Editors Corner

Paul Davidson

Is risk management a science?

Abstract: Risk management computer models developed by the quants of

Wall Street and used by investment bankers did not predict the financial de-
rivative crisis that almost sunk the global financial community in 2007. This
article explains why these complex models were wrong and why models like
Talebs black swan approach are all based on nonapplicable axioms. It then
explains how Soross concept of reflexivity is similar to Keyness liquidity theory
of financial marketsan analytical framework that explains what caused the
financial crash of 20078.

Time is a device that prevents everything from happening at once. All

decisions that are made today will have their results or payoff at some time
in the future. This is most obvious in investment decisions in plant and
equipment where the realized rate of return will be achieved only years
after the decision to invest is made. But once the decision is made, the
decision maker is stuck with the investment over its useful life. In other
words, investment in plant and equipment is like marriage in a Catholic
worldtill death do us part. Will the rate of return actually made over
the life of the investment be the same as what the entrepreneur expected
at the moment the investment decision was made? And how was the
entrepreneurs expected rate of return estimated?
For decisions made today for the purchase of financial assets, it is also
true that the realized rate of return over the life of the financial asset will
only be known at the end of that life. Again, we may ask if the return
will be equal to that expected at the time the purchase decision is made.
If, however, the financial asset is liquid, that is, traded in a liquid market
(characteristics to be defined below), then the moment the holder decides
something is going wrong and his/her expected return is unlikely to be
achieved, the holder can make a fast exit by selling the asset and thereby

Paul Davidson is editor of the Journal of Post Keynesian Economics. This paper was
presented at the Professional Risk Managers International Association convention,
New York City, May 15, 2012.

Journal of Post Keynesian Economics/Winter 20122013, Vol. 35, No. 2301

2013 M.E. Sharpe, Inc. All rights reserved. Permissions: [Link]
ISSN 01603477 (print)/ISSN 15577821 (online)
DOI: 10.2753/PKE0160-3477350207
302 JOURNAL OF POST KEYNESIAN ECONOMICS

limiting the potential anticipated loss. Consequently, the decision to buy

a liquid financial asset involves estimating the rate of return from the
date of purchase to the expected date of sale in the market. Divorce is
not only possible before death, but it is very likely in the world of liquid
assets. Rarely is the expected return equal to the actual return recovered
over time. If a financial asset is illiquid, then the holder is stuck with the
asset until death do them part.
A sage once said about the future, Nothing is certain except death and
taxes. To which I might add, That is why good accountants are worth
their weight in gold for although they cannot tell you how to avoid the
former, they can tell you how to avoid the latter. Unfortunately, in the
world of experience, little is known with certainty about future payoffs of
decisions made today. If the return on economic decisions made today is
never known with perfect certainty, then how can managers make optimal
decisions on where to put their firms money today?
In recent years, following developments in mainstream economic and
financial theory, managers were often told to base their decisions on risk
management computer models that permit the decision maker to know
with actuarial certainty the payoff on any portfolio decision made today.
These risk management models were based on a scientific methodology
that presumed that probabilities (calculated from past data) can be pooled,
managed, and tamed to reliably predict the future.
How good is this scientific methodology underlying risk management
models? In an amazing mea culpa testimony before a congressional
committee on October 23, 2008, the maestro of financial markets, Alan
Greenspan, stated:
This [financial] crisis...has turned out to be much broader than any-
thing I could have imagined.... those of us who had looked to the self
interest of lending institutions to protect shareholders equity (myself
especially) are in a state of shocked disbelief....In recent decades, a
vast risk management and pricing system has evolved, combining the
best insights of mathematicians and finance experts supported by major
advances in computer and communications technology. A Nobel Prize
was awarded for the discovery of the pricing model that underpins much
of the advance in derivatives markets. This modern risk management
paradigm held sway for decades. The whole intellectual edifice, however,
collapsed. (emphasis added)
Under questioning by members of the congressional committee, Greenspan
admitted that the financial crisis forced him to reappraise his views on fi-
nancial markets and the risk management model. Greenspan then stated:
 is risk management a science? 303

I found...a flaw in the model...in the [assumed] critical functioning

structure that defines how the world works....I still do not fully under-
stand why it [the flaw] happened, and obviously to the extent that I figure
why it happened I shall change my views.
The purpose of this presentation is to explain to Alan Greenspan and to
others why the intellectual edifice of the risk management paradigm col-
lapsed and what scientific theory can be used to understand movements
in financial markets.

