Economics needs a scientific revolution
Maxine Clarke
Tuesday, 18 November 2008 16:42 UTC
Financial engineers have put too much faith in untested axioms and faulty models, says Jean-Philippe Bouchaud, head of research of Capital Fund Management and a physics professor at cole Polytechnique in France, in a Nature Essay (455, 1181; 2008). To prevent economic havoc, that needs to change. From the Essay:
Compared with physics, it seems fair to say that the quantitative success of the economic sciences has been disappointing. Rockets fly to the Moon; energy is extracted from minute changes of atomic mass. What is the flagship achievement of economics? Only its recurrent inability to predict and avert crises, including the current worldwide credit crunch. Why is this so?
Classical economics is built on very strong assumptions that quickly become axioms: the rationality of economic agents (the premise that every economic agent, be that a person or a company, acts to maximize his profits), the ‘invisible hand’ (that agents, in the pursuit of their own profit, are led to do what is best for society as a whole) and market efficiency (that market prices faithfully reflect all known information about assets), for example. Physicists, on the other hand, have learned to be suspicious of axioms. If empirical observation is incompatible with a model, the model must be trashed or amended, even if it is conceptually beautiful or mathematically convenient. So many accepted ideas have been proven wrong in the history of physics that physicists have grown to be critical and queasy about their own models.
Unfortunately, such healthy scientific revolutions have not yet taken hold in economics, where ideas have solidified into dogmas. These are perpetuated through the education system: students don’t question formulas they can use without thinking. Although numerous physicists have been recruited by financial institutions over the past few decades, they seem to have forgotten the methodology of the natural sciences as they absorbed and regurgitated the existing economic lore.
Regulation also needs to improve. Innovations in financial products should be scrutinized, crash-tested against extreme scenarios outside the realm of current models and approved by independent agencies, just as we have done with other potentially lethal industries (chemical, pharmaceutical, aerospace, nuclear energy).
Crucially, the mindset of those working in economics and financial engineering needs to change. Economics curricula need to include more natural science. The prerequisites for more stability in the long run are the development of a more pragmatic and realistic representation of what is going on in financial markets, and to focus on data, which should always supersede perfect equations and aesthetic axioms.
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Replies
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A lot of economic theory may still look pretty naive, even though some of the best mathematical minds from my university ended up in this field. Still, there is of course plenty of room for improvement, as Bouchaud explains.
But in my mind one of the other critical factors that’s so diffucult to understand is the human element. There may be a good understanding based on statistical behaviour. But if as in the present situation some of the basic rules get broken, theory fails, and this will always be hard to predict. Amongst one of the most fundmental rules for a bank is of course to understand the risks you are exposed to. Even though computer models might have predicted the risks correctly, they were fed overly optimistic data by their human operators. There is a nice commentary in the NYT that appeared shortly after the Lehmann fiasko: How Wall Street Lied to Its Computers
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The essay Economics needs a scientific revolution, Nature (455, 1181; 2008) by Jean-Philippe Bouchaud is stimulating and an interesting read. In explaining the current global financial crisis, it points out the divide between theory and observation in Economics. The supremacy of theory has led to assumptions taking the form of axioms and markets have been deified. In a Bayesian world, this has led to the prior being certain, and hence, whatever be the observation, the posterior is equal to the prior. All empirical observations become irrelevant.
Having largely agreed with Bouchaud, I point out some differences. First, inability to predict and avert a crisis cannot be a basis to gauge a discipline’s success or failure. Just as the space shuttle Columbia’s disaster cannot be construed to be a measure of judging Aeronautics and Space research, the current financial crisis cannot be a measure of judging Economics. Crisis or disaster by nature is rare and not predictable. Like the violation of some safety regulations in the Columbia disaster the current global financial crisis, to put it simply, is an outcome of greed by some players who manipulated the markets for their advantages. Modelling apart, an economic system should have effective regulation to safeguard us against misuse of markets by vested interest.
Second, understanding the market with more appropriate tools and techniques of modelling is necessary, but it is more important to acknowledge that market is a tool, albeit, an important one. It is a means, but not an end in itself.
Third, the dominance of markets has its roots in the dominance of utilitarianism. John Rawls, a prominent moral philosopher of the 20th century, successfully argued against the monoconcentration of utilitarianism and its associated formulaic reductionism in favour of plural concerns. On concerns of justice, his focus was on the least advantaged while assigning priorities to equal liberties and equal opportunities (that is, against arbitrary privileges). This is made possible by invoking the original position, that is, by putting decision makers under a veil of ignorance – they do not know which group they belong to and thereby doing away with vested interest. One feels that the silent scientific revolution, which goes beyond Economics, is already under way.
