The mechanics of money

Let me start with an admission which is that I don’t read as much as is commonly believed. It’s just that I refer to books in my speeches which conveys the impression that I am reading almost every book that is being printed. (Printed? Yes. Not sure whether I will, or indeed will ever want to, get into the kindle mode). That is guff; the reality is much less flattering.

These days, I read much less than I should or I need to. I lived in Addis Ababa in Ethiopia for two years when I was in the World Bank; my family stayed back in India. After the job offer was made to me, my prospective manager took me out to the best Italian restaurant in town and marketed the job to me all through the dinner.

Best advice

As we were finishing, he asked, “Do you have any concerns?” I said, “All that you said about the job is very good, Fred. But, what do I do over the weekends?” His reply was one of the best pieces of advice I ever received: “Subba, think of all the books you wanted to, but could not read. Plunge into them.” That’s exactly what I did – for all of two years until I moved to Washington and all its distractions.

It is not that as Governor I don’t get the time to read. I do. But the time that I get is irregular – not the most conducive for book reading.

I keep telling myself that I must read for at least half an hour every day, but have failed so far. So, when I finish reading a book, it feels like a big accomplishment. It’s also comforting because I am at least trying to live up to the hype that the RBI Governor is a well-read person.

Finance is people

I’ve just finished reading The Physics of Wall Street by James O. Weatherall, a PhD in physics, and now an Assistant Professor of Philosophy in the University of California at Irvine. We all know that post-crisis, use of quantitative techniques in finance has come for a lot of harsh criticism, even ridicule.

The charge is that the so-called quants brought in sophisticated mathematical modelling to finance, ignored the limitations of the assumptions underlying their models and made predictions with beguiling precision, all of which encouraged excessive risk-taking and brought on the eventual meltdown.

Forgotten in this euphoria was the fact that finance deals with people, not physical objects. The laws governing financial markets are not immutable like the laws of physics.

The most high-profile, if also the most strident of such critics, has been Nassim Taleb ( Black Swans , Antifragility ) who argues that the world is just too random and any attempt to find a structure is futile, and any claim to finding one is hubris.

But there is another side to this debate. The use of quantitative techniques contributed enormously to the growth of the financial sector. The Black-Scholes options pricing model, for example, was more than a piece of geeky mathematics; it was transformational.

It ended the anti-intellectualism of American finance, demonstrated that a more scientific approach to speculation is possible and converted financial markets from bull rings to quantitative power houses.

Engrossing history

That story needed to be told and The Physics of Wall Street does that. But the book is more, indeed much more, than a spirited defence of the value that quantitative frameworks brought to the financial sector. It is an engrossing history of several mathematicians and physicists who made a foray into finance with their different mental constructs and tool-kits. Some of these transitions were serendipitous, others were more deliberate and structured – but all of them were interesting and fascinating.

The history that Weatherall tells starts much before Black-Scholes, actually with the French mathematician Louis Bachelier, and his 1900 paper which argued that stock prices capture all available information and move randomly.

This was in essence what later came to be formulated by the Chicago School as the efficient market hypothesis except that Bachelier didn’t call it that. In a just world, says the author, Bachelier would be to finance what Newton is to physics.

After taking us through the history of several other scientists who brought fresh thinking, concepts and techniques to finance, the book ends with a rallying cry by the author for an ‘Economics Manhattan Project’ calling on the advanced economies, particularly America, to invest intellectual and financial resources in an inter-disciplinary project with a lofty goal of generating ideas for making the financial sector an aid to real sector growth.

Making things happen

The use of quantitative techniques in finance has perforce to reckon with the quirks of human behaviour.

As TheEconomist asked some years ago, is a hurricane more likely to hit because more hurricane insurance has been written? Common sense says no. But in the financial world, that common sense does not hold.

The more financial insurance is written, the more likely that the insured event will occur because people who benefit from that contingency can make it happen.

Can mathematical models replicate complex human behaviour? If they can’t, are they any good at all? The book’s answer is that making simplifying assumptions in building models leads to solutions to problems that are otherwise intractable. But those solutions are valid only as long as the assumptions underlying the model hold.

The difference between physicists and finance professionals, according to the author, is that physicists are trained to ask: ‘When do the assumptions of my model fail and what happens then?’ The post-crisis response should then be not to shun quantitative modelling but to be conscious of the limitations of quantitative models. And, of course, to improve them to approximate reality as closely as possible.

(The author is RBI Governor. The article was originally published in RBI's house journal, Without Reserve.)

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