Knowing the cause of future outcomes

We have already noted that the results of any decision today will depend
on the passage of some amount of calendar time. How can we know these
future outcomes? Since biblical times, humans have tried to understand
what causes things to happen. The human mind believes that there must
be a cause that occurs in time before any observed outcome occurs. For
most of the history of mankind, it was believed that the design of God or
the Gods was the cause of anything that happened in the world of experi-
ence. Beginning in the seventeenth century, however, some philosophers
believed that explanations of events that one observed could be developed
on the basis of reasoning of the mind rather than religious belief. This was
the beginning of the intellectual movement historians call the Enlighten-
ment or the Age of Reason where order and regularity was seen to come
from the human analysis of observed phenomena. The power of reason
was not in the possession but in the acquisition of truth.
Reasoning involves the human mind creating a theory to explain what we
observe happening. For example, Sir Isaac Newton saw an apple fall from
the bough of a tree to the ground. Newton explained why apples always
fall by the scientific theory of gravity. Charles Darwin created the scientific
theory of evolution to explain the different species inhabiting the earth. In
the twenty-first century, most of society believes that understanding comes
with the development of scientific theories. Do we have a scientific theory,
or is it the will of God, that explains the prices in financial markets?
A theory that attempts to explain real world observations on the basis
of a model starts with a few axioms. An axiom is an assumption accepted
as a universal truth that does not need to be proved. From this axiomatic
foundation, the theorist uses the laws of logic to reach conclusions that
explain what we observe in the world of experience. All theories are
generally accepted in some tentative fashion. Theories are never con-
clusively established.
304 JOURNAL OF POST KEYNESIAN ECONOMICS

Economic theorists build a theory or model based on some fundamental

axioms that they accept as self-evident truth. The tools of logical deduc-
tion are then used to reach one or more conclusions. These conclusions
are then presented to the public as the explanation of economic events
that are occurring in the world of experience. If the facts of experience
conflict with the economic theory, then one or more of the theorys
fundamental axioms are flawed and should be discarded so a different
theory can be built.1
So if we are to enlighten Alan Greenspan as to why the risk manage-
ment intellectual theory collapsed, we must explain which of the axioms
that are the foundation of that edifice are flawed. Furthermore, we must
recognize that the aim of science is to understand processes that are oc-
curring in the external world around us. Prediction about future events
may be a tool of certain scientific methodology, but it is not the goal of
science itself. Nor can all scientific theories provide the basis for mak-
ing accurate predictions. At best, prediction may be regarded as a useful
by-product if it can be attained under the theory developed.
There are two different major economic theories that attempt to ex-
plain the operation of the money-using, entrepreneurial economy that
we call capitalism and its financial markets. The first and most widely
recognized one is the classical economic theory, which is sometimes
referred to as the theory of efficient markets or mainstream economic
theory. Efficient market theorists claim that if economics is to be a sci-
ence it requires rigor, consistency, and mathematics. Nobel Laureate
Paul Samuelson has explicitly added one additional characteristican
axiom that most efficient market theorists implicitly assumenamely,
economists must accept the ergodic axiom in their models if economics
is to be a rocket science on par with physics, astronomy, and chemistry
(Samuelson, 1969). I will explain in a moment what this ergodic axiom,
a term Samuelson borrowed from statistical mechanics, presumes re-
garding knowledge about the future. But first I raise the question that
if efficient market theory possesses the characteristics attributed to it
by its advocates, then how is it possible that efficient market theorists
did not foresee the financial crisis that started in 20078? Moreover,
how many risk managers who had to put their employers money
where their computer model mouths were saw the financial collapse
of 20078 coming?

