The rules of theoretical physics

The New Yorker has a discussion of new books by Lee Smolin and Peter Woit here. Both authors discuss the problem with String Theory - that it isn't a theory at all, in the conventional scientific sense of making predictions that, if false, disprove the theory.

Both authors suggest part of the problem is that the game of physics is currently set up to reward mathematical dexterity over physical veracity, so we have a generation of theoretical physicists growing up who are fabulous mathematicans but who have no incentive to produce better physical theories. Of course once a community gets established and so acquires some power, this becomes self-perpetuating. They define physics as what they do, despite the evidence to the contrary.

(I'm not saying this is bad work, academically, and neither are Smolin or Woit: just that it is not science because it isn't falsifiable. One should never underestimate the ingenuity of the experimentalists, so perhaps one day some of these theories will be testable, but no one appears to have any idea how to do that today.)

This, then, is a great example of a game labouring under an unhelpful historical precedent. Particle physics used to be over-funded partly because it was glamourous science (a theory of everything my arse - a theory of everything that matters to a small number of theoretical physicists more like) and partly because it was seen as useful for building bigger bombs. Now we don't need bigger bombs and particle physics hasn't had much to say about the Universe since the neutrino mass debacle of 1985 or so. So maybe it's time for the rest of physics - all those people doing useful and interesting atmospheric, solid state, and statistical* physics - to rise up against the particle people and take some of their funding. Because, in science as in finance, that is one way of keeping score.

*Quantum computation is looking seriously interesting at the moment...

The utility of complexity

A recent article in Salon (watching an ad required to enter) nicely captures one of the preoccupations of this blog. It begins with a discussion of an essay by Devesh Kapur, The Knowledge Bank. Paraphrasing slightly, Kapur suggests that economic consultants are not primarily motivated by finding successful outcomes:

The very nature of academia means that researchers [...] are not accountable for the consequences [of their work] in the sense that it responds to professional incentives, not to development payoffs. These professional incentives place a large positive premium in academic papers on the novelty of ideas, methodological innovation, generalizability and parsimonious explanations. Detailed country and sector knowledge, an acknowledgment that the ideas may be sensible but not especially novel, that uncertainty and complexity rather than parsimony are perhaps the ground reality, are all poor country-cousins of research that purports to find universal truths.

Kapur is talking about the social sciences in general and developmental economics in particular, but the conclusions hold much more broadly. As Salon says:

One of the clearest fault-lines in economic debates [...] is between those who believe they know one answer that fits all questions, and those who believe every question deserves a different answer -- that what works for Singapore may not work for Somalia, that the circumstances of Bangladesh require a different approach than the conditions of Brazil. It's a fault-line that transcends ideological differences between right and left, free trader and protectionist. On one side, a willingness to accept complexity and uncertainty also concedes that one may not know what the answer to a given question is; on the other, the rightness of the answer is taken as a given, and it's the implementation that must be at fault; it's never "I don't know" and always "how did you screw it up?"

This is a lovely summary of a ubiquitous fallacy: just because we sometimes have to pretend that the world is simple to get on doesn't mean we have to believe it. Incrementalism -- trying something you think might work, seeing what happens, and adjusting your strategy based on the outcome -- is surely the only rational response to a complex, partially comprehended reality. Bangladesh is different from Brazil, and 2006 Britain from 1990 Britain, for that matter. Yesterday's remedies might work, but we should approach their application with a suitable sense of humility.

Multi-factor interest rate models

There are at least three things that make interest rate derivative modelling really hard. It has all the problems of equity derivative modelling, including dealing with the volatility surface,--and data for out of the money implieds isn't often plentiful. It concerns a curve rather than a single underlying, and there are various obvious constraints, like non-negative (forward) Libors. Lastly, there are two calibration instruments, caps and swaptions, which often seem not wholly compatible.

Which problems people have chosen to work on is always insightful. The game of theory building, at least in academia, rewards complete less descriptive models more highly than insightful model fragments. Thus there has been a lot of work on models which use ever more refined processes for the short rate, and quite a lot on stochastic models of the full curve under a few (typically at most 3) sources of uncertainty. Stochastic and to a lesser extent local volatility models are catching up fast, so we are starting to see Libor Market Models - that is models where the variables are the forward Libors under a suitable numeraire - with stochastic volatility.

But it strikes me that this may be an example of where setting up the rules so you have to have a model that actually prices something before you can publish is holding us back. We do not need yet another Brownian style coupled spot process and vol process model, Markovian or otherwise. What we need is some fresh thinking about the sources of uncertainty in interest rates beyond one variable for level, the second for tilt and the third for curvature.

