Many years ago, I was invited to give a talk, “Whose Dream? The Role of Mathematics in Radical Economics,” at American University.*
I was reminded of that event on reading Ian Stewart’s essay on the Black-Scholes equation and the financial crash.
Black-Scholes underpinned massive economic growth. By 2007, the international financial system was trading derivatives valued at one quadrillion dollars per year. This is 10 times the total worth, adjusted for inflation, of all products made by the world’s manufacturing industries over the last century. The downside was the invention of ever-more complex financial instruments whose value and risk were increasingly opaque. So companies hired mathematically talented analysts to develop similar formulas, telling them how much those new instruments were worth and how risky they were. Then, disastrously, they forgot to ask how reliable the answers would be if market conditions changed.
And that’s exactly what happened years earlier with Long-Term Capital Management. The board of directors of LTCM included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Prize in Economics for a “new method to determine the value of derivatives.” Their dream of conquering uncertainty, and of making tons of money in the process, is told in the Trillion Dollar Bet.
* This was before we used the internet to arrange such seminars. So, the title of my talk, conveyed by telephone, appeared on posters all over campus as “Who’s Dream?” Needless to say, the participants in the seminar wanted to know what Dr. Who had to do with economics.