1 The alternative would be to change the facts to fit the unrealistic theory, as, I

must admit, sometimes happens in academia and in Washington.

 is risk management a science? 305

The mantra of this efficient market theory is that enlightened decision

makers in free financial markets will always know the future outcome
for any decision made today. These decision makers, therefore, always
pick those choices that provide the highest possible future returns. Con-
sequently, free markets are efficient in the sense of allocating capital to its
best (most profitable) use. Any government interference in these efficient
markets will, therefore, always produce a less than optimal outcome. In
other words, interventionist government economic policy is the problem,
while the free market is the solution.
Whether they declare themselves Monetarists, Rational Expectation
theorists, Neoclassical Synthesis (Old) Keynesians or New Keynesians,
the backbone of all mainstream theories is the efficient market analysis
model where it is presumed that correct information about the future
exists today, and this information can be obtained by decision makers.
For Old and New Keynesians the only thing that prevents efficient
markets from operating in the short run is the presumption of some
temporary fixity in money wages paid to workers, for example, union-
determined wages, government minimum wage laws, and/or the fixity
of output prices due to monopolies. In the long run, wages and prices
will be flexible and therefore the market outcomes will be efficient as
determined by the deep parameters (immutable fundamentals) of the
system.2

How do we know the future?

Instant riches await anyone who knows the future of financial market
prices! To know the future in financial markets, Greenspans risk manage-
ment intellectual edifice assumed one merely has to calculate proba-
bility distributions regarding future prices to develop todays significant
and reliable statistical inferences (information) about the future. Once
self-interested decision makers have this reliable statistical informa-
tion about the future, their actions on free markets optimally allocate
resources into those activities that will have the highest possible future
returns, thereby enriching themselves and their stockholders while as-
suring global prosperity.
In order to draw any statistical (probabilistic risk) inferences regard-
ing any universe, however, one should draw and statistically analyze a
2 Thus, most mainstream economists who call themselves Keynesians, including

Nobel Prize winners, urge government action only because they are too impatient to
wait for the long run. For as Keynes said, In the long run we are all dead (Keynes,
1923, p. 80).
306 JOURNAL OF POST KEYNESIAN ECONOMICS

sample from that universe. Drawing a sample from the future economic
universe of financial markets, however, is impossible. Accordingly, if one
presumes, as efficient market theorists do, that the economy is always
governed by an unchanging ergodic stochastic process, then this ergodic
axiom presumes that the economic future is already predetermined, and
a sample drawn from the past is equivalent to a sample drawn from the
future. In other words, calculating the probability distribution from past
statistical data samples is presumed to be the same as calculating the risks
from a sample drawn from the future. If financial markets are governed by
the ergodic axiom, then we might ask why do mutual funds that advertise
their wonderful past earnings record always note in their advertisements
that past performance does not guarantee future results?3
This ergodic axiom is, therefore, an essential foundation for all the
complex risk management computer models developed by the quants
on Wall Street. If, however, the economy is governed by a nonergodic
stochastic process, then these computer models are potential weapons of
math destruction because probability distributions generated from past
market data are not reliable estimates of a probability function that would
be obtained if one could draw a sample from the future.4
Nobel Prize winner Robert Lucas (1981, p. 563) boasted that mainstream
theory axioms such as the ergodic axiom are artificial, abstract, patently
unreal. Like Nobel Laureate Samuelson, Lucas insists such unreal as-
sumptions are the only scientific method of doing economics. Lucas (ibid.)
states that progress in economic thinking means getting better and better
abstract, analogue models, not better verbal observations about the real
world. The rationale underlying this argument is that these unrealistic
assumptions make the problem more tractable mathematically and, with
the aid of a computer, the analyst can then statistically predict the future.
Never mind that the prediction might be disastrously wrong.
To understand why the risk management theoretical edifice failed, one
must understand the difference, as stochastic probability mathematicians
would say, between a nonergodic stochastic process and an ergodic sto-
chastic process as the basis for obtaining reliable statistical information
today about future outcomes, that is, about whether today we can know

3 For deterministic economic models, the ordering axiom plays the same role as the

ergodic axiom in stochastic economic models.

