A Simple Theory of the Financial Crisis or, Why Fischer Black Still Matters

The key question about the current financial crisis is how so many
investors could have mispriced risk in the same way and at the same
time. This article looks at the work of Fischer Black for insight into
this problem. In particular, Black considered why the “law of large
numbers” does not always apply to expectations in a market setting.
Black’s hypothesis that a financial crisis can arise from extreme bad
luck is more plausible than is usually realized. In this view, such
factors as the real estate market are of secondary importance for
understanding the economic crisis, and the financial side of the crisis
may have roots in the real economy as a whole.

That's the abstract from an article by me, Financial Analysts Journal, Vol. 65, No. 3, 2009. I don't yet know of an on-line copy.


When an online copy comes out, can you link it here on MR? It sounds interesting.

"..... The herd is evil smelling , but it gives warmth."
Romain Rolland

a financial crisis can arise from extreme bad luck

Yes, an asteroid impact might cause a financial crisis. Based on your abstract only, it seems that irrationality, whatever its role in markets, is alive and well in finance professors.

The real economy? Finally.

I always found it odd that so many economists believe we suffer a failed financial system. I ask: If something else failed then wouldn't the financial system always reflect that failure? They never have an answer, carpenter and hammer and all that.

It is like they have a fundamental misperception of what financial system due, yet they claim that area aws their area of expertise. We need to separate financial economists from transportation economists, housing economists etc.

I always have a hard time with people who wave their hands and say "Bad Luck" esp where there are competing theories that do not require bad luck but simple self interest.

Minsky's argument is that in a credit expansion firms that take on more leverage do better and get rewarded for doing better, causing all firm to take on too much leverage until an inevitable bit of credit default (more commonly known as bad luck) happens which causes the leveraged investments to no longer make money.

According to you, Fischer Black's explanation is only the bad luck part.

I am a huge fan of FB, but in this particular case, not so much. I think in general his extension of equilibrium to all of economics was based on his love for equilibrium and not facts.

Nice article, but it begs the question — where will the sectoral shift go?

Grammar nazi,

I generally frown on snootiness - it just isn't usually very constructive, and I will be adding nothing of real substance to this discussion of Tyler's piece. But since you chose the handle "Grammar nazi," you sorta asked for it. You've used the phrase "begging the question" incorrectly (as any analytic philosopher will be quick to tell you).


Fischer Black was making a mathematical argument about the possibility of a string of extreme events among a distribution of probabilities. He was essentially ascribing 'luck' (bad that is) to having many high standard deviation events in the market that has bad effects on the economy as a whole.

Like problems with most scientific / mathematical outlooks, they stem from assumptions. When the assumptions are wrong, it doesn't matter what the formula is. The assumption that I believe is wrong is that markets and the economy can be represented by a Gaussian distribution.

Pure Gaussian distributions assume a random event. The market and the economy are not random, but they are chaotic. And while daily changes in the market do seem to fall on a Gaussian curve, that doesn't make them random.

So while Fischer Black discuss high standard deviation events as 'bad luck' they do so because they assume any event that falls on the curve to be random. Some of us don't make that assumption and instead see the events that show up on the curve as chaotic and therefore are NOT surprised that there have been something like 167 5+ standard deviation days on the Dow since 1920. That is 167 days of more than +/- 5.78% close to close change on the DOW out of 22475 trading days.

Is it 'bad luck' that so many 'extreme' events have happened? To a mathematician or economist who see the world as random and able to be modeled, the answer is yes. To a trader who sees the market as chaotic but not random, the answer is no. While such events aren't always predictable, the aren't unexpected.

Okay, BC, I admit that I misused «begging the question» (I'm in good company, though, as your link shows). I stand corrected. What I actually wanted to say was this: the phrase «sectoral shifts out of A, B, C, D and E», where said A-E together account for most of the U.S. economy, naturally leads one to wonder *what* kind of productive activities is the economy supposed to shift to. This question is arguably as important and difficult as the one about the causes and mechanisms of the current crisis.

scattergood is correct.

Let it be noted that the word "luck" appears only once in the article, and "chance" not at all. The statement "...Black’s revolutionary idea was simply that we are not as shielded from a sudden dose of bad luck as we would like to think" is followed by a text that seems entirely disconnected from that introductory statement.

It is symptomatic of the problem with the article that it refers to subprime loans as "risky" investments. In the aggregate they were not in the slightest degree "risky". An individual bet is a risk. But a strategy of continuous small bets isn't "risky" -- it's a certain loser. The economy went in the ditch because those at the controls put it on a path which was certain to end in the ditch. "Luck" had nothing to do with it.

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