Bertrand Russell and the perils of forecasting

Published in Unpopular Essays, 1950, Russell sets up the following trichotomy as a forecast to be realised before the end of the 20th century.

Either
a) The end of human, and possibly all other, life
or
b) A collapse in human numbers and a return to barbarism
or
c) A unification of the world under a single government.

He prefaced these options by suggesting that something unforeseeable might also happen. And he rounded them off by suggesting that what he could say without hesitation was that humanity could not possibly continue as it was.

Ignoring the implicit option d) of something completely unforeseeable then, (which makes this not a trichotomy but whatever a 4 option-scenario is called), Russell has surely created a fallacious (and lesser spotted) false trichotomy. For certainly none of his options came to pass by the year 2000, and arguably humanity had largely carried on as it was.

Russell has clearly buried an IED in his front lawn with this argument, to be trodden on at a later date. But forecasting is a perilous business and superior intellect is no guarantee of accuracy. He was not the first, nor will be the last, to blunder in this regard.

More surprising perhaps is the curious argument a few pages on. Here Russell argues that either Soviet communism or American capitalism will come to dominate the world. He expresses a preference for the latter, but backs his commitment with a very curious notion. He does not prefer Americanism because capitalism is inherently better than communism. Rather he prefers it because of the respect it (Americanism) affords ‘freedom of thought, freedom of inquiry, freedom of discussion, and humane feeling’. Whereas the Soviet outlook values none of these things.
But surely here is a more serious informal fallacy at work? For Russell is ignoring the rather obvious point that he is presuming these freedoms have nothing whatsoever to do with capitalism, nor their absence anything to do with communism. He tacitly suggests that were America to adopt communism, these freedoms would continue to exist. A curious political philosophy this that surely only a theoretical Marxist could reasonably argue. The evidence for liberalist communist states is thin on the ground. For illiberal capitalist states we have the recent example of China. But on the whole, presuming the complete separability of capitalism and freedom of thought/inquiry/speech whilst also asserting the compatibility of these latter with Soviet-style communism, seems more than just contrarian; it is surely to be wilfully oblivious to a mountain of evidence.
Unpopular Essays is an excellent collection, but this particular essay is a bit of a turkey and easily the most dated of the anthology.

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The hidden assumption upon which the Euro relies for its survival

What is money? An elementary economics textbook will usually characterise money as a store and unit of value and a medium of exchange. In other words, money is money if it allows for a conversion of the value of one good (say hours worked or physical commodities) into a recognisable standardised form (such as pounds and pence), if it allows one to effectively save goods that are otherwise un-storable (again, such as hours worked) and if it can be used to eliminate the need for simple bartering; rather than needing to find that special someone who is looking to swap their chickens for my lemonade, I can simply look for someone selling chickens for money and someone else looking to buy lemonade with the same.
This concept of money sees it purely as something functional. Money, by this characterisation, is merely understood in terms of its usage. All there is to money on this reading is an instrument enabling exchange, storage and valuation. And it is money seen in this light that makes single currencies such as the Euro seem a jolly good idea. After all, if money is just a means of exchange, a purely functional device, then for economies that trade together to use the same money makes sense; the very argument that supports the use of money in any local economic system, supports the use of the same type of money across related economic systems. The benefits from combining two or more separate currencies are similar to those from electing to use money instead of bartering for example.
But is there more to money than the textbooks suggest? Does a paper currency have any intrinsic rather than merely instrumental value? Consider for example the claims often made in support of retaining the pound sterling rather than adopting the euro. From sections of the press, giving up the pound is claimed to be giving up a way of life, an ancient fact of British tradition, a rich fiscal heritage and even as providing an insult to the Queen herself. This does not tally with a purely functional understanding of money in the strict sense. If money is just a medium of exchange etc., there is no room for sentiment. And this is often offered in response to assertions that the pound has some intrinsic value over and above its functional purpose; surely it matters not one jot whether the Queen’s head appears on the currency rather than some Scandinavian bridge or pseudo-Hellenic ruin? The currency is just an instrument used in trade, they claim; it has no meaning beyond this.
This presumption belies the euro. The idea that a currency is nothing more than a device to facilitate trade. It deprecates the idea that a currency has any intrinsic meaning over and above this utilitarian definition; it dismisses the longevity of any particular currency as irrelevant sentimentality. But this ignores the importance of the emotional attachment that people might form to a currency, however irrational it might seem. And this is something supporters of the euro have wilfully ignored to their cost.
For now we see what happens to a currency which has no longevity to speak of, nor to which any of its users have formed any meaningful emotional attachment. We see continual threats and insinuations intimating the abandonment of the currency by disgruntled stakeholders. It is all but inconceivable that any user of the pound sterling such as say Wales or Cornwall might consider departing and minting their own currency. Or that California might abandon the US dollar, to satisfy its own short term fiscal interest. Is this simply due to the strong political union that exists between these places and those with which they share a currency? Possibly, but surely there is also an intrinsic attachment to the currency itself that prevents the question even being asked in the first place. The hidden assumption belying the euro is that no currency has any intrinsic value in itself; all that matters is that the political union is strong enough to withstand exogenous shocks and trading partners show fiscal responsibility so that the currency is protected. Even as the adequacy and truth of these latter propositions appears increasingly contentious, it is the former supposedly harmless assumption that might be the euro’s final un-doing. For it is the intangible and non-functional value of a currency – its value to its users for its own sake, its long-standing and its history which prevents the nuclear option of abandoning the currency ever being an option at all. Sentimental attachment to a coin or note may seem quaint and reactionary to European ‘progressives’. But perhaps as far as money is concerned it is an existential qualifier the euro fatally lacks.

