Did Nobel Prize work wreck financial markets?

On Oct. 14, 1997, the famous Black-Scholes-Merton option-pricing model was awarded what is typically known as the Nobel Prize in Economics. This was quite a puzzling development, for that date marked, almost to the day, the 10th anniversary of an event that had openly illustrated how flawed the model actually is and how drastically it can break down when applied to the real financial world. Option traders, the very ones who were supposed to have fallen irremediably in love with BSM, responded to the event by publicly rejecting the model´s main tenets. That is, by the time that the Royal Swedish Academy of Sciences decided to honor the model, BSM had, for 10 years, been widely discredited and amply shown not to work. Many may naturally wonder why such underperforming constructs should be worthy of such a coveted award. Plenty may marvel what those Swedes are up to.

Best-selling author Nassim Taleb, a veteran option trader himself, is one of those who wonders and marvels. He is actually urging investors to sue those responsible for the Nobel Prize in Economics. The charge? Taleb says that flawed mathematical models endowed with the “Nobel” played a decisive role in unleashing the 2007-08 credit crisis, and that without the Swedish stamp of approval no one would have taken those models seriously, thus preventing the carnage caused by their embracement. In case that none of the investors who lost big is willing to put on the gloves and take legal action, Taleb says that he is more than ready to sue those responsible himself. The key question, of course, becomes: Would he have a case?

He might. Admittedly, it may be hard to find legal justification for going against the awarding of a trophy to a financial theory that simply turns out to be mathematically ill-conceived. But the analysis takes a different turn once we consider that the real trouble with the failed finance theorems that boast the Nobel label is not so much that they are hopelessly unrealistic or impossibly misguided, but that, as Taleb aptly pronounces, they can have (and have had) a deleteriously harmful impact on markets, economies and societies. Bluntly stated, monstrous meltdowns that would almost surely not have happened otherwise took place precisely because the theories became widely used out there.

Going back to Black-Scholes-Merton, the model had a murderous rap sheet. The event mentioned at the beginning of this piece, and that served to unveil BSM´s structural deficiencies, was none other than the infamous Black Monday, the single largest oneday drop in Wall Street history experienced on Oct. 19, 1987. The main culprit behind the unprecedented setback (which saw the Dow Jones Industrial Average fall by almost 25 percent) was stock trading strategies directly inspired by BSM. So by the time BSM was given the Nobel, everybody knew that the model had the demonstrable capacity to ignite chaos, on top of having been abandoned by its supposed users, and disowned (and warned about) by the theoreticians who actually tried to apply it. Again, what were those Swedes thinking? How could they so carelessly neglect the evidence?

Just like the 1987 crash was caused by a flawed mathematical model, the 2007-08 butchery was aided and abetted by flawed, Nobel-endowed mathematical models. The theory in question is Modern Portfolio Theory (MPT). The transmission mechanism that crystallized MPT´s nefarious influence on the markets and the economy was the all-important Value at Risk (VaR) model. VaR, drinking from MPT, rests on the notions that financial returns follow a normal probability distribution, that past volatility is a reliable measure of risk, and that diversification based on past correlations is a reliable way to reduce risks. Those three basic notions typically break down miserably in reality, and should have been doubted from the get-go, not gloriously honored.

While MPT got its Nobel in 1990, before VaR had caused any troubles, the model was a decisive factor behind the bloody September 1998 market crisis that threatened the system. Had the Swedes issued a loud statement of contrition following said disaster, VaR may have been abandoned by bankers and regulators, and the latest catastrophe might have been prevented as a result. But the Swedes kept quiet.

Such neglectfulness is the foundation on which a suit might be successfully built. When theories that, on top of being foundationally flawed and unworldly, had: a) demonstrably caused mayhem before, and b) clearly contained the seeds for future mayhem get awarded the Nobel nonetheless, that´s when you realize that the possibility that someone may contact a lawyer in order to bring the Swedes to task ceases to sound entirely lunatic, and begins to look at least half-plausible.