Friday, 23 June 2017

Political and Financial Crises: some connections between the Credit Crisis and the current crisis in UK politics

My book, Ethics in Quantitative Finance, was motivated by the wish to understand the relationship between mathematics and financial ethics in the aftermath of the Credit Crisis (GFC).  While the GFC occured a decade ago, the topics discussed in Ethics in Quantitative Finance are still relevant today as the UK endures a "Great Political Crisis", a year after voting to leave the European Union.  Had someone drawn a connection between mathematics, ethics and politics for me in 2006 I would have ignored them, suggesting that the scholarship underpinning the book is transformative.

A fundamental insight made in the book is that when market-makers (jobbers or dealers) give a  bid-ask quote, they are offering an opinion and so money is behaving as a language that carries that opinion in prices.  On this basis, I employ Habermas' theory of communicative action and in this context the book describes how mathematics ensures the objective validity of a price by ensuring reciprocity, the dual quoting ensures sincerity and the truthfulness of the price while the social rightness is delivered by charity.  I argue that these norms, truth, truthfulness and rightness, are developed in commercial practice and provide the basis for democratic discourse.  That is, sound politics are a consequence of sound commerce and I provide examples in pre-Socratic Greece, the emergence of bourgeois communes in high medieval  Europe and seventeenth century Britain and the Netherlands.  I also highlight that there is a symbiotic relationship between finance and politics: sound finance delivers sound politics, sound politics deliver sound finance.  Pre-Socratic Greeks understood that if there emerge wealth inequalities the political stability collapses but mathematics, by ensuring reciprocity, inhibits the emergence of inequality, and this is a theme returned to throughout the book.

The idea that reciprocity is deeply embedded in financial economics was fully formed by around 2011 - the RCUK, the UK government's research administrators, identified the idea a sa "Big Idea for the Future" seven years ago.  Explaining the significance of reciprocity took longer and was undertaken as I experienced the Scottish Independence Referendum campaign that lasterd from September 2013 until the vote in September 2014, the general election of 2015, the EU referendum campaign of 2016.  The general election campaign of 2017 highlighted the connections between the GFC and the current political crisis.

The Scottish Independence Referendum campaign was widely lauded (by English commentators) as a good example of public engagement in politics.  As someone voting in the referendum I regarded it as a complete failure of politics.  On one hand, the nationalists promised the electorate milk and honey in an independent Scotland, what became labelled a manifesto of hope.  The unionists prophesied doom and destruction.  In terms of parenting, one approach was to offer a child a toy to behave, the other was to threaten to take a way a toy if the child misbehaved.  There was no actual discussion of what was the best  policy, in terms of the metaphor t, the parents did not explain why they wanted the child to behave in a particular way.

This was encapsulated in the debate about the currency of an independent currency, and was the point on which I judged the validity of the arguments.  Alex Salmond asserted that Scotland would use the UK pound, as the obvious alternative of adopting the Euro was unpopular.  Unionists pointed out that Scotland would never be independent of England if it retained the UK pound.  What annoyed me was the referendum campaign did not discuss the relationship between money and sovereignty they, and the unionists, simply made assertions as to an unknowable future in an attempt to accumulate votes.

I understood the campaign in terms of a simple mathematical model of decision making under uncertainty that I often describe.  During a British winter, some birds need to eat up to 40% of their body weight to survive the night,  and so their very existence depends on making the right decisions about looking for food.  Let's say a bird has 6 hours to find 9 berries and it has two choices:

  • [Play it Safe] The bird stays where it is, where it knows there are berries in the hope of finding a few.  The chance of finding one or two berries in the hour is 50:50.
  • [Take a Risk] The bird flies off, in the hope of finding berry-bonanza but with a high chance of only finding enough to replace the energy lost in flying.  The energy cost of flying is one berry and the chance of only finding the one berry in the new field is 5 in 6, but there  is a 1 in 6 chance of finding 10 worms (and getting an excess of 9).
Notice that the expectation of both strategies is the same, one-and-a-half berries in an hour and so the bird can expect to get the nine berries in the six hours.  However the second approach is riskier (for any concave utility function the expected utility of the second strategy is always going to be less than the first).    However, if the bird has only found five berries after five hours, it is certain to die if it does not switch to the risky strategy, where it has a small chance of finding the 10 berries that will ensure survival.  A similar argument applies if the bird has found more than 8 berries after 5 hours - it can afford to take a risk.

The financial interpretation is that only the middle class should be risk averse the rich can afford to gamble, the poor have nothing (substantially) to lose by gambling but there is the small chance they become rich.  This is an explanation as to why the poor defy economic 'rationality' in buying lottery tickets, it is actually practically reasonable. In Ethics in Quantitative Finance I suggest that the adoption of utility in the nineteenth century was motivated by the rich de-legitimising speculation by the poor, since the poor can become rich through speculation.  Today, economists like to obscure this simple mathematical model under the veil of "prospect theory" or the S-shaped utility functions of Friedman & Savage.

