- Sophisticated models used by investment firms to calculate risk contributed to the market crash of 2008.
- Despite their ubiquity, these risk models fail to take into account important forces that affect the market.
- Researchers are building ways to work around these limitations and prevent a repeat market crash.
- Yet these strategies may limit profits, making it unlikely that banks will adopt them without being forced to do so.
The market crash of 2008 that plunged the world into the economic recession from which it is still reeling had many causes. One of them was mathematics. Financial investment firms had developed such complex ways of investing their clients’ money that they came to rely on arcane formulas to judge the risks they were taking on. Yet as we learned so painfully three years ago, those formulas, or models, are only pale reflections of the real world, and sometimes they can be woefully misleading.
The financial world is not alone, of course, in depending on mathematical models that aren’t always reliable for decision-making guidance. Scientists struggle with models in many fields—including climate science, coastal erosion and nuclear safety—in which the phenomena they describe are very complex, or information is hard to come by, or, as is the case with financial models, both. But in no area of human activity is so much faith placed in such flimsy science as finance.
This article was originally published with the title A Formula for Economic Calamity.