4 For a more detailed explanation of the difference between ergodic and nonergodic

stochastic processes and its implications for many economic problems domestically
and internationally, one should read Davidson (2009). After reading it, perhaps clients
and colleagues should read it as well to get the proper scientific theory for understand-
ing the economic system and the future price movements in financial markets.
 is risk management a science? 307

the future.5 If in the real world of experience, households, entrepreneurs,

portfolio managers, and the like do not have, and cannot obtain, any
significant statistically reliable information about the economic future,
then they cannot make decisions that will prove, in hindsight, to be ef-
ficient. The explanation of market efficiency is the result of accepting
the unrealistic ergodic axiom as the foundation for mainstream economic
and financial theory. It is not the fault of using the deductive method,
rigor, and mathematics per se. So we should not blame the messenger
for the message!
In sum, the ergodic axiom underlying the typical risk management mod-
els represents a model remote from an economic reality that is governed
by nonergodic conditions. There is an alternative economic theory that is
applicable to a realistic economic world of nonergodic uncertainty and still
allows one to have a scientific understanding of the functioning of financial
markets in a capitalist system. This alternative theory that discards the
ergodic axiom is Keyness (1936) liquidity theory/George Soross concept
of reflexivity. Keynes, his post-Keynesian followers, and George Soros all
reject the assumption that people can know the economic future, which
is not predetermined. Instead they assert that people know they cannot
know the future outcome of crucial economic decisions made today. The
future is truly uncertain and not just probabilistically risky.
Keynes suggested that classical theorists invented a world remote
from reality and then lived in it consistently. Keynes stated that classical
economic thinkers were:
like Euclidean geometers in a non-Euclidean world who discover that
apparent parallel lines often meet, rebuke these lines for not keeping
straight. Yet, in truth there is no remedy except to throw over the axiom
of parallels and to work out a non-Euclidean geometry. Something similar
is required to-day in economics.6
Keyness theory is more general than mainstream economic theory
because it is based on fewer restrictive fundamental axioms. In empha-
sizing the uncertainty of results in making investment decisions, Keynes
eliminated the ergodic axiom. George Soros has explained why the ef-
ficient market theory is not applicable to real world financial markets
with a slightly different terminology than Keynes but conceptually in
the same way. Soros (2008) wrote, we must abandon the prevailing
[efficient market] theory of market behavior (p. 65) and that there is a
5 There are some processes, even in physics, that are governed by nonergodic sto-

chastic systems.
6 By the way, rebuking these lines is a way of altering the facts!
308 JOURNAL OF POST KEYNESIAN ECONOMICS

direct connection between market prices and the underlying reality that
I [Soros] call reflexivity (p. 66).
What is this reflexivity? In a letter to the editor of the Economist pub-
lished in the March 1421, 1997, issue, Soros objects to Samuelsons
insistence on requiring the ergodic axiom to make economics a science.
Soros (1997, p. 5) argues that the ergodic axiom does not permit the
reflexive interaction between participants thinking and the actual state
of affairs that characterizes real world financial markets. In other words,
the way people think about the market today can affect and alter the
future path the market takesthe economic financial future is not prede-
termined by any natural law. Soross concept of reflexivity, therefore, is
equivalent to Keyness rejection of the ergodic axiom. Reflexivity means
that peoples thoughts and actions create the future, while mainstream
economists presume the future has already been predetermined (like the
movement of heavenly bodies in the study of astronomy).
Keynes used a beauty contest (1936, p. 156) analogy for the stock mar-
ket to illustrate how we try to make good portfolio investment choices
and this also illustrates Soross reflexivity. In picking winners in this
stock market beauty contest, you must anticipate the winner among the
contestants, where total public votes will determine the winner. In this
case, you should not pick who you think is the most beautiful contestant,
nor even the contestant you think most everyone else thinks is the most
beautiful contestant. Instead you should devote your intelligence to
anticipating what average opinion expects the average opinion to be
as to who is the most beautiful. The conclusions of the KeynesSoros
analysis is, as I will explain, (1) that the use of money contracts in all
production and consumption decisions provides decision makers, oper-
ating in an uncertain world, with some legal certainty about future cash
inflow and outflow outcomes of todays decisions, and (2) liquidity, the
ability to meet ones money contractual obligations as they come due,
is an essential aspect of decision making in a capitalist economy and a
financial markets system.
In the introduction to his best-selling book Against the Gods, a treatise
that argues that the economic future is more than the whim of the gods
(p. 1), investment adviser Peter L. Bernstein deals with the questions of
the relevance of risk management techniques on Wall Street. Bernstein
(1996, p. 6) wrote:
The story that I have to tell is marked all the way through by a persistent
tension between those who assert that the best decisions are based on
quantification and numbers, determined by the [statistical] patterns of
 is risk management a science? 309

the past, and those who base their decisions on more subjective degrees
of belief about the uncertain future. This is a controversy that has never
been resolved...to what degree should we rely on the patterns of the
past to tell us what the future will be like?

