Flawed financial models sanctioned by business schools encouraged the risky bets that sank the economy. They should be scrapped
Amid all the pomposity surrounding discussions of the credit crisis ("capitalism is over!", "hang anyone with a pinstriped suit!") it is easy to forget what truly triggered the malaise. Simply put: A tiny bunch of guys (some gals, too) inside a handful of financial institutions made hugely leveraged, often complex, massively sized bets on the health of the (mostly U.S.) subprime housing market. As the latter inevitably turned sour, those bets inevitably sank the punters, and as these behemoths floundered, so did the financial system and thus the economy at large.
It wasn't a failure of capitalism or a reminder that perhaps we had forgone socialism a tad too prematurely. The crisis does not symbolize how rotten our system was. Rather than pompously try to fix beyond recognition an arrangement that (overall) has served humanity quite well, why not focus on understanding what truly happened and on making sure that it can never happen again?
So the key question would be: What allowed those insanely reckless bets to take place? When going down the list of responsible parties it is impossible not to point an accusatory finger at theoretical finance. It wouldn't be unreasonable to conclude that without the preeminent presence in finance land of scions of the quantitative family, the crisis may not have happened at all.
The insatiable gorging by investment banks on subprime mortgages was inevitably facilitated by the mathematical concoctions that assigned AAA treatment to utter garbage and that sanctioned the wild speculation on impossibly toxic securities. And, mind you, the current meltdown is not the only case of theory-caused troubles. The October 1987 crash and the Long-Term Capital Management crisis of 1998, for instance, also trace their origins to the presence in the markets of irremediably malfunctioning mathematical models.
Why has the world been so receptive to the theoretical siren song? Why has the math continued to be employed even well after it has been exposed as flawed and dangerous? Among other things, because of the status quo prevalent inside business schools for the past 50 years.
Ever since the Ford and Carnegie foundations decided in 1959 that B-schools had to become less "vocational" and "institutionalist," and more "rigorous" and "scientific," those institutions have been ruled by the iron fist of analytical dogmatism. Proofs, equations, and mathematical symbols reign dictatorially supreme, having unmitigatingly steamrolled any other considerations (such as, sin of sins, softish descriptions of what management practitioners actually do out there). The only possible path to career advancement inside B-schools and toward the golden dream of hired-for-life tenure is through the production of abstruse, convoluted theories and methodologies.
Harsh internal censorship guarantees that professors toe the official line and that the analytical tyranny is not disrupted. Dissenters are effortlessly tossed aside, mercilessly railroaded, ruthlessly expelled. The theoretical totalitarianism is of course particularly acute, Taliban-like in fact, in the case of financial economists, those individuals typically (and irredeemably) cursed with a terminal case of physics envy.
Why should we care if a bunch of cloistered business academics get their kicks out of producing incomprehensible quantitative diatribes? If someone wants to pay them (quite well) for that, what's it to us, frankly? Yet we should care, mightily. Bluntly stated, our well-being is at stake. For theories (of the financial kind, in particular) have the demonstrable power to cause turmoil in the real world, and the B-school establishment, by churning out, promoting, and legitimizing the use of theories, greatly contributes to the embedding of those potentially lethal analytical Trojan horses into our economies and markets.
B-Schools Must Reform
For better or worse, people tend to slavishly bow to the dictums emanating from the university campus ("if those Harvard professors say that's right, then it must surely be right, right?"). Too many outsiders (policymakers, bankers, investors, the media) have voluntarily shackled themselves to the equations-adorned, PhD-stamped official line. And that is why chaos-igniting, intrinsically flawed theoretical machines like Black-Scholes and Value at Risk are allowed to affect (quite negatively on many occasions) the lives of real people in the real world. If we care for our economic health, we should fight the theoretical invasion that has caused so much pain.
B-school deans and administrators should assist us in that battle. And not just because this would give them a chance to perform a welcomed public service—to act as statesmen of sorts, defending the social good. Egotistical self-preservation would be incentive enough. Analytical despotism has already served B-schools quite ill for the past few decades. Among other things, the theoretical reign of terror may have pushed away great potential teachers while attracting the wrong kind. But that's nothing compared to the negativeness that could ensue in coming years. Were B-schools, in the face of so much destruction, to continue to fanatically embrace theoretical dogmatism, their relevance (very existence?) may be threatened beyond repair.
Excruciating reform is excruciatingly needed. If inaction continues to be the chosen strategy, people (including students, donors, employers, and politicians) might begin to wonder what's the point of institutions that unrepentantly peddle poisonously broken dogmas, unmoved by the wreckage all around them. Better to act soon and free B-schools from the analytical straitjacket once and for all.