“Compared to physics, it seems fair to say that the quantitative success of the economic sciences is disappointing,” begins Jean-Philippe Bouchaud, an econophysicist at Capital Fund Management in Paris. That’s something of an understatement given the current global financial crisis.
Economic sciences have a poor record of success, partly because they are hard (Newton once pointed out that modelling the madness of people is more difficult than the motion of planets). But also because economists have singularly failed to apply the basic process of science to their discipline.
By that I mean the careful collection and analysis of observable evidence which allows the development of hypotheses to explain how things work.
This is a process that has worked well for the physical sciences. Physicists go to great lengths to break hypotheses and replace them with better models.
Economics (and many other social sciences) works back to front. It is common to find economists collecting data to back up an hypothesis while ignoring data that contradicts it.
Bouchaud gives several examples. The notion that a free market works with perfect efficiency is clearly untenable. He says: “Free markets are wild markets. It is foolish to believe that the market can impose its own self-discipline.” And yet economists do believe that.
The Black-Scholes model for pricing options assumes that price changes have a Gaussian distribution. In other words, the model and the economists who developed it, assume that the probability of extreme events is negligible. We’re all now able to reconsider that assumption at our leisure.
Bouchaud could also have added the example of economists’ assumption that sustained and unlimited economic growth is possible on a planet with limited resources. It’s hard to imagine greater folly.
So what is to be done? Bouchaud suggests building better models with more realistic assumptions; stronger regulation; proper testing of financial products under extreme conditions; and “a complete change in the mindset of people working in economics”.
All these things seem like good ideas.
But Bouchaud seems blind also to the greatest folly, which would be to imply that the roller coaster ride that we have seen in recent weeks can somehow be avoided in these kinds of complex systems.
Various physicists have shown that stock markets demonstrate the same kind of self-organised criticality as avalanches, earthquakes, population figures, fashions, forest fires…. The list is endless.
And of course, nobody expects to be able to prevent the spread of bell bottoms or earthquakes or avalanches. If you have forests, you’re going to have forest fires.
What people do expect, however, is to have mitigation procedures in place for when these disasters do happen. That’s where econophysicists need to focus next.
Ref: arxiv.org/abs/0810.5306: Economics Needs a Scientific Revolution