Keyness theory of liquidity and Soross reflexivity concept support

Bernsteins latter group. One would hope that the empirical evidence
of the 20078 financial collapse, despite Wall Streets sophisticated risk
management computer models, has at least created doubt regarding the
applicability of the ergodic axiom to our economic world. Even Alan
Greenspan in testimony before Congress seems to be having second
thoughts, although he still has not completely changed his tune.
Samuelson, Lucas, and others adopted the ergodic axiom because
they want economics to be in the same class as the hard sciences such
as astronomy. The science of astronomy is based on the presumption
of an ergodic stochastic process that governs the movement of all the
heavenly bodies from the moment of the Big Bang to the day the uni-
verse ends. Accordingly statistical analysis using past measurements of
the movements of heavenly bodies permits astronomers to predict future
solar eclipses within a few seconds of when they actually occur. Noth-
ing Congress, the president of the United States, the United Nations, or
environmentalists can do will alter the predetermined dates and time for
future solar eclipses. For example, Congress cannot pass an enforce-
able law outlawing solar eclipses in order to provide more sunshine and
thereby enhance crop production. In an ergodic world, all future events
are already predetermined and beyond change by human action today. In
a nonergodic world, human actions, assuming Congress is human, can
create the future. Following Samuelsons lead, most economistsfrom
Nobel Laureate Joe Stiglitz on the political left to Milton Friedman on the
political rightand most economic textbook writers either implicitly or
explicitly have assumed that observable economic events are generated
by an ergodic stochastic process.
What about Talebs (2007) black swan? Talebs black swan concept
attempts to explain market crashes as an event lying in the far-off tail
of an ergodic probability distribution, an already predetermined out-
come but one that is so far out on the tail of the ergodic probability
distribution that its occurrence is so rare that it is never likely to be
observedexcept in the long run when we are all dead. So why were
there three financial crises (black swans) within some peoples lifetime
of 100 years1907, 1929, and 2007? Talebs theory is incompatible
with the facts.
310 JOURNAL OF POST KEYNESIAN ECONOMICS

Uncertainty, money contracts, and liquidity

For decisions that involve potentially large cash outflows or possibly
large cash inflows that span a significant length of calendar time,
people know that they do not know what the future will bring. They
do know, however, that to make a mistake about the future can be very
costly and therefore that putting off a contractual commitment today
in order to remain liquid may be the most judicious decision possible.
In their book on competitive equilibrium, Arrow and Hahn (1971, pp.
256257) wrote:
The terms in which contracts are made matter. In particular, if money is
the goods in terms of which contracts are made, then the prices of goods
in terms of money are of special significance. If a serious monetary theory
comes to be written, the fact that contracts are made in terms of money
will be of considerable importance.
If this sounds obvious, I should point out that economists who believe in
efficient markets also assume contractual decisions are made in terms of
real thingsnot money flows. Liquidity is irrelevant in efficient market
theory.
Keyness liquidity theory provides what Arrow and Hahn call a serious
monetary theory for domestic and international transactions as a way
of coping with an uncertain future. Money is that thing that government
decides will settle all legal money contractual obligations. An individual
is said to be liquid if he/she can meet all contractual obligations as they
come due. For business firms and households, the maintenance of ones
liquid status is of prime importance if bankruptcy is to be avoided, for
bankruptcy is the economic equivalent to a walk to the gallows. Main-
taining ones liquidity permits a person or business firm to avoid the
gallows of bankruptcy.7
Our modern capitalist society has attempted to create an arrangement
that will provide people with some control over their uncertain economic
destinies. In capitalist economies, the use of money and legally binding
money contracts to organize production, sales, and purchases of goods
and services permits individuals to have some control over their future
cash inflows and outflows and therefore some control of their monetary
economic future. Business firms that engage in forward monetary sales
contracts provide themselves with the legal promise of future cash inflows
sufficient to meet the business firms costs of production and generate a
7 Yet, as my good monetarist friend and sometimes op-ed writer for the Wall Street

