On the Analogy Between Modern Financial Theory and “Lysenkoism” in Stalin's Soviet Union

Yet, intellectually impressive as it is, most of this theoretical edifice was based on a deeply flawed understanding of the way the world actually works. Like medieval alchemy, it was an elegant and internally consistent intellectual structure based on flawed assumptions.

One of these was that stock price movements obey a Gaussian distribution. While the Gaussian distribution is the best-known distribution, it is only one of many, and has the special property that its “tails” are very thin—i.e., that events from outside the norm are truly rare, never-in-the-history-of-the-universe rare. History tells us that's not right; markets surprise us quite often.

Among some of the other common but manifestly indefensible claims of Modern Finance are that:

• modern “free markets” ensure that financial innovation is a good thing, which benefits consumers and makes the financial system more stable;

• risks are foreseeable and, incredibly, that you can assess risks using a risk measure, the Value-at-Risk or VaR, that gives you no idea of what might happen if a bad event actually occurs;

• highly complex models based on unrealistic assumptions give us reliable means of valuing complicated positions and of assessing the risks they entail;

• high leverage (or borrowing) doesn't matter and is in any case tax-efficient; and

• the regulatory system or the government will protect you if some “bad apple” in the financial services industry rips you off, as happens all too often.

The invention and dissemination of Modern Financial Theory is a startling example of the ability to achieve fame and fortune through the propagation of error that becomes generally accepted. In this, it is eerily reminiscent of the work of the Soviet biologist Trofim Denisovich Lysenko, a man of modest education whose career began when he claimed to be able to fertilize fields without using fertilizer.

Instead of being dismissed as so much fertilizer themselves, Lysenko's claims were highly convenient to the authorities in the Soviet Union, and he was elevated to a position of great power and influence. He went on to espouse a theory, “Lysenkoism,” that flatly contradicted the emerging science of genetics and was raised to the level of a virtual scientific state religion. Those who opposed his theories were persecuted, often harshly. Lysenko's theories of agricultural alchemy in the end proved highly damaging and indeed embarrassing to Soviet science, and Lysenko himself died in disgrace.

Of course, the analogy is not perfect: proponents of Modern Financial Theory did not rely on Stalin to promote their ideas and silence their opponents, nor did they rely on the prison camps. Instead, their critics were sidelined and had great difficulty getting their work published in top journals, so ending up teaching in the academic “gulag” of less influential, lower-tier schools. But what the two systems share in common is a demonstrably false ideology raised to a dominant position where it inflicted massive damage, and an illusion of “scientific” respectability combined with a very unscientific unwillingness to listen to criticism.

—Kevin Dowd and Martin Hutchinson, introduction to Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Chichester, UK: John Wiley and Sons, 2010), 5-6.