Even Nobel Prize winners in economics can be wrong. Very wrong.

And be careful with the advice of market analysts. Be skeptical with the pronouncements of central bankers, especially when they're acclaimed as financial geniuses in the media and are whooped up in books such as Maestro by Bob Woodward, a Pulitzer Prize-winning journalist who may know everything about presidents but has no expertise in economics.

Indeed, even acclaimed academic experts misread markets. One can sometimes get more truth on the market by reading humor columnist Dave Barry.

That's what one thinks after reading the series of compelling essays in the book Panic, which details and analyzes various market panics from 1987 to today's mess. The latest crash happened so fast that it's easy to forget that just a year ago some prominent financial analysts were saying that things were OK and we could ride out a market downturn without much damage.
"Bear Stearns is fine. Do not take money out of Bear." That's what Jim Cramer was saying on his show on CNBC in March 2008 when Bear stock was at $62. Soon afterwards, Bear Stearns was almost worthless-or worth about as much as Cramer's famed stock for TheStreet.com, which virtually tanked overnight in the dot-com blowup of 2000.

Some of the essays in Panic are by editor Michael Lewis, who also selected pieces from Fortune, Time, The New Yorker and Bloomberg News, as well as a delightful piece by humorist Barry. Lewis begins with a simple proposition-that a popular options pricing model, acclaimed as brilliant and still used in many quarters, is wrong.

The idea, devised by Nobel prize-winning finance professors Fischer Black and Myron Scholes, is that institutional investors can avoid risk by taking a short position and increasing that position as the market falls and this will supposedly help them weather market storms. But the quickly accepted model has helped spur crashes going back to 1987.

"Managers," writes Lewis, explaining the idea, could create "put options for themselves, cheaply, by selling short the S&P as it falls, and thus in theory be free of all market risk."

Both Scholes and professor Robert Merton, who wrote a paper about the Black-Scholes model and also won a Nobel Prize, parlayed their insights into big money in the hedge fund world. Big institutional investors and traders ate it up. They believed it would save them from down markets. Indeed, the theory held that derivatives would prevent protracted down markets.

It became the received wisdom of the trading and hedge fund industries. To question it, said one trader, was to invite ridicule. "If you try to attack it, you're making a case for your own unintelligence," Lewis quoted one trader as saying. But even though Black-Scholes worked great in the classroom, it turned out to be a disaster in the marketplace.

When a market crashes, no one buys. It creates a vicious cycle. A market declines and more people must sell. As more people sell, there are fewer and fewer people who buy. Soon, the market goes into a freefall, which was what Black-Scholes was supposed to avoid.

When the theory meets a dynamic market, it falls apart because one can't produce an option on the stock market by buying and selling the market itself, Lewis explains. The market "will never allow it," he warns.

The theory not only caused the 1987 crash, but also contributed to the celebrated failure of Long-Term Capital Management, and it has blown up in the current crash as well. "A few smart traders," Lewis writes, "have abandoned the theory. But the market itself hasn't." By the end of 2006, there were trillions of dollars in derivatives, he notes. In other words, by the end of the year, there were $415 trillion in securities for which there was no satisfactory pricing model.

"Added to this," Lewis writes, "are trillions more in exchange-traded options, employee stock options, mortgage bonds and God knows what else-most of which, presumably, are still priced using some version of Black-Scholes."

With this new wisdom, the smart money players, such as the biggest institutional firms that thought they had figured out the universe, suddenly don't look so smart. "No one believes the original assumptions anymore," says John Seo, the co-manager of the hedge fund Fermat Capital, which invests in catastrophe bonds. "It's hard to believe that anyone-yes, including me-ever believed in it. It's like trying to replicate a fire insurance policy by dynamically increasing or decreasing your coverage as fire conditions wax and wane. One day, bam, your house is on fire and you call for more insurance."

Panic is an interesting book. My one minor criticism is that it doesn't devote enough space to the role of the Federal Reserve in all these crashes. It seems to me that the seeds of the current crash, as well as the crash of 2000, were planted by Fed Chairman Alan Greenspan. He kept flooding the markets with cheap money whenever he saw the first sign of trouble instead of allowing bear markets to run their course. The strategy seemed to work in 1987, so it was used again and again until the bubble burst. These policies, which I believe contributed to this surreal expectation of permanent bull markets with little risk, also fed the reckless backing of subprime mortgages.

Even in 2007, Greenspan could write in his memoirs about 2006 loan origination rates, "I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk, and that subsidized home ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownerships are worth the risk."

After the fact, Greenspan's comment would seem to suggest that, like the Bourbons after the French Revolution, he had learned nothing and forgotten nothing. Greenspan's subprime rationale was thus: Expanding property ownership would make America a better country. However, the market knew better than investment theories such as Black-Scholes and knew better than a failed socio-economic goal which has now had the perverse effect of destroying the dream of millions of American households.

So this book is useful precisely because it shows supposed masters of the investment universe sleepwalking through history. One of its benefits-besides gathering diverse kinds of good business writing in one place-is that it doesn't propose any grand investing principles for avoiding the next crash. Smart readers probably wouldn't believe them in this environment anyway.
Lewis' virtue is in identifying some of the big things that have gone wrong. And he should know. He admits he sometimes bought tulips, and his portfolio sometimes blew up.

The book has no great investment advice to impart other than the negative advice: If the average investor reads this account of financial mayhem carefully, he or she will become more skeptical and less likely to be taken in by the next round of Greenspans, Woodwards, Blacks, Scholeses and Cramers.

Yet once the market turns around, whenever that is, a new generation of experts (or should I say mountebanks) will be waiting to sell the average investor another round of financial moonshine. The argument for this book is the same argument for the study of history: A careful review of past mistakes usually means a person is less likely to repeat them.