Journal Alan Meltzer has often told me, Bankruptcies are good for the health of the
capitalist system. If you believe Alan, I have a bridge nearby that I can sell you.
 is risk management a science? 311

profit. Households and business entrepreneurs willingly enter into money

contracts because each party thinks it is in their best self-interest to fulfill
the terms of the contractual agreement and be able to predict and control
with some legal assurance cash inflows and outflows. If, because of some
unforeseen event, either party to a contract finds itself unable or unwill-
ing to meet its contractual commitments, then the judicial branch of the
government will enforce the contract and require the defaulting party to
either meet its contractual obligations or pay a sum of money sufficient
to reimburse the other party for damages and losses incurred. Thus, as the
biographer of Keynes, Lord Robert Skidelsky (1996, p. 57) has noted, for
Keynes injustice is a matter of uncertainty, justice a matter of contractual
predictability. In other words, by entering into contractual arrangements,
people assure themselves a measure of predictability in terms of their
contractual cash inflows and outflows, even in a world of uncertainty.
Thus, liquidity is at the center of the operations of our monetary economy,
and therefore financial markets that are well organized and orderly permit
decision makers to maintain liquidity in case some unforeseen future event
should make it otherwise impossible to meet a future money contractual ob-
ligation unless they can sell a financial asset for money in a well-organized
and orderly market. The sanctity of money contracts is the essence of the
capitalists system and Keyness liquidity analysis. In Keyness theory of the
operation of a monetary economy, liquidity, that is, the ability to meet ones
contractual obligations, becomes an essential foundation for understanding
the operation of our economy. The primary function of well-organized and
orderly financial markets is to provide liquidity so that holders of financial
assets traded on such markets know they can make a fast exit and liquify
their portfolio at a price close to the previous market price at any time they
fear something bad may happen in the uncertain future. With sufficient
liquidity, one can always meet ones money contractual commitments. In
our society, one can never be too beautiful, too handsome, or too liquid!
The maintenance of ones liquid position is of prime importance if default
and bankruptcy are to be avoided.
Once it is recognized that in a money-using economy decision mak-
ers know that the future is uncertain (in the nonergodic sense), then the
demand for liquidity to meet unforeseen possible net cash-flow problems
becomes paramount in decision makers plans. Thus, money contracts
(inflows and outflows) are used by individuals to protect themselves from
adverse net cash flows. The purpose of liquid assets traded on organized
and orderly financial markets is to provide a security blanket against
ones inability to meet a contractual obligation outflow. Thus, when the
market for mortgage-backed derivatives that were advertised to be as
312 JOURNAL OF POST KEYNESIAN ECONOMICS

good as cash and triple-A-rated and therefore perfectly liquid collapsed,

the loss of so much liquidity caused panic (a reflexivity response) in
other markets for derivative assets that had been previously thought to
be very liquid. Asset holders in many markets tried to make fast exits,
and the result was a financial collapse and crisis. Because many of the
holders of these assets were banks, the balance sheets of many major
banks took hits that could have been fatal except for the governments
Troubled Asset Relief Program effort.
An essential characteristic for a financial market to be a truly liquid
market requires an institutiona market makerwhose function is to
maintain orderliness. This market maker must possess sufficient resources
so that if many are making a fast exit, then the market maker will step in
and buy enough to maintain orderliness in their movement in the market
price. Consequently, markets without market makers with sufficient re-
sources can become disorderly and result in financial crisis.
In sum, risk managers of financial assets should realize that the eco-
nomic system is nonergodic. Consequently, the best strategy is to maintain
liquidity by dealing primarily in securities where the market provides a
market-maker institution that is trustworthy and has sufficient resources
(and even, when necessary, has access to the central bank for additional
funded liquidity) to maintain an orderly market. When purchasing a
financial asset in a market without a market maker, one must recognize
the possibility of being trapped in a disorderly market till death do us
part. Does any portfolio manager want to take this risk?

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