We weigh the risks in our lives without a second thought. What are the chances that the upcoming rain storm will wash out the trail I want to hike on? If I buy this item today, will I regret it if the price drops next week? If I wait until next week, will I regret not snapping it up now if it's all sold out? What terms should I negotiate on my mortgage or my life insurance?
Everything is a tradeoff, and there are many unknowns. Sometimes we guess right, but more often, it sometimes seems, we don't. But we don't often question the very process of making these tradeoffs in assessing what to do.
Peter Bernstein points out that this way of thinking is actually quite new. It came about over the past several centuries, as we learned to recognize patterns in nature and eventually in humans. It's a complicated story, actually, and Bernstein for the most part tells it well.
If you believe that God controls all outcomes, why question what numbers come up in your nightly game of dice? Somewhat amazingly, no one sat down and tallied how often each possible combination arises until the late Middle Ages. Slowly but surely, the principles of probability were unraveled, with a few steps back amidst the many steps forward. A veritable explosion of measurement began.
I should mention that the book is really about the application of these ideas to economics (but only a little imagination is required to extend them to other areas). So most of Bernstein's examples are about markets. After a few centuries of learning to control nature, it seemed that markets worked predictably on the principles of statistics.
But with the turn of the 20th century, the falsehood of this belief was revealed. Markets began to crash in surprising ways, and the economy began to hint that it hid complexity far greater than had been suspected. (This was also, of course, the time when the Newtonian paradigm of predictability in physics was breaking down, with the dawning of atomic physics and quantum mechanics).
It seemed that humans had to be added to the equations. At first, economists tried to force human psychology into a statistical model (if presented with a certain tradeoff, 75% of people will choose A while 25% will choose B). And some still use this paradigm, although most at least recognize that it is crude.
Bernstein makes an interesting point about this transformation. It is easy to condemn the belief that God controls everything as one that does not allow humans to use their brains. But in fact, the purely statistical model is just as restrictive. It seems less so because it requires some brainwork to figure all the statistics, but in fact, there is still no choice.
Recognizing that-- gasp-- humans might not behave predictably or logically adds a crucial element of choice and randomness to the markets. Now we are talking about the true risk of playing economics-- your information is not perfect at the time you must make a decision, and even if it were, you could not know for certain what the other humans in the system will do in the future. This is what makes economics such a challenge, such a dynamic system, such a potential source of pain (and fear, uncertainty, and doubt!).
Bernstein's style is to tell the tale as a series of short biographies of the major players, from Fermat and Pascal to Black and Scholes. I'm not sure this format totally worked. Certainly he should have spent much less time on the early figures. The book did not get really interesting until he brought in more modern market concepts in the second half of the book. The early stuff is needed for historical context, but it should have been cut to about one-third its length.
The other mild quibble I had was that Bernstein flowed effortlessly from a mathematical to a social science context without quite indicating when the "fundamental" aspects ended. This is hard to describe, and I want to avoid appearing to be a physics snob, but there really is a difference between the truth of the probability of getting certain dice throws and the truth behind market fluctuations in our modern global economy. Things that rely on humans are different.
Bernstein does not explicitly discuss much philosophy, but his ideas provoke some interesting themes for the thinking reader. How does "choice" influence the global economy? How does the speed of modern information processing change the picture? Do our efforts to chase down every source of uncertainty and create new market instruments to address it (such as derivatives) actually create new risks and new "laws"?
"Against the Gods" is indeed a remarkable story. I wish it had been told as less of a great-man tale of all the heroes of economics, but buried in the biographical sketches are some very intriguing concepts. Economics is a social science, which automatically makes it complicated. The global economy is a beast we created ourselves, and stuggle everyday to understand. This book helps to show what we are up against.
As an industry analyst, I appreciate the ideas all the more. I see that the evolution of a new technology trying to break into the market is a far from logical process, absurdly dependent on who did what when. And yet, there are overall patterns that can be used to predict the overall shape of the trajectory. Forecasting is very difficult, and yet it is necessary. It is even necessary when it is wrong.
As you read the book, try to look beyond economics and business into other areas of life that have risk (which is nearly everything). You will find many applicable and surprising ideas from the book. I'll give it a "+"-- the key to enjoying "Against the Gods" is the skip some of the beginning part if it starts to drag. The end is worth getting to.
Copyright © Kim Allen 2003
