A Gathering Storm We Totally Missed

I think that it is by now pretty clear that there is no simple answer to the causes of the biggest financial crisis since the Great Depression. 

Plain, old-fashioned greed - that is, the pursuit of individual wealth, possessions and power - clearly played a major role.  So did the Wall Street's bonus system which practically encouraged its people to make risky investments so they can earn huge sums of money in a good year, without having to worry about the impact of their risky, short-term bets in subsequent years.

There is plenty of blame to go around: the management of the financial companies; the rating agencies; the regulators; the extreme anti-government ideology that prevailed in the US in the last several decades.  Our financial crisis is best seen as a systemic failure of massive proportions.

But, there is one group whose role in this systemic failure I personally find particularly troublesome: my own technical and research community.

The US technical community has never been shy about speaking out on issues we consider important to the national interest – be it energy and the environment; stem cell research; smoking and health; or the need for increased federal support for R&D and education.  We don’t mind, - perhaps rather enjoy, - berating companies and government alike when we strongly disagree with their actions.  It is a very important part of our system of checks and balances.

Many of our studies and reports are remarkably prescient in their observations and recommendations.  For example, in October of 2005, the National Academies released an excellent report, Rising Above the Gathering Storm, which succinctly summarized its findings by writing "Broad Federal Effort Urgently Needed to Create New, High-Quality Jobs for All Americans in the 21st Century," and made a number of concrete recommendations to do so.   

The report went on to say that “Without a major push to strengthen the foundations of America's competitiveness, the United States could soon lose its privileged position.  The ultimate goal is to create new, high-quality jobs for all citizens by developing new industries that stem from the ideas of exceptional scientists and engineers.”  It later recommended that “Each year, policy-makers should provide 25,000 new, competitive four-year undergraduate scholarships and 5,000 new graduate fellowships to U.S. citizens enrolled in physical science, life science, engineering, and mathematics programs at U.S. colleges and universities.”

But, as far as I can tell, we in the technical community were pretty quiet about the gathering financial storm that was rising all around us.  While correctly bemoaning the shortage of students in science and engineering, we have been sending some of our best and brightest math, physics, economics and finance students to become quants on Wall Street.  Without them, Wall Street could not have developed what Warren Buffet called financial weapons of mass destruction in the 2002 Bekshire Hathaway annual report, which ultimately led to the global financial meltdown.

What happened?  What caused our technical community to miss the looming financial crisis?  Why did we ignore the warnings of experts like Warren Buffet?  Why didn’t we at least commission a panel from the national academies or some other highly respected institution to investigate the problems and make recommendations, as we routinely do in so many areas?

And, how about our universities?  Over the last decade we have seen the rise of programs in financial math and financial engineering aimed at training young people for jobs in Wall Street and other financial institutions.  I understand that these programs were responding to the market demand for such skills.  But why didn’t the universities also pay attention to badly needed research and education in systemic risk?

Let me offer some personal observations.  To begin with, don’t blame the quants.  If you are a brilliant young scientist, engineer or mathematician, and you are offered a large starting salary on Wall Street with the potential to make lots more money in the future, how can you possibly resist? The quest for money and everything that goes with it is a powerful Darwinian force, something of an aphrodisiac.  Few of us would have been able to resist the siren song of riches coming from the financial institutions.

There is little question that we are truly undergoing a technology-driven transition of historic proportions from the industrial to the knowledge economy.  All our institutions must adapt to all the changes in the wake of this disruptive transition – including government, business and universities.  It takes time to adapt to disruptive changes and new environments.

Rising Above the Gathering Storm, the 2004 National Innovation Initiative and a number of other such reports have pointed out that we need massive innovation to tackle the new Grand Challenges of the 21st century.  This is both very complex and very new.  Most of our institutions, including many of our top universities and research labs, have not made the necessary adjustments to these new requirements.

Over the last hundred years we have made huge advances in our understanding of, and ability to work with ever more complex physical systems through science and engineering.  We are now beginning to apply IT, the Internet and related systems capabilities to people-oriented, services-centric, market-facing complex systems.  These complex organizatinal systems are different in nature from the physical systems we have so much experience with.  Their basic components are people, not things.  Complex organizational systems are thus highly unpredictable, full of fat tails, black swans, and highly improbable events - such as our financial meltdown.

What kinds of skills do we need to manage and make decisions in such a complex, unpredictable world?  The kind of hard, technical skills we associate with science and engineering are more important than ever, given that technology is increasingly permeating all aspects of business, society and our personal lives.  But, it is not enough for the quants to have such skills.  If managers and regulators are in the dark as to what the quants are doing and do not understand the implications of the products they are creating, our global crises will not only continue, but perhaps grow even worse.

At the same time, we need quants, - and scientists and engineers in general across society, - with significantly better so-called soft skills, who can better understand the impact of their actions and decisions on their companies, markets and people around them. 

For their part, universities need to break down the silos.  We have to re-invent engineering and science, as well as business and management education, to emphasize soft, people-centric skills as well as hard, quantitative skills.  To help us deal with the increasingly unpredictable world we find ourselves in, we need educational programs that combine the ability to deal with complex systems, complex markets and complex organizations.  People with such a mix of technical, business and people skills will be needed across society to help navigate the increasingly troubled waters that companies and nations will continue to encounter.

We did not do so well this time around.  Our technical and research communities failed to anticipate the current financial crisis.  Let’s use the moment as a wake-up call so we are better prepared for the next big ones.  The one thing we know for sure, is that such improbable, massive events will only keep coming at an ever faster pace in the future.

Comments

[Mickey]

Well, we techies are generally willing to help; but we suffer from the worry that we might be chastised for public participation. Either by the managers in the corporations we work for; or by the representatives of the governments that govern us; or by rich people with competing views of the world who might exploit the 'legal system' to force us to pay them all our cash, or to spend all our time defending ourselves.

All of those forces drive a 'coin-operated' mentality; pay me and I will deliver engineering advice.

That isn't necessarily good 'for the world'. Should there be a safety valve ?

I've deliberately posted this anonymously because I don't want any 'comeback'; the points need making, but I think they are fairly general and they are not intended to be disparaging of any particular corporation, government, or rich person.

[BiEr]

I recall working at Research when the community stood up and disagreed with management. We were simply told to look at Murray Hill to see where IBM Research was headed. A reduced focus on research and investment for the future.

Well we have arrived at your destination minus thousands of qualified individuals that one keeps hearing the need for in Scientist and Engineers. While you push for more H1 visas while laying off your own.

There is no need to look outside the windows of the North corridor to find you answer, it resides inside.

[Stuart Anderson]

The technical community have pointed out the inadequacy of the foundations of "financial math". For example, the very accessible account in: B. Mandelbrot and R.L. Hudson, The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin and Reward, Basic Books, New York (2004) (xxiv + 328 pp., ISBN 0-465-04355-0).

There are also many good examples of how earlier "highly improbable failures" (e.g. the failure in 1998 of Long-Term Capital Management - run by Nobel Economics Laureates) evoked an inadequate response from the Financial establishment. See, for example, Donald MacKenzie's very accessible article on the LTCM failure:
http://www.lrb.co.uk/v22/n08/mack01_.html

Both these authors are unusual - Mandelbrot is a "maverick" and MacKenzie works across disciplines - mathematics, sociology, history, economics. They, and many more, already work in the space you suggest we need to develop.

The technical community have been warning of the potential for catastrophic financial failure for at least a couple of decades - but the financial community weren't listening.