Back in 1996, the economic historian Peter Bernstein published Against the Gods: The remarkable story of risk (Wiley & Sons). It won a heap of prizes and sold more than half a million copies — no mean feat for a book about mathematical history.
Its cover shows a ship being tossed by the waves. The message was simple: whereas once we used to be superstitious and pray for a successful outcome to risky ventures, now we can predict and mitigate risk with appropriate mathematical modelling — hence, against the gods.
How differently this book reads today. A year ago this week, Wall Street’s oldest bank, Lehman Brothers, collapsed, having leveraged itself 40 times over in the search for massive profits. The story can be told in many different ways. For some, it is a simple tale of greed and hubris. For some, it is about the failure of the regulatory system. But it is also a story of misplaced faith in mathematical modelling.
Bernstein’s book tells the story of how mathematicians set about understanding games of chance, working out probabilities, and eventually developing strategies to offset risk. In the 1970s, maths wonks at the University of Chicago applied their work to the stock market, showing how one risk could be offset against others.
Computers throughout the financial world came to operate a mathematical model known as VaR (value at risk), which balances risk across a portfolio, thus apparently controlling and minimising risk. With this sense of mathematical insurance, traders pitched into the casino with even greater enthusiasm. They felt untouchable. They had calculations to underwrite their punter’s instincts. The unknown mysteries of the market had been tamed.
But then it all crashed. The hedge-fund manager (and world-class poker-player) David Einhorn called it right when he described VaR as “an airbag that works all the time, except when you have a car accident”. Mr Einhorn began to short sell Lehman Brothers stock months before it collapsed. He made a fortune.
This side of the Lehman collapse, Bernstein’s faith in mathematical modelling looks little more than hubris. The unknown cannot be so easily tamed. Any half-decent theologian could have told him that.
Yet, as the sneering title of his book indicates, he believed that faith in numbers could replace the theologian’s respect for the unknown. It all seems so obvious now. But greed can easily blind people to common sense. The unknown cannot be made predictable by a sprinkling of mathematical abracadabras. Indeed, there is a word for that: superstition.
The Revd Dr Giles Fraser will be installed as Canon Chancellor of St Paul’s Cathedral at evensong on 24 September.