"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

-- John Maynard Keynes

With all the focus on Wall Street's "greed" as the cause behind the meltdown in global financial markets, it may seem odd to blame something as abstract as ideas. Yet it was a single set of ideas -- "modern finance" -- that gave Wall Street banks the (over)confidence to take on the enormous risks that they did, and thereby unwittingly sow the seeds of the current financial crisis. After all, if it weren't for the impressively complex models of risk management developed by financial "rocket scientists," companies like AIG would have never sold the derivatives -- read "financial weapons of mass destruction" -- that ultimately led to Wall Street's implosion.

The Death of Modern Finance: The Emperor Had No Clothes

Until the 1970s, modern finance existed in a kind of a parallel universe. Academics would develop theories and publish them in little-read journals. Few financial economists ever ventured out of the realm of academia. Ironically, it was when ideas of modern finance, such as the "Black-Scholes Option Pricing Model" and the design of complex mortgage-backed securities in the 1980s, seeped onto Wall Street that the trouble started. Like modern-day Jesuits, hundreds of thousand of CFAs (Chartered Financial Analysts), MBAs and PhDs in Finance acted as converts, spreading the religion of modern finance into the most obscure parts of the world. Whether in Beijing or Barcelona, everyone studied the same "good books." And the elaborate financial tools these missionaries were taught gave them a false sense security.

Much like the legal profession, modern finance became laced with its share of concepts with intimidating sounding names -- ceteris paribas ("all else being equal"),Gaussian distributions ("bell curve") and homo economicus ("the rational man"). This was as it always has been. After all, as George Bernard Shaw observed, "all professions are a conspiracy against the laity."

Yet there was always something distressingly artificial about the assumptions behind modern financial theory. In the real world, nothing is ever really "held equal." And distribution of prices is never "bell shaped" -- at least when it really matters. And homo economicus -- turned out to be little more than a self-flattering delusion made up by hyper-rational theorists. Homo economicus, for example, never looked inside his own brain. If he did, he'd see that our brains are divided into three parts: the reptilian ("fight or flight"), the limbic (emotional) system and the cerebral cortex (rational). And the rational part rules a lot less than we'd like to think.

Consider the most basic of economic laws: the "law of supply and demand." It is only common sense that if the price of DVDs goes up, your demand for them will go down. Yet consider how you felt about the stock market rally over the past three weeks. The prices of stocks were going up. Yet you probably wanted to buy more, not less. Yet you won't find an explanation for this behavior in a three-year CFA curriculum. By assuming all economic actors are rational, such behavior simply couldn't exist.

To be fair, much of the cutting-edge work in financial theory focuses on market failures. And "rational expectations theory" attempts to explain why you want to buy more stock when the price goes up. Popular works by mainstream economists like Yale's Robert Schiller have already begun to broach many of the shortcomings of modern finance. But it was not until the work of Princeton's Daniel Kahneman (with Stanford's Amos Tversky) -- which won the Nobel Prize in 2002 -- that "behavioral economics" became a credible area of study. The irony was that Kahneman won the Nobel Prize in Economics, without having taken a single economics course in his life.

Nevertheless, modern finance -- the school of thought that came to dominate Wall Street over the last 30 years or so -- remains startlingly out of touch with the real world. Virtually no economics research on the crowd behavior has made it into any modern finance-based investment curriculum. Yet common sense tells us that financial markets are driven by little else. Growing acceptance of behavioral economics notwithstanding, financial engineers view analyses of financial manias much like medical doctors view homeopathy -- harmless enough, but not something you take too seriously. The elephant in the room is that everyone -- even financial economists -- knows that financial markets are driven by "fear" and "greed." But when is the last time Harvard Business School -- "the West Point of Capitalism" -- offered a course in the subject? Ironically, you are more likely to take a course at Harvard with the word "pornography" in the title than the word "speculation."

The Death of Modern Finance: The Road Ahead?

In many ways, the spread of modern finance has done enormous harm. The ostensible credibility of a set of complicated-looking equations -- particularly in the field of derivatives -- encouraged the kind of risk taking and leverage that proved to be the downfall of some of the world's largest financial institutions.

Modern finance contained within it the seeds of its own destruction. It became so impressively complicated that it was easy for a small group of financial engineers to bamboozle the world's largest financial institutions into issuing tens of trillions of dollars of derivatives. After all, the financial models said that the risks were under control.

Modern finance needs a new paradigm. That is easier said than done, of course. But a good start is for modern finance to abandon its aspiration to become the "physics of social sciences" and return to its roots as a social science. Modern finance depends on human behavior. Behavioral psychology and sociology -- and not dangerous mathematical models -- are the future of finance.

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