An earlier and slightly elaborate version of this write-up is available here.
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In Jean-Philippe Bouchaud’s article “Economics needs a scientific revolution,” 455, 1181 (2008, it has been suggested that economics is a science. In general, complaints abound as the theory did not predict the global crisis. Economic models don’t work for real life; they were not meant to do so. It is important that if economic theories are used for anything, they are used for the right reasons. Economic theories are not able to predict outside of their rational models. The issue is not economics but the fundamental nature of equilibrium, which has been misunderstood and misused when discussing economic models.
Economics cannot be considered a science; its theories are not testable by scientific methods—see Gul and Pesendorfer’s statement “the testable implications of a theory are its content”(Faruk Gul and Wolfgang Pesendorfer, “The Case of Mindless Economics,”in The Foundations of Positive and Normative Economics, edited by Andrew Caplin and Andrew Schotter (University Press, Oxford, 2008)). The theoretical condition of economics defines the variables within, and these variables are not akin of dynamic life.
One of the most important culprits of the crash is the increasing GDP demand by the nations. If a country does not have a higher GDP than it had the year before, it is a major concern. Yet we know that equilibrium is the only point of stability and any movement away from it is inherently unstable. Growth is movement away from equilibrium. The only safe change of equilibrium is a fundamental change, which is an irreversible change, such as the manufacturing of a table, for example. Once made, the table exists. The price of that table should be irrelevant to the equilibrium.
Economic equilibriums are defined as financial equivalences of that table—it is not the number of tables made that matters but the number of tables sold and for how much. In macroeconomic models equilibriums play “catch-up” to what happened in the market. Equilibriums don’t “catch up;” they tend to stay where they are. As new equilibriums can only be created with fundamental changes, bubbles made by inflated prices represent fake growth and are not movements away from the true equilibrium. A subjective price-based growth cannot create a fundamental equilibrium. In the case of bubbles, forces must be applied to pull it back to the true equilibrium. Indeed, we are heading back to an earlier fundamentally stable equilibrium.
What we need to change is how we measure growth and what growth we measure.
In terms of economics, the crisis should not have happened for the following simple reason: this was a desired outcome based on the rational actors of the model. Economic theories do not concern themselves with consequences, only outcomes. Neither human decision-making processes nor the consequences of those actions are incorporated into most of its models. Every single agent (prior to the crisis) behaved in a self-maximizing way (some define this as greed), honoring all tenets of the model. If anything, the crisis provides proof to economists that the “theory worked.”
In reality, economic models should not be used to predict future economic activity because the models look only at what happened in the past. The statistical models used look at data of the past and from introductory statistics we know that to predict future outcome from past activity is inappropriate.
Rather than blaming economics, the question should be: Why do policy-makers turn to economists for advice? Alan Greenspan admitted that he did not see this coming, did not understand what happened, and was wrong in his assumptions.
As human nature is volatile, the crash is psychological. It could never have been seen by a model that ignores human brain physiological processes. Neuroeconomics studies how perceived or actual consequences of decisions modify those decisions. Neuroeconomics works in dynamic environments with experiments on people in real time. It researches human action-reaction forces. Neuroeconomics is much more useful for policy advising than standard economics can ever become.
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RE: Jean-Philippe Bouchaud’s article “Economics needs a scientific revolution,” 455, 1181 (2008) I have cited this frequently in my debates with neighbors and colleagues over our economic strife!
NATURE has printed Letters and news describing Levy Flights, and I suggest that use of random numbers might be a sizable flaw in our natural models — economic, cosmological, climate, etc. Rather, “Levy” numbers would be a different baseline data input. I am new to this forum, and thought economics might be as good a place as any to start. Perhaps a minor but fundamental correction to science is what our economy needs!
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Economic or Moral Crisis ?
- The present economic crisis is only a part of the general Human morality/mentality crisis that is reflected in inter and intra-generational cultural, economic and ecological injustice of society (e.g. cultural and biodiversity loss, gap between reach and poor, natural resources depletion and pollution). It is caused by domination of material values, profit motives, over-consumption (greed) and resource intensive economic growth in consumerist culture, that is unsustainable socio-ecologically and psychologically (1).
References
- 1. Maiteny, P. (2000). The psychodynamics of meaning and action for a sustainable future, Futures, 32: 339-360.
- 2. Odum, H., and Odum, E. (1981). Energy Basis for Man and Nature, New York: McGraw-Hill.
- 3. Daly, H.E. and Farley, J. (2003). Ecological Economics: Principles and Applications. Island, Washington, DC.
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