Saturday, 24 January 2009

Einstein, Newton, Markopolos and Madoff - and what they teach us

Imagine Albert Einstein lived not at the beginning of the twentieth century, but in the early Eighteenth Century. Imagine he was an Austrian patent clerk without any scientific credentials or standing, but nonetheless had managed to devise and publish his theory of relativity, exactly as it was finally published, only in 1730, just 43 years after Newton originally published his Philosophae Naturalis Principia Mathematica. At this time classical mechanics (of the Force = Mass x Acceleration variety) was widely accepted and was a perfectly well functioning, pragmatic, simple account of celestial (and every day) mechanics).
Let’s say Einstein had correctly anticipated, in broad-brush terms, all the supporting scientific development which would be needed for Relativity to be a coherent scientific, well formed and operational thesis.

Now, in those circumstances as they were: an unknown Austrian clerk pitting himself against a man who was Lucasian Professor of Mathematics at Cambridge University and President of the Royal Society, and whose theory of mechanics appeared to work perfectly well, what is more – would Einstein’s theory would have gained any currency in the scientific community?
Allow that Einstein might have argued for this theory on the grounds that, at extremely high velocities, the supposed relations between acceleration, mass and force would not hold up: that, at the limit, classical mechanics was wrong.
I contend that Einstein’s theory would have been rejected for certain (for all we know such a theory was proposed, but hasn’t survived the ensuing centuries). Here are some of the reasons that would have been given for rejection:
  • You have no credentials. You’re a crackpot. You’re quesrtioning one of the greatest scientific minds in the history of the western intellectual tradition. Go away, get properly credentialised as a scientist (by studying the works of people like Isaac Newton), and then see if you still agree with your deluded theory.
  • Your theory is hopelessly complicated, counter-intuitive, and involves the absurd requirement that we reject the constancy of space and time, and instead agree on the constancy of the speed of light. It fails, utterly, the principle of Occam’s Razor.
  • There is simply no need for this theory. Mr. Newton’s existing theory is perfectly adequate for our needs.
Of course, this is speculation, and probably idle speculation. But were we to know the answer, we would have a real insight into how science – or any community of experts – works.
Recently there has been a fascinating example of just such a situation, not in the annals of science, but in the arcane and highly specialised world of fund management.

Bernard Madoff was little known outside the New York investment community before late 2008. Nonetheless, before that time he was one of the most respected and successful senior members of the New York financial community – itself the most sophisticated gathering of financial experts anywhere in the world. He chaired the Nasdaq stock exchange, at one stage was the largest market maker on it, and ran a hedge fund for 48 years, which he grew from a $5,000 investment in 1960 to a portfolio, of of 2008, with something like $50 billion under management.
His firm, Madoff Securities LLC, was the largest single hedge fund on the planet. Amongst his clients were some of the most storied names in international finance, including Fairfield Greenwich, Banco Santander and HSBC, each of whom invested more than a billion dollars. Madoff’s returns over serveral years were consistent, regular, and immensely impressive: They averaged 12-13 per cent, after fees, every year.

Yet, as we all now know, Bernard Madoff was running a giant, fraudulent Ponzi Scheme. The returns, the positions he purported to be invested in and the cashflows were all fictional. To the best of anyone’s knowledge now, it seems Madoff was using the continuing stream of new customer investments to pay returns to existing customers.

Now, with the benefit of hindsight, commentators say Madoff’s claims are laughable; his supposed returns preposterous: they defied known laws of mathematics as much as economics given the strategy he purported to pursue.

We can only stare bewildered into vacant space wondering how an industry apparently based on the very principle of excellent management of just this sort of risk, where self-interested individuals with literally hundreds of million dollars of their own (and their clients’) money at stake, can have possibly let this happen. We do know that it did, and that is that.
So let’s consider the 17th Century Einstein scenario. What would have happened if, say three years ago, the appropriate regulatory authorities were warned, in minute detail, that the only possible explanation for Bernard Madoff’s returns were that he was fraudulent? If the equivalent of our anonymous patent clerk from Austria set out in a single, clear, concise and compelling document, entitled “The World’s Largest Hedge Fund is a Fraud”. Imagine if that 15 page document alleged that it was highly likely that Madoff Securities is the world’s largest Ponzi Scheme”, and outlined nearly 30 “red flags” correctly predicting analysis existing publicly available evidence that was only consistent with insider trading or a Ponzi Scheme.

Now this is far more striking than the evidence Einstein could have hoped to level against Newton. What would have been the likelihood of the Securities and Exchange Commission acting on that information. Again, I would say – admittedly, with the benefit of hindsight – it would be low. I say wit the benefit of hindsight because that’s exactly what someone did do – an options trader by the name of Harry Markopolos, in November 2005. You can see his document for yourself online, and now he's published a book about it. The SEC took absolutely no action.

This isn’t offered in indictment of securities regulation in the United States (not by me, at any rate; Markopoulos feels differently)  – almost the contrary. What I think this speaks to is the limitations of rational argument – the same limitations apply not just in finance and politics, but also in science and academia. These collective self-delusions don’t only arise in the absence of free debate contrary, but more or less in spite of it, and in almost any intellectual field: science, sociology, politics, ethics, finance, sport – all are susceptible to mass delusion.
This ought to tell us something about how we collectively think about things. Our claim to rationality seems not to be as robust as we might like it to be. With irony, we wonder, is our belief in our own rationality itself a product of mass delusion?