**This article was written and published in my school’s (Columbia University) student-run newspaper earlier this year. However, I originally wrote this in the fall of 2007—before it was evident that the financial sector was coming apart at the seams.
What is the likely scenario when someone lends money to another who has a history of not repaying? Well, the answer is not as obvious as you may think. If you are a normal human being, i.e. your cognitive faculties are in good order, then you would probably say the most likely scenario is that the person will not pay back. But if one asks a mathematician working at any popular hedge fund or at a rating agency, for example, then the answer depends on the manipulation of a few numbers and opaque formulas. Therefore, the “real” answer—like beauty—is in the eye of the beholder. Milton Friedman once said, to paraphrase, who cares about assumptions if your prediction is right? I add a corollary, if one’s results are right today, they won’t necessarily be right tomorrow. So on that note, I want to discuss two major assumptions that support some theories of finance and economics—disciplines that are near and dear to me. These assumptions have been discredited by common sense or history, but have been recycled and presented as new approaches. But mean regression is not only confined to statistics; it also applies to the acceptance of defunct assumptions. So-called experts that glorify them tend to exude a strand of hubris in their abilities to predict and to utilize methods that quite frankly invade the territory of faith, rather than to present a realistic observation of our surroundings.
Let me expose one such article of faith that is not much talked about but is of a monumental crux to the disciplines: homo economicus—a being that is rational, self-interested, and omniscient. This unique homo sapien, lauded in textbooks and in the classrooms of most of academia, is present everywhere but in real life. But he exists, say the experts. Take their word for it. Homo economicus is capable to instantaneously calculate all available information, consider alternatives, and discount activities that have not occurred yet. The complexities and ambiguities of life are reduced to a few variables, disguised under bell-shape curves or non-parametric estimations. He is then boxed in a static, two-dimensional graph that in part endeavors to depict in futility the unknowable uncertainty (or “unknown unknowns,” as the former Sage of the War Department—as I like to call him—Donald Rumsfeld, once uttered). We “now know”, however, that homo economicus might not be as rational as expected. For instance, he is able to maintain contradictory beliefs without hesitation, hold on to losing positions longer than he should, react differently depending upon how the “facts” are framed, and is plagued by numerous cognitive biases unbeknownst to him. One of the most renowned economists to ever live, Alfred Marshall, declared in 1890 that economics relates to the “study of mankind in the ordinary business of life.” Despite the insurmountable evidence confirming this observation, homo economicus is still on the loose—mankind is far from perfect and from obtaining complete knowledge and foresight.
The other assumption implicitly accepted relates to our fiat monetary system (i.e. value by decree)—as if it has existed since time immemorial. Money is fundamental to all economies because it is supposed to function as a storage of wealth for people. Without a sound monetary system the division of labor becomes severely strained. Today the pieces of colored paper (called money) issued by almost all nations derive their value from government magic: a law dictates how much something is worth. The U.S. Dollar, for instance, is supported by the “full faith and credit of the United States.” Some will quickly point and say, “wait a minute, it has to do with supply and demand.” Supply and demand intersect to yield a price not a value—there is a difference. It is incredible that this type of faith-based conjecture (fiat currency) is allowed to pervade as scientific and inerrant. Like an alcoholic at an open bar, that person is likely to have too much liquor. The same logic applies to governments that can wantonly print paper money: It creates distortion in the process of capital allocation. Looking at the annals of worthless money history, it can be noted that long-term purchasing power of all fiat paper is zero.
Assumptions are crucial. Without accurate accounting and recognition of them, decision-making becomes an obfuscated process. Wrong judgments are reached. Wrong decisions are made.