The terrible truth about economics

“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

12 Responses to “The terrible truth about economics”

  1. Kevin Killick says:

    Somewhat of a vindication for people like Nassim Taleb who have been ostracised for such views in the past.

  2. Mr. Gunn says:

    That’s right, and I think with Taleb it was as much personality as it was his work.

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  5. Doug Scott says:

    There are ways of controlling chaotic processes, so it’s not all gloom. Obviously, Keynes and his followers didn’t hold on to classical economics but bent the rules slightly to deal with what they could measure. That’s what most practising economists seem to do (I am not an economist).

    The reference to forest fires reminded me that the Australian aborigines used to upset the settling English farmers by regularly burning off the forests. Australians now do the same, having realised that ever since they started to do so, the incidence of huge forest fires has diminished significantly.

  6. Kent says:

    Wow Doug, what a great comment about burning off to control forest fires. Maybe it’s just because it is election year in the US but what is up with the phobia that the slightest market regulations automatically leads to “socalism”? Is the US really that naive? Look at the mess the lack of regulations has got us into today!

    Obama wants to tax the rich a bit more to “distribute the wealth”. Many VERY democratic countries already do this.

    My advice for after we get out of the sh*t-hole we’re in? Put away the cold war hang over and lets empirically find the optimum balance between a free and controlled market. Sure burning off the whole forest stops future fires as well but that’s not too useful.

  7. Sandro Magi says:

    I think Paul Krugman’s article is worth mentioning here. He discusses economics and its relation to sciences, and also many of the problems of the economists’ mindset. There’s nothing wrong with the way economists devise and analyze models, since they are trying to eliminate noise to distill the causal factors in a model. Economics would be brutally hard otherwise.

    Krugman makes a valid point however, that economists then begin to confuse reality with their models, which leads them to sometimes believe ridiculous things.

    Re: “Free markets are wild markets. It is foolish to believe that the market can impose its own self-discipline.”

    Free markets are self-regulating, if everything they manage are private goods. Of course, not everything is a private good, and so free markets cause problems if left unattended.

    Re: “Bouchaud could also have added the example of economists’ assumption that sustained and unlimited economic growth is possible on a planet with limited resources.”

    Technically, our resources are not as limited as one might think. Given sufficient energy, any resources can be created or transmuted at will. It always comes down to energy, and we’re nowhere near tapping the limits of the energy available from the surface of the Earth, let alone in our solar system.

  8. emmanuel says:

    After the “perfect market” myth, now is coming the spare wheel myth of “self-organized” systems, but you say a myth? No, it is true, a shown by “various physicists”… The butterfly effect triggering the Irak war or the global warming? Using metaphora as scientific propositions, it simply the proof that the arguments are NOT scientific!

  9. Kjalnot says:

    The biggest mistake of all, when talking about economics, is thinking that it might actually be possible to create fundamental laws that always hold true (like you can in hard sciences).

    This is because economics is not controlled by rules, it is driven by behaviour. As soon as you could prove, with evidence, that, say, the stock market will go down because of X. Because everyone knows that is what is going to happend, they will adjust their bevaiour, and that will change the situation, making the “proof” no longer true.

    We would all love if economics could produce laws and proofs, but in fact, we actually KNOW that such a thing is not possible

  10. My assumptions are three:

    1) One’s value scale is totally (linearly) ordered:

    i) Transitive; p ≤ q and q ≤ r imply p ≤ r

    ii) Reflexive; p ≤ p

    iii) Anti-Symmetric; p ≤ q and q ≤ p imply p = q

    iv) Total; p ≤ q or q ≤ p

    2) Marginal (diminishing) utility, u(s), is such that:

    i) It is independent of first-unit demand.

    ii) It is negative monotonic; that is, u’(s) < 0.

    iii) The integral of u(s) from zero to infinity is finite.

    3) First-unit demand conforms to proportionate effect:

    i) Value changes each day by a proportion (called 1+εj, with j denoting the day), of the previous day’s value.

    ii) In the long run, the εj’s may be considered random as they are not directly related to each other nor are they uniquely a function of
    value.

    iii) The εj’s are taken from an unspecified distribution with a finite mean and a non-zero, finite variance.

    A Non-Mathematical Explanation of the Axioms: http://www.axiomaticeconomics.com/axioms.php

    Socrates and Hume at Billiards: http://www.axiomaticeconomics.com/socrates.php

    This latter paper is a simulated dialogue between Socrates and David Hume over a game of billiards in heaven. They are visited by a swami and a physicist, both of whom counsel Socrates on where his billiard ball will go after he hits it with his cue ball. Then, Socrates and Hume contrast these two quotations:

    David Hume: “When I see, for instance, a billiard ball moving in a straight line toward another,… may I not conceive that a hundred different events might as well follow from that cause?… All these suppositions are consistent and conceivable. Why then should we give preference to one which is no more consistent or conceivable than the rest?”

    Cristobal Young: “Milton Friedman, torchbearer for the ‘free market’, insisted that the realism of background assumptions is not important. ‘In general, the more significant the theory, the more unrealistic the assumptions’. Good theory may well make use of ‘wildly inaccurate’ assumptions, and proceed ‘as if’ the assumptions held true. The purpose of theory is to generate testable implications.”

    Here I am quoting Cristobal Young’s review of Robert Nelson’s book, Economics as Religion, which Bouchard mentions in his paper.

  11. kio says:

    I disagree with almost everything that Dr. Bouchaud wrote.
    So, had to compile a paper :
    Does economics need a scientific revolution?
    http://ideas.repec.org/p/pra/mprapa/14476.html

  12. James says:

    You do realize that the financial sector is by far the most regulated part of the economy, right? Self-discipline is hard to maintain when the government says that it’s watching over you to make sure you don’t mess up (whether or not that’s true).