A Brave Army of Heretics -economicprincipals.com
For the last 125 years, however, ever since the views of Leon Walras and other theorists of general equilibrium became encoded in a famous textbook of Alfred Marshall (or, rather, partially encoded), technical economists have viewed the economy as a system in which individuals deal with one another only through the market mechanism, reacting to signals about prices and quantities as if they were determined by some central authority, best thought of as an auctioneer. Individual actors adapt as best they can to market signals which they are powerless to affect, until some sort of balance between supply and demand is achieved. Then things settle down and no individual has any reason to change his behavior, unless some external “shock” to the system occurs.
Prior to sub-prime implosion, the risk management techniques were derived from this same theoretical viewpoint on how people interact with one another in the markets. The theories were misguided and flat-out wrong. Real risk is far more complex. To complex, in fact, for the quants to get a handle on pushing pencils and punching numbers on their geeky HP calculators. So they chose instead to just ignore the risks they could not explain, or write formulas to manage. Misguided, unpracticed, collegiate theories. Same thing that happened to LTCM. They didn’t learn then and they aren’t learning now, because money managers making the same mistakes speculating in China and commodities, which is where they’ve got your pension tucked away, also safe and sound, yeah right.
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