The Physics of Wall Street

Some say physicists and mathematicians caused the financial crisis by unleashing derivatives, credit-default swaps, collateralized-debt obligations, computerized trading programs and complex financial models nobody could possibly understand.

Like Frankenstein's monster, these ubiquitous financial creatures started behaving in unpredictable ways. Soon the economy was destroyed and the villagers were storming Wall Street with torches and pitchforks. In some circles, it even became dangerous to say the word "quant."

Physicist and mathematician James Owen Weatherall says this is all a big misunderstanding. Sophisticated financial modeling and complex financial products don't ruin economies. People do.   The goal of physics and mathematics is to create models, discover the flaws in those models, build better models, and then repeat the process in the never ending pursuit of enlightenment. The goal of Wall Street, however, has sometimes been to build complicated models and sell them.

At 29 years of age, Mr. Weatherall holds advanced degrees in physics, philosophy, mathematics and creative writing. He teaches at the University of California, Irvine, and researches topics such as "Quantum control of electromagnetically induced transparency dispersion via atomic tunneling in a double-well Bose-Einstein condensate." (If you have to ask, don't ask me.)

He has also written a far more accessible book, "The Physics of Wall Street," due out next month. In it, he explores how ideas from physics and mathematics have made their way into financial markets for better and sometimes worse. Even ancient Sumerians sold options contracts, which are essentially derivatives, he observes. And the idea of calculating probabilities to make financial bets has been around for centuries.

He argues, convincingly, that complex financial tools can be used wisely or foolishly. A hammer will drive a nail if you hand it to a carpenter, or smash a car window if you hand it to a thief. That doesn't mean we shouldn't make hammers.

So here we are, four years after the great financial collapse, and nobody seems to have a clue how to prevent it from happening again.

So-called financial reforms have been incremental and mostly aimed at solving yesterday's problems.

Federal Reserve Chairman Ben Bernanke wants to keep bailing out the banking system and inflating the stock market by buying bonds and holding interest rates near zero.

Congress apparently wants to keep entertaining the masses with fights over the fiscal cliff and the debt ceiling.

"I don't think we've done anything since 2008 to make ourselves safer," Mr. Weatherall said in a telephone interview. "If anything, we've done plenty of things to make markets still more volatile...We just don't how to fix the economy in any kind of permanent way."

He said it is time for a new sort of Manhattan Project--this one aimed at fixing the world instead of blowing it up.

We should take America's best and brightest minds and put them to work on the biggest challenge of our time. Just as we beat Hitler to the atomic bomb, and Russia to the moon, we can swiftly tackle a seemingly intractable problem like our crisis-prone economy, Mr. Weatherall said.

Why do we have a Department of Homeland Security, but not a Department of Economic Security?

"It will be expensive," Mr. Weatherall conceded. "But it matters. It's about whether or not people are going to be able to feed their kids."

Currently, many of America's genius-level thinkers go to Wall Street where they work on the problem of making themselves as rich as possible--even if it is at the expense of the economy. But Mr. Weatherall said a new generation is coming of age in the aftermath of the crisis that may not be in it for the big money. He counts himself among them. He said he doesn't plan to follow in the footsteps of so many great mathematical minds and go to work for a hedge fund.

Naysayers step aside. In the 19th century, pessimists argued science would never be able to prove the existence of atoms. Today we power our homes with them. So seemingly impossible problems do have solutions when we are willing to work on them.

"What would a solution look like? I don't think anybody knows the answer," Mr. Weatherall said. "But what we do know is that the answer doesn't look like the things we keep trying."

(Al's Emporium, written by Dow Jones Newswires columnist Al Lewis, offers commentary and analysis on a wide range of business subjects through an unconventional perspective. Contact Al at al.lewis@dowjones.com or tellittoal.com)