...The models governing our financial system were developed in the 1950s. They were built, as Persaud explains, upon the assumption that "each user is the only person using them." That assumption may have made sense when only the Rand Corporation (which developed the models) had the data to act upon them. But as Persaud wrote in the Financial Times in March, in "today's flat world, [where] market participants from Argentina to New Zealand have the same data," the assumption is nothing short of nuts. As the market shifts, the models used by all the major investment banks "throw up the same portfolios to be favored and those not to be." This is the Heisenberg uncertainty principle for financial markets: by being observed, the observed gets changed. The global, simultaneous and practically instantaneous "adjustments" lead "the herd" (a.k.a. our financial system) right off the cliff.

"But why," faith-based free marketers will ask, "doesn't the market figure this out? Why don't newer models outcompete the old?"

The answer is in part (and weirdly) cultural, and in part regulatory. To resist the models requires a George Soros-like confidence. Few have the courage to stand up to the "quants"—math geniuses, or engineering wizards, who feign certainty despite running models that largely omit the most basic John Nash-based insights into strategic thinking. The safe thing (for a financial manager) is to follow the numbers, even if that leads the financial system off the cliff.

But perhaps more important is the role of government. The instability here was not caused by a lack of regulation. It was caused instead by the wrong regulation at exactly the wrong time. ...