Professor Charles Goodhart: more historians and fewer mathematicians and physicists in finance

On 22 January 2009, at a seminar in Warsaw, Poland, Professor Charles Goodhart (of the London School of Economics, ex-Chief Economic Advisor and External Member of the Monetary Policy Committee of the Bank of England) stated: “One of the lessons of the recent crisis, a lesson for bankers and for regulators, is, hire fewer mathematicians and physicist who build models on the basis of data that they can observe over relatively short period, and hire a few more historians who know what can go wrong even if they don’t necessarily have a good data basis to put into particular models”.

This is a kind of statement that shows either a complete lack of understanding of a speaker or is a smokescreen based on assumption of a lack of understanding of the audience, how the financial world is structured. This makes it easier to understand that this widespread ignorance made the current crisis was inevitable (i.e. deterministic with near 100% risk), the crisis is unlikely to go away anytime soon and that the history will repeat itself in the future anyway.

For years the British banking system has had a systemic problem that no one has dared to address thus far. It is an aberration, which has been widely discussed amongst mathematicians and physicists working or related to the City.

The financial products were created by mathematicians, physicists, quantum mechanics experts, engineers and so on. This is the kind of people that understood very well the products they were making, their limitations, associated risks, how these products affected one another (including effects on risks of events that were related to one another or independent). They were also creating products descriptions/manuals that contained all such information. But…

These products were traded on the markets by historians, philosophers, modern linguists, psychologists, lawyers, etc. A massive majority of them did not even have a faintest clue what they were dealing with. And their intuition was even worse: how can you explain to these professionals, art graduates, the characteristics of exponential function, issues resulting from Cobham Thesis or even basic principles of probability? Basically they were unable to understand product descriptions/manuals. (But they had “broader look”, “wider perspective”, i.e. precisely the capabilities that Professor Goodhart referred to. For example, when they were calculating a monthly interest rate from an annual one, they were dividing the latter by 12 rather than taking 12th degree root. They were justifying the correctness of such approach by stating that it was simpler [!!!] and that results were not that different. This is a bona fide example from Halifax.) But they loved financial products since these let them make a lot of money, and over-intellectualised names of these products made them feel as if they were geniuses. They did not realise, however, that, in fact, they had been building a gigantic global pyramid scheme. A great majority of financial institutions’ top executives (boards, senior advisors, etc) had similarly useless professional background. The whole situation looked as though a bunch of kids unable to read were given a lorry load of dynamite with an excellent instruction how to handle it. Is there any surprise that they eventually blown themselves up?

(Having written that, an allowance must be made that it is a precise but broad description of the mechanism. In terms of individuals there were some exceptions, e.g. historians who could understand science properly. Going further back in history: Louis de Broglie, a founder of quantum mechanics, was a… historian. Moreover it is almost certain that there were top decision makers, amongst them science graduates, who understood that they were engineering a pyramid akin to Albanian gangsters’ enterprise but far bigger in size. These are the real conscious engineers of the current crisis which was described as “the largest heist in history”.)

For years a lot of City mathematicians and physicists were privately laughing their socks off and were quite openly saying that the financial system would go bust. And soon. The word “nuts” was possibly the mildest adjective they used to refer to their trader colleagues and financial top executives. But very few believed in these warnings: money, status, lifestyle were too attractive to the beneficiaries of this conspicuously exuberant madness.

Returning to Professor Goodhart’s suggestion: the solution is actually the opposite. Mathematicians and physicists should be employed in banks but mainly in decision making roles. They are unlikely to build a pyramid. They are unlikely to be fooled by historians when it comes to finance. Professionals with no science capabilities should steer well clear of the financial system. Interest rates, NPV’s, compounded risk assessment, are not exactly a rocket science, but are well beyond their intellectual capabilities. They may have a role in PR, social policies, corporate responsibilities.

This is assuming that Professor Goodhart does not propose a return to a very traditional banking with the most sophisticated models calculated on fingers, with more diligent bankers using abacus (but only for addition as using it for multiplication is likely to be too challenging). One has to rule out using a slide rule, as a logarithmic scale and its applications will be well beyond their reach. There is nothing wrong with such an approach in principle, but soon India and China will leave us far behind.

Well, well, well… the British Prime Minister (and previously Chancellor of the Exchequer for years) that has presided over the current mess, Mr Gordon Brown, is a historian. Do we need more of this profession responsible for the financial system? It seems to me that Professor Goodhart’s lecture in Warsaw was not really his finest hour.

Incidentally, if anyone wonders upon the FT's coverage of the current crisis and why it is so devoid of data and models, so thin on financial substance, look no further than professional credentials/qualifications of the Editor, Mr Lionel Barber, or its “star” reporter on the subject, Ms Gillian Tett.

More reporting confirming the analysis above: “Recipe for Disaster: The Formula That Killed Wall Street”.