Root Cause of the Financial Collapse

Search for the Root Cause. As an financial systems IT manager, I believe in finding the “root cause” of any breakdown of a system. Since it began I have looked for a “root cause” of the Financial Collapse of 2008 through today.

In a 2010 blog post, I wrote about the Dismantling of the American Dream. But this only dealt with the tactical decisions that lead to the financial collapse. It always bugged me not to know how reasonable people believed these decisions served the greater good of society or more selfishly their own desires for short term gain with long term stability.

In the last few years, I have read hundreds of books on

Throughout all of these I looked for common themes, events or trends that I could trace back to the beginning. I kept asking myself: “What started all of this?” I felt either there was mass conspiracy (unlikely) or mass-delusion based on some fundamental belief that fell apart.

One Core Erroneous Belief, I think, is the effectiveness of The Black-Scholes Model used to mathematically govern options prices over time as being a good thing for financial markets.

The key idea behind the derivation was to hedge perfectly the option by buying and selling the underlying asset in just the right way and consequently “eliminate risk.” As it turns out risk could be postponed, shifted and concentrated, but like any closed system, it is impossible to eliminate it.

From Theory to Practice. Invented in 1973, The Black-Scholes Model won the Nobel Prize for Economics in 1997. It won in that year because of its’ contribution to the then growing bubble of ever more sophisticated and opaque financial risk calculations.

All the following are abstractions of this same original proof:

  • Derivatives
  • hedge funds
  • mark-to-market
  • mortgage-backed securities
  • sub-prime lending
  • credit default swaps
  • collateralized-debt obligations
  • quants
  • flash crash
  • systemic risk
  • too-big-to-fail

Every one of the above are direct descendants of the Black-Scholes Model. This model transformed a very human decision-making process about investments, capital and risk into a very inhuman mathematical computation that could not continue ad infinitum.

I am not “blaming” the formula or its’ originators. Like the atomic bomb someone was going to invent this. The world has benefitted from its use short term. But like the arms race I believe the Black-Scholes formula (and it’s derivations) has brought us to the point of mutually assured economic destruction through the riskless concentration of income and wealth in the top 1% of Americans and the world as a whole. And the kings highway of the NYSE’s Jersey data center keeps the High Frequency Traders (HFTs) banging in and out of positions more than a porn star. And similarly the people getting it the worst barely feel the f’in they are getting.

Key to Financial Stability: The Middle Class. It is human decisions of a vibrant middle class that disperses risk throughout a population of rational economic actors. It dilutes gains and losses into a larger pool of people. It provides the chance for more people to make a little more money through good investment decisions and others to lose a little money as a penalty for bad investment decisions. Human decisions build the middle class and inhibits calculated-concentrations of wealth in those who possess the systems power to obtain it. Human decisions slows capital and keeps it from chasing the latest fraction of return anywhere in the world in a nano-second.

What we are seeing are a series of extreme financial transaction events. And I believe in this environment, a more standard t-distribution in place of Black-Scholes is a better basis for the valuation of options. That method requires the intervention of humans into the decision-making process for particular buys and sells.

Following again the nuclear weapons analogy, like the movie War Games (about a defense department computer system nearly starting a nuclear war), our future may largely be determined by how carefully we “unplug” some of the inhuman mathematical computations and re-introduce human decision-making with all its’ fragility, irrationality and blessed randomness.

Same disclaimer from 2010 post. Through some bizarre twist of fait I am a part of and benefitting from financial services work. Thankfully my employer is intensely focused on business ethics and doing the “right thing” not what makes the most money; those are not the same thing.

I appreciate and work very hard in my job and give money and time to as many causes as possible. Of all the lines on my taxes, Line 17 (charitable giving) is most important to me; far more important than my AGI.

My future is to demonstrate to my kids how to:

  • Reduce consumption
  • Maintain a skeptical awareness of their ego
  • Recognize media messages fueling consumerism
  • Travel internationally
  • Live frugally, simply and in peace (God willing)


Root Cause of Financial Crisis by Craig Burma is licensed under a Creative Commons Attribution 3.0 United States License.

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2 thoughts on “Root Cause of the Financial Collapse

  1. I still need to ponder your analysis of the Black-Scholes Model. However, I do agree with your action points at the end. I put emphasis on my Line 17 and while I have yet to travel internatially recently (post family/kids…did backpack through Europe a long time ago), I am constantly teaching my children both the benefits and drawbacks of our culture as well as the economic and poliitcal reality of many parts of the world. And don’t get me started on consumerism and marketing, positive thinking/esteem and consumption!

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