The Metaphysics of Markets

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Why regulating banks is so difficult

Of course, the recent credit crisis was caused by politician’s failure to regulate banks. Clearly, if banks had been properly regulated, we would not be in the mess we are in. And yet, even now, very little has been done to introduce new legislation to prevent further crises. What are the politicians playing at?

This is a typical response to the crisis, but not one I find convincing. To see why politicians have so far done almost nothing to alter the regulatory framework of the banking system, you only have to analyse the preceding paragraph closely. Far from being obvious and prescribing a straightforward course of action, the preceding statements contain a number of dubious assumptions. For example, do we really know what is meant by a bank? Defining a bank is no simple matter, as I argue extensively in The Metaphysics of Markets. Regulating by making distinctions between types of institutions (eg banks/non-banks) is only possible if ‘a bank’ can be clearly delineated. Regulating certain activities rather than certain persons or institutions is also rather tricky. With the use of structured products and derivative instruments (in particular those that trade over-the-counter ie directly between institutions rather than on-exchange), almost any type of trade can be replicated synthetically. In such cases, there is a futility in attempts to regulate.
Is this simply a counsel of despair then? Not quite, since effective regulation should be possible if a more considered approach is taken than has hitherto been the case. Simple definitions and characterisations of institutions must be reviewed. The theoretical problem with current legislation must be understood; after all, we do presently have some regulation (contrary to certain commentary). If our existing regulation is inadequate, we must try to see why, before simply tweaking it as we have done time and again in the past in response to other crises.
The apparent lack of political interest in these matters probably reflects an acknowledgement of the prima facie intractability of the issues. But the complexity of the problem at hand is rarely in itself adequate justification for not seeking a solution. And on this score more than any other, politicians certainly stand culpable.

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Does Occam’s razor give too close a shave?

Occam’s razor is a reasonably well-known principle of methodology. The idea is to prefer parsimony to complexity, between competing hypotheses of equal explanatory power. This, intuitively, seems a sensible idea. Occam’s razor has been re-packaged and re-phrased many times, whether as the lex parsimoniae, or as Einstein’s recommendation to makes things as simple as possible, but no simpler.
All sound advice. But note, that Occam’s razor is not a law. The lex parsimoniae is only a law in the same sense that we talk of a Law of Averages; there is no actual law to speak of. Occam’s razor is more of a principle or a recommendation.
But there is a danger that this is forgotten and the negative side to the razor is overlooked. For there is a fairly obvious flaw with this idea if taken to extremes, namely the risk of rejecting an accurate, complex hypothesis in favour of a simpler hypothesis, which is also correct but less powerful.
For example, imagine Newton had proposed Einstein’s theory of general relativity instead of his mechanical, gravitational theory. Suppose he had explained general relativity precisely as Einstein had done and then had shown how in a particular, localised arrangement, the Newtonian equations of motion ‘fell out’ and that therefore he had a hypothesis for the motion of particles.
Now a devotee of Occam might suggest that a more parsimonious, yet equally powerful explanation of the simple motion of particles, is given by the Newtonian equations of motion alone. All the additional theory of relativity is completely untestable (in the late 1600s). So we should keep it simple and reject this for now. And herein lies the problem; we have just cut out a far more powerful and (presumably) accurate theory with our razor.
My point is that parsimony is desirable, but this is not a logical demand. It is a normative statement. Efficiency or simplicity we naturally covet, but we must not be beholden to them. The world is complex and a lot of the simple stuff has been explained with simple theories. But it is not unreasonable to think that more complex theories might be necessary in future, to augment our knowledge. And an over-adherence to Occam might hold us back, by its embedded potential to catapult out complex yet helpful theories.

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What are financial derivatives?

A simple, textbook definition of financial derivatives will typically resemble the following:

A derivative is a financial contract, asset or instrument that derives its value from another underlying security.

