A molecule of gas doesn’t have a temperature, or a pressure. It’s just a point that moves at a particular speed, depending on how much energy it has. But when you have a million billion or so of them in a sealed box, their collective behaviour can be explained in those terms: even though each individual particle is moving at random, you can predict with extraordinary accuracy how many of them will, for example, hit the walls of the box at any one time. Individually random behaviour creates a predictable group.
At the heart of James Owen Weatherall’s book is the idea that the economy can be described in similar terms. An individual person is not an economy and has none of the characteristics of the economy. But a million people acting individually create an economy – and, says Weatherall, the history of financial thinking has been driven, in part, by physicists and mathematicians, looking for the rules that allow an economy to be predicted, as Boyle’s Law mathematically describes pressure and temperature, and predicts the aggregate behaviour of atoms. Newton might have said, “I can calculate the movement of the stars, but not the madness of men”, after losing a fortune in the South Sea Bubble, but his successors in the world of physics think differently.
It’s worth saying what Weatherall’s book is not, because I approached it with a certain amount of wariness. There are certain codewords that warn that Here Be Pseudoscience, words like “neuro”, “nano”, or “quantum”: the “quantum healing powers” of some quackish health fad, or the “nano-components” of an overpriced hi-fi set. I was worried that the “physics of finance” might be similar, that Weatherall was purporting to tell us how to get rich quick by applying “insights” from relativity or string theory to the stock market. But instead it’s an informative and frequently fun look at the history of financial thinking, and its cross-pollination with physics.
It’s a jaunty ride through the ages, from early 20th-century France to modern Wall Street via the Las Vegas of the Godfather films and Frank Sinatra. It takes in some famous names – Poincaré, Pascal, Fermat, Mandelbrot – and shows how some surprising moments of serendipity have altered the course of finance. For instance, the development of nylon may not, on the face of it, have much to do with finance, or physics. But, says Weatherall, the vast profits made thanks to the previously unsexy field of polymer chemistry helped break down the walls between pure and applied science, and gave scientists more licence to pursue more offbeat topics – which, for some physicists, included the mathematics of the stock market.
Similarly, as the space race pushed the US government to hurl money at physics in the years after the Second World War, thousands of bright young graduates took up the science – only for the funding to disappear almost the moment that Neil Armstrong’s feet touched the moon. Suddenly, there were thousands of unemployed, mathematically trained minds, just at the moment that Wall Street was waking up to the idea of employing physicists.
It’s not perfect, by any means. In the middle, after the fun stuff about Nasa and Vegas, it gets bogged down, hurling dozens of acronyms at the reader – the Chicago Board Options Exchange (CBOE), the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), et cetera. And it is light on the input of non-physicists – for instance, it’s odd that a book about macroeconomics can have only one mention of John Maynard Keynes, and that in a throwaway reference to “Keynesian” as opposed to “Chicagoan” economists. At least one American critic of the book, writing from a finance perspective, describes this neglect as “arrogant”. Yes, it’s about “the physics of finance”, but to borrow a physical term, these thinkers didn’t exist in a vacuum.
But it is full of interesting insights about chaos theory and fractal mathematics – it has the clearest explanation I’ve ever read of why the length of a coastline gets longer depending on how small a ruler you use, for instance – and historical titbits, such as that the Gold Standard was ended in America to put interest rates in control of free markets.
Most importantly, it explains how models of anything – whether physics or finance – are approximations, and while they improve, the key is always to be aware of that. Early financial models thought that the randomness in markets was fairly benign: the “random walk” could only stumble so far. Later ones revealed far wilder, more dangerous randomness hidden in the data. But the failure to grasp the risks and randomness in the movement of money was a factor in every major crash. Weatherall’s book, which reminds us that people are at least trying to understand those risks, is oddly reassuring.
by James Owen Weatherall
288pp, Short Books t £11.99 (PLUS £1.35 p&p) Buy now from Telegraph Books (RRP £12.99, ebook £8.92)