In This Issue
The Bridge: 50th Anniversary Issue
January 7, 2021 Volume 50 Issue S
This special issue celebrates the 50th year of publication of the NAE’s flagship quarterly with 50 essays looking forward to the next 50 years of innovation in engineering. How will engineering contribute in areas as diverse as space travel, fashion, lasers, solar energy, peace, vaccine development, and equity? The diverse authors and topics give readers much to think about! We are posting selected articles each week to give readers time to savor the array of thoughtful and thought-provoking essays in this very special issue. Check the website every Monday!

Engineering Financial Markets?

Monday, January 25, 2021

Author: Richard N. Foster

As the world reels from the impacts of the coronavirus pandemic, growing climate instabilities (including the worst forest fires in California’s and Colorado’s history, as well as unusually numerous hurricanes), and increasing distrust among the world’s nations, questions about how to build and rebuild the world’s economies going forward—locally, nationally, and -internationally—have never been more urgent.

The question is really how to rebuild the world’s economies in a more sustainable way. Put another way, Can market and financial health be “engineered” to reduce these shocks in the coming decades?

Engineering’s History of Social Impact

Engineers have always been a vital part of defining and meeting major challenges. Indeed, they have conceptualized, designed, and built a host of the world’s defining advances, including

  • railroads and the numerous and vast bridges that made them economically worthwhile
  • reliable equipment to generate and deliver electricity (AC or DC) to millions of homes, bringing light to the dark and extending productivity
  • the first “lighter than air” vehicles, which subsequently changed relationships between nations and generated substantial wealth for airline industry employees and investors alike
  • large-scale facilities for producing the drugs to defeat the influenza that was killing millions in the first decades of the past century
  • integrated circuits, which released the power of digital computers and led to a reenvisioning of the telephone as a computer that could carry voices to the most distant lands
  • new sources of radiation for medical imaging (CT scanning, MRI, ultrasound) and new approaches to surgery (robotics).

All of these had and continue to have significant economic and social impacts. Is it now possible to “engineer” the world’s financial markets? Can engineering methods be used to calm the markets and design them for growth without turbulence?

Early Economic Thinking

History shows that others have long thought about ways to influence—through design—markets and finance:

  • In the 7th century BCE the astronomer and mathematician Thales, according to Aristotle, became rich through olive speculation.
  • Pope Innocent IV, in a commentary on canon law in roughly 1250, justified the charging of a risk premium for assets.
  • Ten years later St. Thomas Aquinas endorsed insider trading, making profits based on information not known to the buyer.
  • In 1654 Blaise Pascal and Pierre de Fermat developed the first derivative pricing formula by solving the “problem of points.” It is now known that their solution converges to the continuous-time Black-Scholes option pricing model.
  • In 1738 Daniel Bernoulli published Exposition of a New Theory on the Measurement of Risk in Russia. The manuscript was not published in English until 1954, 10 years after John von Neumann and Oskar Morgenstern introduced expected utility in the Theory of Games and Economic Behavior.
  • In 1926 Norbert Weiner, the originator of cybernetics, developed the theory of random processes, based on James Clerk Maxwell’s late 19th century development of the kinetic theory of gases, providing the basis for Robert Merton’s 1960s theory of continuous-time finance.

These examples may seem to suggest that there is a natural link between finance and engineering. But in reality the challenges of engineering financial systems are quite different from any that engineering has previously addressed.

Can engineering methods be used to calm the markets and design them for growth without turbulence?

The simple summary is that financial systems think about themselves, and they think about themselves thinking about themselves. This recursive behavior undermines predictability, which is typically a core requirement of and value delivered by engineers.

Market Reflexivity

The experience and wisdom of George Soros provide an instructive example.The Hungarian-born American polymath studied for his PhD at the London School of Economics under the philosopher Karl Popper. Popper argued, and Soros deeply believed, that the absolute truth can never be known with certainty. As Soros (2009) wrote, “Even scientific laws can’t be verified beyond a shadow of a doubt,” and this thought became the core of his theory of “reflexivity” (circular relationships between cause and effect, especially as embedded in human belief structures[1]).

“Reflexivity” as presented by Soros (2009) is based on the observation that “Scientific laws are hypothetical in character and their truth remains subject to testing. Ideologies which claim to be in possession of the ultimate truth are making a false claim; therefore, they can be imposed on society only by force.” Soros would not have made a productive engineer. He saw the potential flaws in all systems, even those of his own design.

Soros applied his theory and beliefs in the weeks leading up to Black Wednesday in Britain, September 16, 1992. It was that day that the UK government was forced to make the exceptional move of withdrawing the pound sterling from the European Exchange Rate Mechanism, after a failed attempt to keep the pound above the lower currency exchange limit. At the time, the United Kingdom held the presidency of the European Communities.

