The way we manage financial risk has a lot in common with the old concept of scientific socialism. The modern-day riskometer is pseudoscientific, and the increased reliance on it leads to disastrous systemic risk.
One of the things I find so fascinating by the financial system is that so many of the people who work in it proclaim a belief in free markets — many indeed see themselves as libertarians — while going about their business in a very socialistic way, without any irony. I could discuss bailouts, but not today.
We don’t hear much of scientific socialism any more, but it used to be quite a common concept — a scientific roadmap for how to avoid all the worst aspects of capitalism.
Scientific socialism was a concept proposed by Friedrich Engels in 1880 in his book Socialism: Utopian and Scientific, that described Karl Marx’s political, economic and social approach as scientific socialism. In other words, the understanding of political, social, and economic phenomenon through the use of scientific methods, to anticipate potential future outcomes and developments.
Scientific socialism implied the creation of testable theories based on empirical observations; when the reality did not happen as predicted by the theory, ad hoc assumptions were added to the initial theory to ensure it fitted the actual facts.
Karl Popper, in his 1945 book The Open Society and Its Enemies, described scientific socialism as a “pseudoscience”.
Popper argues that science is founded on testable theories based on empirical observations, where theories are then changed or refuted based on actual outcomes. Since one cannot test the claims of scientific socialism — they cannot be falsified — it is pseudoscientific.
So what does that have to do with the management of financial risk?
The way we measure risk is by what I have called the riskometer. It is a device that allows the operator to plunge it into the bowels of the City of London and out pops a measurement of risk.
For the technically minded, it combines a concept of risk (like Value-at-Risk), a probability (e.g. 99% daily) and a measurement technique (e.g. GARCH).
My claim is that the riskometer is pseudoscientific in the same way as scientific socialism.
But, but doesn’t present itself as such. No, it is an objective and scientific way to measure risk, and by using it, we move away from subjectivity, incompetence and even corruption.
I can now hear the objections, like backtesting. I discussed backtesting here, but the answer is no, it don’t solve the problem.
The fundamental problem is that no measurement of risk can be fully verified because risk is a latent process. All we can do is to validate and output from a model to an assumption about what is important.
And, we can create an infinite number of statements about what is important, most of whom are mutually inconsistent.
In the language of Karl Popper, we can’t falsify a risk forecast, and consequently, it is not scientific.
So, risk models — riskometers — are no more scientific than scientific socialism.