Typically, derivatives are treated as distinct instruments within financial institutions. Historically, banks have tended to have ‘derivatives desks’ and specialist ‘derivatives traders’.
However, in The Metaphysics of Markets, I question whether this straightforward definition is adequate and likewise whether the segregation of ‘derivatives’ as an asset or security class is appropriate. This is because the fundamental nature of derivatives contracts can be hard to pin down. After all, what about well known cases of futures markets ‘driving’ spot markets? Does this make the relevant underlying contract derivative?
My suspicion is that derivatives instruments are generally misclassified. A better approach is to realise that derivativeness is a property or attribute rather than a class in its own right. And whilst certain commonly-perceived to be derivative instruments such as options contracts exhibit a great deal of derivativeness, this is not the same is simply classing them as derivative instruments simpliciter.
Why does this apparently subtle difference in interpretation matter? It matters because derivatives as currently conceived are thought to be separable. It is thought that derivatives can neatly be isolated in terms of their risk and character and even in terms of their users. But this could well be a false impression. If derivativeness is thought of as a property that many assets can exhibit, this is more than just a change to our current perception. It has profound implications with respect to regulation and risk management for instance.
Derivatives instruments (although this term is formally question-begging in any enquiry into the nature of derivatives) are generally thought to be well defined and understood. However, to my mind, the elementary definition of derivatives that is commonly accepted, is insufficient. This means comprehension of derivatives and their impact is based on a false proposition from the outset. And this is never an optimal starting point.

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The Metaphysics of Markets

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On debugging software and Popper’s philosophy of science

Software containing bugs often produces undesirable results. When the a posteriori output from a programme does not meet our a priori expectations, either the programme logic has a flaw or the programme logic is fine, but the programme design was flawed.
When we test a programme, we are effectively collecting empirical data from which we make inductive propositions about the programme. So, if the erroneous output exhibits a certain pattern, we might infer a rule that might be generating this data. This is inductive science; moving from a limited set of observations to a general principle or law. And inductive science is, philosophically speaking,not uncontroversial. Induction is subject to the risk of ‘black swan’ events; no matter how many examples we find in support of a supposition (“All swans are white”), induction alone can never prove the objective truth of “All swans are white”.
However, Popper noted that we can apply deductive reasoning to the results of induction. So when our supposition that “All swans are white” is contradicted by the discovery of a single black swan, we may deduce that “Not all swans are white”. This move has maximal justification.
When we debug code with known errors, a good procedure is to create test conditions that enable us to apply this deductive technique and thus isolate the faulty lines of logic. We induce a hypothesis such as “All inputs {A} when processed by logic {L1,L2..LN} produce output {B}”, when we expected to see output {C}. We induce this from the output we can see in testing; and remember it is just an unproven hypothesis at this point. Now, if we can product output {B*} from the same inputs and logic, we can deduce something far stronger; a concrete proposition that “Not all input {A} when processed by logic {L1,L2..LN} produce output {B}” or its logical counterpart “Inputs {A} when processed…can produce {B} OR {B*}”.
This is a powerful result; moving from supposition to fact, by deduction. And software debugging is particularly well-placed to benefit from its application.

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On the disquieting absence of the philosophy of finance

In my first book, The Metaphysics of Markets, I argue that finance as we understand it has no philosophical underpinning. But what does this mean exactly? And why should it matter?
Almost any subject studied professionally or academically today has a ‘branch’ dedicated to the ‘philosophy’ of that subject. This branch asks reflexive and abstract questions about the nature of the subject. So for example, the philosophy of mathematics, concerns itself with questions relating to how mathematics ought to be studied, the extent of what can be known about mathematics, and of what mathematical concepts consist. The philosophy of law (jurisprudence) asks what is meant by law and justice and how the judiciary ought to operate.
Such questions can seem remote and intangible. They can seem not to matter pragmatically, as we muddle on regardless of whether or not these issues have been settled. And yet, as soon as our regular or prosaic way of dealing with certain unusual situations seems inadequate, very swiftly we proceed with retort to these fundamentals.
The recent financial crisis has been just one such occasion. Seeing a near melt-down of financial institutions and markets, it is natural to expect discourse to turn towards the fundamentals. However, there is very little in the way of substantial research in this field. In consequence, we see politicians and commentators resorting to mere name-calling (‘greedy bankers’,’reckless speculators’). We see ad hoc solutions to the on-going problems; liquidity provision here, bonus capping or super-taxing there. In short, an amateurish response to a global crisis. And this response is necessarily inadequate given that our understanding of finance and the financial markets is so shallow. The philosophy of finance simply hasn’t been given proper consideration.
In The Metaphysics of Markets I offer an explanation of why, historically, this gap in our understanding exists. Briefly, it is a result of the direction taken by economists and their descendants, finance theorists. This path has been to over-emphasize pseudo-scientific methods and mathematical modelling. Finance theorists have played at mathematicians, forgetting they are to be found in Humanities faculties.
I suggest that finance theorists, regulators and financial market participants should give thought to matters that underlie their subject, as have other thinkers in other fields. It is time to consider what exists in the financial markets, instead of assuming that this is known. It must be asked whether the markets have a purpose other than that currently presumed. It must be asked what can be known of the markets. Is there an ethical basis to the markets or is the Friedmanite concept of a value-free corporate structure the right answer? I offer several possible answers to these questions as well as outline many of the other branches that the philosophy of finance ought to encompass. It is a matter I consider of grave and pressing importance if we are to understand and deal with financial crises which, modern history suggests, will continue to occur only too readily.

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