted