This is a very interesting, though very complicated, article. I'd be lying if I said I understood everything in it. But while it, and the basics of the financial crisis, are hard to figure out, I believe it is important for people to try to understand what is going on and why it came about.
A year ago, it was hardly unthinkable that a math wizard like David X. Lee might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.
For five years, Li's formula, known as a Gaussia copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.
His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.
Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.David X. Li, it's safe to say, won't be getting that Nobel anytime soon.
There are a few different explanations and sources of information which I've found to be particularly enlightening on this subject.
First, the National Public Radio program "This American Life: The Giant Pool of Money" did a fantastic piece last May profiling a number of the people responsible for the crisis and the basics of contemporary finance. I already mentioned this program on my blog a couple weeks ago, but I believe the program is so good that it is worth bringing up again. The program can be heard for free here. I highly reccomend listening to this hour-long show for a thorough explanation of the financial collapse in layman's terms.
Second, the Public Broadcasting Services program "Frontline: Inside the Meltdown" profiled the collapse of Bear Stears, Lehman Brothers, and the fallout of those bankruptcies in a program that aired last week. The hour-long program can be watched for free on the internet here. This show helped me understand why and how the demise of Lehman Brothers nearly ruined the global economy a few months ago. It also does an excellent job of profiling the most important people trying to contain crisis: Hank Paulson, Ben Bernanke, and Tim Geithner.
Third, this short video from Jonathan Jarvis attempts to give a visual explanation of the credit crunch. If you have about eleven minutes free, this is worth watching:
The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.
And finally, I think that this article on "Complexity Theory" is insightful in explaining how a crash in our complex world was inevitable:
Although Complexity Theory says that our contemporary societies are doomed for collapse, I find something comforting in the idea. I don't think I'm sadistic or anything. Instead, I like how the theory highlights the absurdity that is life in today's world.
A discernible change is taking place in the forum of environmental awareness. As the subject matures and our insights deepen, specific concerns are now accompanied by a general uneasiness as leading philosophers and scientists begin to examine the structure of our modern civilization and question its viability. One of these new avenues of consideration is Complexity Theory.
Complexity Theory argues that societies become progressively more unstable and vulnerable as the network of interconnections within them increases -- not particularly good news for a globalizing system in which increasing complexity is precisely the thrust of economics, finance, manufacturing, technology and almost everything else we do. The sobering implications may explain why many proponents of Complexity Theory preface their comments with an apology. "We don't want to tell you this," goes the essence of their message, "but we think you should know."
When the New Scientist published two articles on Complexity Theory (Apr. 5/08), its editor anticipated some reader discomfort. "We are predisposed to pay attention to bad news," noted the editorial. "There is a good reason for this. We need to be warned of difficulty and danger so we can protect ourselves.... [But] if the warning is too scary or distressing, we attack the messenger as a doom monger."
Complexity Theory comes with its hint of doom, ominously reminding us that no civilization has ever survived the stresses of history, with the possible exception of China and Byzantium -- in a much reduced state for 450 years following the 15th century Arab invasions. But Sumer, Persia, Egypt, Greece, Maya and even Rome all collapsed, primarily because they succumbed to overwhelming complexities.
Joseph Tainter, writing in The Collapse of Complex Societies, explains why. "For the past 10,000 years, problem solving has produced increasing complexity in human societies" (Ibid.). Food production is a classical example. Each time people find the solution to a food shortage -- irrigation, fertilizer or plants with higher yields-- the population rises to meet the food supply and the next problem to solve is more complicated and challenging. Every solution adds extra levels of organization, complexity and interdependence, which adds inefficiency and diminishing returns for the total amount of energy expended.
Progress is a process of perpetual problem solving, with each new solution adding more specialists and more layers of peripheral tasks that don't directly address the problems being solved. A civilization finally peaks at its maximum level of complexity when all its efforts are being used just to maintain its equilibrium. Then an unusual adversity arises: invaders, crop failure, disease, climate change, depletion of a critical natural resource, or anything that stresses a structure already precariously balanced. Then the civilization collapses and reorganizes itself at a simpler level.
The lead on the David X. Lee article is great. When things were booming, the minds behind our world's complexity were destined for Nobel Prizes. Now, they're the objects of scorn to the millions upon millions of people who were burned by the interconnectedness they gave the world.