Market participants think about how other participants in the market are thinking. Bridges do not think about other bridges.

In 1997 the UK Treasury estimated the cost of Black Wednesday at £3.14 billion. The crisis damaged the credibility of Prime Minister John Major. The ruling Conservative Party suffered a landslide defeat in the 1997 UK general election and did not return to power until 2010.

Soros, however, made over £1 billion in profit by short selling sterling based on his belief that finance was not “engineering.” Engineering requires clear estimates of uncertainty and he did not believe that finance could ever provide those assurances. Finance was thus quite different from conventional engineering.

Doubts about Finance as Engineering

Soros is not a trained engineer but others—including many trained engineers who now make their living in finance—also believe in the reflexivity of financial -markets. This group bets that the markets sometimes have it wrong.

Others have joined the chorus of financial engineering critics:

  • Financial engineer Nassim Taleb (2007) recognizes the market’s susceptibility to extremely rare, hard-to-predict, high-impact events that he calls “black swans.”
  • Felix Salmon (2009), a financial analyst and writer, points to the “Gaussian copula,” the apparent correlation of random and independent variables in “high-dimensional” systems. In other words, given systems of sufficient complexity it is a statistical certainty that variables with no causal connection between them will be shown to be mathematically correlated.
  • Ian Stewart (2012), emeritus professor of -mathematics at the University of Warwick, points out that, in the Black-Scholes model routinely used to value options, key variables—the risk-free rate and volatility—are assumed to be constant, but in the real world they are not. Indeed, they are not always predictable—even the timing of their likely unpredictability is -unpredictable.
  • Scott Patterson (2012), a Wall Street Journal investigative reporter, cites high frequency trading as a major cause of market volatility and preferential treatment of select firms.

Civil, electrical, and chemical engineers do not bet on the uncertainty of science; they bet on its certainty. And these are just a few of the fields where that certainty is fully justified. They bet that the science is right. They bet that they will be able to set reliability estimates for future forecasts.

Unfortunately, that is not the way markets always work. While there are many estimates of future “volatility,” experienced traders know that none are routinely reliable—they can change in an instant when politics change, an unexpected economic crisis occurs, or a pandemic surges. Such events fall well out of the range of reliable “engineering” estimates. Their only characteristic is that the patterns observed today are unlikely to be the patterns of tomorrow.

Said another way, markets think about themselves thinking about themselves; bridges do not think about themselves. More accurately, market participants (there are no markets without participants) think about the thoughts and thinking of other participants in the market. That is the essence of finance. That is what Soros and other “punters” do. It is essential to their work. But it does not work when designing bridges or dams or computer systems or new drugs.

Of course, there are segments of the market where, and points in time when, the volatility is predictable, and in those cases bets are made and leverage increases. But in all cases, these are old, well-established sectors of the economy. They are not in the new, largely undefined areas of the economy that are likely to grow, such as artificial intelligence, machine learning, and CRISPR-Cas 9. Engineering winning financial bets on the future prices of tires is imaginable. Betting on the future sales of electric vehicles is not.

Concluding Thoughts

For millennia engineers have been sensing, defining, and solving societies’ and the world’s most pressing problems and opportunities. Often, they have had to invent new ways of characterizing and then solving problems rather than simply applying what worked in the past. Indeed, not infrequently they have had to discover new science to be able to achieve their objectives.

On this 50th anniversary of The Bridge the need for engineers to help define and address the world’s newly emerging problems is clear. For the past 2000 years, engineering and engineers have risen to the challenges ahead.

That said, engineers and their methods are not -wholly predictable. We should be quite pleased that they are not. They will ensure our future by tackling the world’s largest and most important problems. They will do it, as they always have, not only by applying reliable methods from the past but by inventing, discovering, and developing new methods to meet opportunities and challenges, no matter how difficult—including finance. That is what engineers have always done and that is what they will continue to do.

References

Patterson S. 2012. Dark Pools: High-Speed Traders, AI -Bandits, and the Threat to the Global Financial System. New York: Crown Business.

Salmon F. 2009. Recipe for disaster: The formula that killed Wall Street. Wired, Feb 23.

Soros G. 2009. Theory of general reflexivity. Financial Times, Oct 26.

Stewart I. 2012. In Pursuit of the Unknown: 17 Equations That Changed the World. New York: Basic Books.

Taleb NN. 2007. The Black Swan: The Impact of the Highly Improbable. New York: Random House.

 

[1]  https://en.wikipedia.org/wiki/Reflexivity_(social_theory)

About the Author:Richard Foster is an emeritus senior partner of McKinsey & Company.