Dr. Strange-Economist or: How I Learned to Stop Worrying and Love Financial Models

Abstract

The unfolding global financial crisis is exposing financial economics and financial models to a growing legitimacy problem outside the ivory tower. Models utilized by bank risk managers, and ratings agencies are now often named as drivers of the housing bubble, the explosive growth in toxic structured financial products, and a general lack of preparedness for the brewing financial storm. The contemporary financial era, enshrined in the scribbles of academic theorists, business school curricula, arcane regulatory rules in Basle, and the risk management departments of banks, is one characterized by its continued exposure to what Hayek referred to as the Pretense of Knowledge. Noble prize-legitimated options pricing, Value-at- Risk (VaR), Gaussian Copulas, and other models that populate the academic literature and practitioner software packages all represent elegant financial modeling techniques that, in the minds of many, were considered “scientifically” corroborated and field tested by credentialed academic experts, sophisticated risk management teams, and gate-keeping regulators. Financial models and economic theory provide users with comfortable representations of an intelligible and manageable decision-making environment regardless of accumulating evidence of their failure, or consistent critique and warning from exceptional industry critics. Despite disastrous failure, the worldview enshrined in contemporary quantitative finance and its arsenal of pedigreed models is significantly institutionalized and not easily shaken off, much like any elaborate entrenched policy related belief system. Perversely, financial models designed to help mitigate risks generated a widespread belief that uncertainty could be tamed, risks mastered, and potential losses estimated with a precision that we might otherwise expect to see only in works of science fiction. This paper examines the political contours of practitioner adaptation of financial models and the consequences of model use in uncertain financial markets where models may not simply be ineffective, but instead outright dangerous to their users and to the public at large.