Against the Gods: The Remarkable Story of Risk (38 page)

Jevons's pride in his achievements reflects the enthusiasm for measurement that characterized the Victorian era. Over time, more and more
aspects of life succumbed to quantification. The explosion of scientific
research in the service of the industrial revolution added a powerful
impulse to that trend.

The first systematic population census in Britain had been carried
out as early as 1801, and the insurance industry's use of statistics had
grown more and more sophisticated throughout the century. Many
right-thinking men and women turned to sociological measurement in
the hope of relieving the ills of industrialization. They set out to improve life in the slums and to combat crime, illiteracy, and drunkenness among the newly poor.

Some of the suggestions for applying the measurement of utility to
society were less than practical, however. Francis Edgeworth, a contemporary of Jevons and an innovative mathematical economist, went
as far as to propose the development of a "hedonimeter." As late as the
mid-1920s Frank Ramsay, a brilliant young Cambridge mathematician,
was exploring the possibility of creating a "psychogalvanometer."

Some Victorians protested that the rush toward measurement
smacked of materialism. In 1860, when Florence Nightingale, after
consulting with Galton and others, offered to fund a chair in applied
statistics at Oxford, her offer was flatly refused. Maurice Kendall, a
great statistician and a historian of statistics, observed that "[I]t seems that our senior universities were still whispering from their towers the last enchantments of the Middle Ages... [A]fter thirty years of effort Florence gave it up."*s

But the movement to bring the social sciences to the same degree of quantification as the natural sciences grew stronger and stronger as time passed. The vocabulary of the natural sciences gradually found its way into economics. Jevons refers to the "mechanics" of utility and self-interest, for example. Concepts like equilibrium, momentum, pressure, and functions crossed from one field to the other. Today, people in the world of finance use terms like financial engineering, neural networks, and genetic algorithms.

One other aspect ofJevons's work as an economist deserves mention. As a man trained in the natural sciences, he could not avoid taking note of what was right in front of his face-the economy did fluctuate. In 1873, just two years after the publication of The Theory of Political Economy, a great economic boom that had lasted for over twenty years in Europe and the United States came to an end. Business activity fell steadily for three years, and recovery was slow to come. Industrial production in the United States in 1878 was only 6% higher than it had been in 1872. Over the next 23 years, the prices of U.S. goods and services fell almost uninterruptedly by some 40%, creating much hardship throughout western Europe and North America.

Did this devastating experience cause Jevons to question whether the economic system might be inherently stable at optimal levels of output and employment, as Ricardo and his followers had promised? Not in the least. Instead, he came up with a theory of business cycles based on the influence of sunspots on weather, of weather on harvests, and of harvests on prices, wages, and the level of employment. For Jevons, the trouble with the economy was in heaven and earth, not in its philosophy.

Theories of how people make decisions and choices seem to have become detached from everyday life in the real world. Yet those theo ries prevailed for nearly a hundred years. Even well into the Great
Depression, the notion persisted that economic fluctuations were accidents of some kind rather than events inherent in an economic system
driven by risk-taking. Hoover's promise in 1930 that prosperity was
just around the corner reflected his belief that the Great Crash had
been caused by a passing aberration rather than by some structural fault.
In 1931, Keynes himself still exhibited the optimism of his Victorian
upbringing when he expressed his "... profound conviction that the
Economic Problem ... is nothing but a frightful muddle, a transitory
and an unnecessary muddle."6 The italics are his.

ur confidence in measurement often fails, and we reject it.
"Last night they got the elephant." Our favorite explanation
for such an event is to ascribe it to luck, good or bad as the
case may be.

If everything is a matter of luck, risk management is a meaningless
exercise. Invoking luck obscures truth, because it separates an event
from its cause.

When we say that someone has fallen on bad luck, we relieve that
person of any responsibility for what has happened. When we say that
someone has had good luck, we deny that person credit for the effort
that might have led to the happy outcome. But how sure can we be?
Was it fate or choice that decided the outcome?

Until we can distinguish between an event that is truly random and
an event that is the result of cause and effect, we will never know
whether what we see is what we'll get, nor how we got what we got.
When we take a risk, we are betting on an outcome that will result
from a decision we have made, though we do not know for certain
what the outcome will be. The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the
linkage between effect and cause is hidden from us.

Just what do we mean by luck? Laplace was convinced that there
is no such thing as luck-or hazard as he called it. In his Essai philosophique sur les probabilite's, he declared:

Present events are connected with preceding ones by a tie based upon
the evident principle that a thing cannot occur without a cause that
produces it.... All events, even those which on account of their
insignificance do not seem to follow the great laws of nature, are a
result of it just as necessarily as the revolutions of the sun.'

This statement echoes an observation by Jacob Bernoulli that if all
events throughout eternity could be repeated, we would find that every
one of them occurred in response to "definite causes" and that even the
events that seemed most fortuitous were the result of "a certain necessity, or, so to say, FATE." We can also hear de Moivre, submitting to
the power of ORIGINAL DESIGN. Laplace, surmising that there was
a "vast intelligence" capable of understanding all causes and effects,
obliterated the very idea of uncertainty. In the spirit of his time, he predicted that human beings would achieve that same level of intelligence,
citing the advances already made in astronomy, mechanics, geometry,
and gravity. He ascribed those advances to "the tendency, peculiar to
the human race [that] renders it superior to animals; and their progress
in this respect distinguishes nations and ages and constitutes their true
glory. "2

Laplace admitted that it is sometimes hard to find a cause where
there seems to be none, but he also warns against the tendency to assign
a particular cause to an outcome when in fact only the laws of probability are at work. He offers this example: "On a table, we see the letters arranged in this order, CONSTANTINOPLE, and we judge that
this arrangement is not the result of chance. [Yet] if this word were not
employed in any language we should not suspect it came from any particular cause."3 If the letters happened to be BZUXRQVICPRGAB,
we would not give the sequence of letters a second thought, even
though the odds on BZUXRQVICPRGAB's showing up in a random
drawing are precisely the same as the odds on CONSTANTINOPLE's
showing up. We would be surprised if we drew the number 1,000 out of a bottle containing 1,000 numbers; yet the probability of drawing 457
is also only one in a thousand. "The more extraordinary the event,"
Laplace concludes, "the greater the need of it being supported by
strong proofs."4

In the month of October 1987, the stock market fell by more than
20%. That was only the fourth time since 1926 that the market had
dropped by more than 20% in a single month. But the 1987 crash came
out of nowhere. There is no agreement on what caused it, though theories abound. It could not have occurred without a cause, and yet that
cause is obscure. Despite its extraordinary character, no one could
come up with "strong proofs" of its origins.