For instance, just to throw something in, suppose we have stochastic variables for each caplet where the next maturity caplet mean reverts to the level of the last one, with progressively increasing mean reversion constants.

Thus we start with a standard CIR model of the short rate

dr = (e - g r) dt + s r^a dW

Where a is often 1/2, and generalise this to processes for each forward Libor r_i

dr_i = (f_i - g_i r_i) dt + s_i r_i^a dW_i

Here the terms g_i are constant; f_i = e_i r_{i-1} for constant e_i, so that the i+1 th Libor reverts to a constant times the i th Libor; and dW_i is a random walk. We would expect that the vols s_i decrease as i increases.

One of the nice things about this kind of setting is that the correlation structure between the forward Libors is built in through the mean reversion, rather than through some (rather artificial to my mind) condition like dW_i dW_j = rho_ij dt. In fact, this might well perform reasonably well with dW_i dW_j = 0 for i not equal to j.

I would much rather read about one of those, even if the authors hadn't figured out how to price Bermudan swaptions with it yet, than yet another variation on (the admittedly rather useful but conceptually rather barren) LMM.

World Bank, World of Banks

From the Guardian: World Bank president Paul Wolfowitz denied that there was a row with Britain, despite the announcement earlier this week by Hilary Benn, the international development secretary, that Britain would withhold £50m of funding unless the Bank started to lend money to poor countries without onerous strings attached.

This rang an ominous bell as I have just been doing some work on country risk. The problem is that 'open market', 'transparency', 'corruption' and so on are relative terms: what they mean depends on where you are standing. On man's big risk is another's irrationally and delightfully high spread.

Hilary Benn apparently believes that Wolfowitz has been rather laxer with some countries whose friendship the U.S. values, like Pakistan, than others. I have no view on this, but I do know that however you decide to write sovereign loan covenants, if you are the World Bank someone is going to be upset with you. Perhaps the answer is to negociate with all of the potential borrowers simultaneously, so at least there is a standard hurdle for everyone? But of course if Benn is right, that is the last thing Wolfowitz would agree too. At least, though, let us agree it is a game where, rightly or wrongly, the guy with the money makes the rules. And of course those rules determine when sovereign default is rational. For Pakistan, it probably isn't. Other states, treated differently, may have another view.

If only Tony and Gordon had paid more attention to Blake's 7

Selected points from a most amusing list ALL I EVER NEEDED TO KNOW I LEARNED FROM BLAKE's SEVEN directly relevant to today's Labour leadership:


* Trust is only dangerous when you have to rely on it.

* It is frequently easier to be honest when you have nothing to lose.

* The art of leadership is delegation.

* All that patience gets you is older.

* Show me someone who believes in something, and I will show you a fool.

* He who trusts can never be betrayed, only mistaken.

* Dignity, at all costs, dignity.

* The choice is very simple -- either you can fight, or you can die.

* In the end, winning is the only safety.

* Power usually makes its own rules.

* Nobody is indispensible.

* Everyone's entitled to one really bad mistake.

Leave the managers alone

I read something rather ill-judged the other day:

Managers do not create wealth; at best, they assist others (workers) to create it; at worst, they not only produce nothing, they are actually, literally counter-productive, imposing time-wasting non-work which impedes productivity by wasting time and energy. There is no opposition between efficiency and justice; on the contrary, an institution run by those who actually do the work is likely to be more effective than one run by interchangeable exploiters who often lack any specific expertise in what they are supposedly managing.

Ignoring for a moment the repetitions and terrible grammar, one is forcefully struck by the sheer imbecilic prejudice of the author. It seems that he has never worked in a team bigger than a handful of people: if he had, he would realise that the jejune Marxist dichotomy between the workers and the owners of the means of production is utterly inappropriate for most contemporary enterprises. While it is easy for those of the doctrinaire left to set up a straw man of capitalism to knock down, it is hardly helpful to the political debate. Many of the them (and yes, George Monbiot, I do mean you too) should take the trouble to find out how corporations work before suggesting how to reform them.

Management, in all but the worst run firms, is not some extraneous layer pasted like marzipan on the solid fruit cake of production: rather it is something most workers do to some extent, the egg whites in the souffle. Successful organisations are open, collaborative, consensual: groups form around an objective; it is achieved; they dissolve. Strategy is evolutionary and co-constructed: it is not imposed by a distant elite on the 'worker'. This isn't just management consultancy B/S -- this is what you have to do to succeed in most industries. Many firms have a lot to do in getting to this area, but criticising them on the basis of a stereotype that is decades out of date is lazy.