On this basis I understood the nationalists inviting the Scottish voters to take the risk while the unionists were conforming to neoclassical economic theory and arguing the risks were too great.  Neither side was actually that interested in undertaking the political task of converging on a settled view of how Scotland should be governed.  Three years on, nothing much has changed here.

Three weeks ago, at the beginning of June, I had dinner with an old friend from my undergraduate studies who happens to be an external examiner for some of our MSc programmes.  We had had a similar dinner last year in the run up to the EU referendum and this year's dinner took place a week before the 2017 general election.  My friend's parents were immigrants from Cyprus and he dismissed the EU referendum as being indicative of the UK's xenophobia.  I disagreed, and went further to argue that it was just such attitudes by the British 'professional' class that led to the Leave vote.  I pointed out that, according the authoritative National Centre for Social Research, around 30% of Black and Asian voters voted to leave the EU while only 20% of the electorate as a whole regarded immigration as the main issue in the vote.  If you look at data the Leave voters were predominantly those poor in property, income and education.  The Leave campaign was identical to the Scottish nationalist campaign in promising milk and honey to the marginalised in a Brexit Britain: vote Leave, you have nothing to lose but might gain.

The prime example was "An extra £350 million a week to the National Health Service", which  appealed directly to the poor.  In the aftermath of the EU referendum the professional classes, those who are going to be risk averse, began discussing living in a "post-truth" world were facts no longer play a role in peoples' decision making.  The fact that these arguments ignore is that at there were no "matters of fact" pertaining to a post referendum Britain.  The Remain campaign mimicked the unionist campaign by calculating, to the nearest hundred pounds, how much worse off the average British family would be if it voted Leave.  This "fact" was as implausible as the "fact" that more money could go to the NHS, and I think the electorate recognised this and so the vote came down to taking the risk, or not.  Bres-xit won, when Yes (to Scottish independendce) lost because Brexit unified those above and below the "risk averse" region, wheras Yes isolated those below the "risk averse" region and did not appeal to those above it.

At the heart of  Ethics in Quantitative Finance is the idea that decisions about an uncertain future cannot rely on "matters of fact" relating to how nature is, what Locke described as physica, but on "judgement of the will", or practica.  Contemporary mathematics is closely associated with physica, but as I explain in the text, before the mid-nineteenth century mathematics concerned itself with both physica and practica.  A key episode in the diminution of practica in maths was the abandonment of moral expectation to solve the Petersburg game in favour of idealised utility functions.

My submission of the manuscript to Palgrave in early April was closely followed by the calling of the 2017 general election.  At the time my reaction was that the Prime Minister had reflected on the forthcoming Brexit process, decided it was going to be impossible and so called an election in the expectation that the Conservative government would lose.  This was regarded as absurd at the time given the lead the government had in the polls in April, a perspective confirmed by the local and Scottish government election results from the beginning of May.

However, the Conservatives proceeded to run an unbelievably inept campaign that centred on the ad nauseum repetition of a "strong an stable" mantra while its poll leave evaporated.  The Labour party focused on an anti-austerity campaign but was ambiguous about specific details.  I still don't understand what a Labour government would do in regard to EU relations or government finances.  The only thing I was sure of was they would subsidise the children of the rich and professional classes who attend university more than they would provide additional funding to the NHS.  Neither party offered the public an "honest set of choices".

The aim of the British Prime Minister in calling the election seems to have been to secure a mandate that would enable her to direct the Brexit negotiations as she wished.  In essence it was to accumulate as many votes as possible while the objective of th eLabour party was to prevent her doing so.  There was no substantial discussion of policy choices or the implications of those choices.

This reminded me of the environment in finance in the run up to the Credit Crisis.  Financial institutions were focused on reaping profits from investing in MBS of sub-prime mortgages, confident in the concrete number of market prices without reflecting on what those numbers implied.  It seems that in the sprinf of 2017 the Conservative government was focused on winning votes, confident in the concrete number of opinion polls without reflecting on what those numbers implied.  They saw a substantial lead and a "majority" in favour of Brexit without understanding where that majority originated.

The political turmoil the UK is experiencing is, like the Credit Crisis, as consequence of politicians (market participants) not being objectively true, subjectively truthfull and socially right.  The problem originate in the GFC.  In its aftermath, government policy has quietly supported the wealthy, through bank bailouts and price support delivered by QE, while loudly calling on the less well off to "tighten their belts".  The crisis will continue so long as the public do not trust finance or their politicians.

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