The Physics of Wall Street: a brief History of Predicting the Unpredictable

Epilogue: Send Physics, Math, and Money! 
•
217
cians enabled a novel kind of risk taking on the part of banks, and that 
we are now suffering the consequences.
Still, it’s not as though market crashes or speculative bubbles are 
a new phenomenon — after all, the largest market collapse in mod-
ern times occurred in 1929, long before derivatives became important. 
What’s more, for the past forty years, essentially the period over which 
financial innovation has been most important, the financial services 
sector has buoyed Western economies. In the United States, for in-
stance, the financial services industry has grown six times faster than 
the economy as a whole. this rapid growth has occurred at the same 
time that other industries, such as manufacturing, have either de-
clined or grown much more slowly. financial innovation, like other 
technological innovation, has thus played a major role in buoying the 
U.S. and other Western economies over the past three decades. More-
over, there is broad agreement among economists that a large, well-
developed financial sector generally spurs growth in other areas of the 
economy — at least to a point. there is also some evidence that if the 
financial sector becomes too large — as indeed, perhaps it has — it can 
negatively impact growth in other areas, largely because finance ends 
up exerting too much control over other industries. that may well be 
right, and it may be reason to implement financial reform. But one has 
to be very careful about throwing the baby out with the bath water: for 
all sorts of practical reasons, economic growth is a good thing. And 
worries that the financial sector in the United States or europe has 
grown too large hardly undermine the basic point that derivatives, and 
by extension Black and Scholes’s insights, have been essential to pro-
ducing the growth in the first place. If financial practices had stopped 
developing in 1975, the world’s economies would be far less developed 
than they are today.
that said, there are many sides to financial innovation. While per-
haps some derivatives have spurred growth, many people have criti-
cized their widespread use on account of how complicated they can 
be, and how difficult to understand. the suggestion seems to be that 
at least some derivatives are intentionally constructed to confuse or 
even defraud unsophisticated investors. for instance, this criticism 

---

218 
•
t h e p h y s i c s o f wa l l s t r e e t
has been leveled against certain derivatives based on consumer loans, 
such as collateralized debt obligations (cdos), that played a major 
role in the 2008 crash. these products involve repackaging mortgages 
and other loans into derivatives that were supposed to have carefully 
tailored risks and returns. In part, the reason these particular securi-
ties have been so heavily criticized is that many investors, including 
some major investment banks, were caught off guard when they rap-
idly declined in value — that is, when they became the “toxic assets” 
that have plagued U.S. and european banks. there was an enormous 
amount of confusion about the real risks carried by these products, 
largely because individual investors were ill equipped to evaluate the 
risks themselves, while credit ratings agencies like Moody’s and Stan-
dard & Poor’s gave the securities ratings that indicated they were much 
safer than they turned out to be. to make matters worse, the Sec has 
charged that Goldman Sachs allowed an outside hedge fund, Paulson 
& co., to construct cdos that were more likely to lose value than their 
ratings suggested — so that Paulson could bet against the misleadingly 
risky cdos.
Surely this episode reveals deep dangers inherent in certain prac-
tices involving derivatives. But really, the issue at hand has little to do 
with derivatives as such. If banks really constructed financial products 
that looked better than they were just so that their biggest investors 
could bet against them, as some regulators and others have charged, 
that is surely unethical. But con artists have been defrauding investors 
for a long time, without the help of cdos. It seems to me that deriva-
tives, even cdos, are best thought of as tools, much like the models 
used to construct them. crop futures, for instance, have played an im-
portant role in allowing farmers to finance the planting season and 
to control risk along the way for thousands of years; more recently, 
currency futures have significantly reduced the risk of international 
trade, enabling the growth of an international economy. Any tool can 
be used for more than one purpose — after all, a hammer can be used 
to hammer a nail, or to bash in a car window. In the hands of police, 
guns can (at least arguably) be an important part of maintaining a safe 
and orderly society; yet obviously guns are dangerous in other con-
texts. figuring out how to adequately regulate and control derivatives 

---