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Physics Envy and Economic Theory

Posted By Barry Ritholtz On June 26, 2013 @ 7:30 pm In Data Analysis,Science,Video | Comments Disabled

Economists were seduced by physics because it made their claims seem more scientific. Their belief was in the concept of equilibrium, in which it would be impossible to profit from trading around a circle of goods or a circle of currencies without actually producing anything. Of course, that is possible, and that did happen, and that’s because you’re never really at equilibrium.

 

Published on Jun 3, 2013

 

Transcript after the jump

 

So I got pulled into economics in 2007 because of the 2008 economic crisis. Mike Brown who had been the first CFO of Microsoft, Chief Financial Officer of Microsoft and treasurer of Microsoft, he came to Toronto in 2007 and took my wife and I out to dinner and said he was trying to put together a research group to work on economics and he would like me to be involved. And I said, “I don’t know anything about economics.” And he said, “That’s okay because nobody does and the whole system is about to collapse.” He said, “The balance sheets of all the big investment banks — it’s like they have cancer. They’re full of holes.” And I remember being very struck by this because this was before anybody was talking about this.

And so I started to meet with a group of people that he was pulling together to understand what was gonna happen and to understand if there was any way to save the situation. It was a very ambitious thing and, of course, we failed. But along the way I was motivated as a kind of public service to get interested in economics.

And what I found . . . economics, in a way, is very easy for a physicist to understand because it’s very mathematical. And the mathematical models that they use are very clean. They’re based on assumptions and hypotheses, and you can study them. And as I studied it I began to understand, some for myself and more from just reading around because the faults with the standard economic models, with the standard models of finance, are well known. They have been in the literature for decades and decades. So let me give some examples.

The standard model of economics is called the neoclassical model and it assumes that markets or systems where trading happens between consumers and firms and there’s certain simple models of how that goes on. And the ideas that these come to equilibrium. Equilibrium not in the physical sense but in special economic sense in which you reach a point at which the prices are fixed such that market forces fix the prices such that you maximize the happiness of the consumers and maximize the profits of the firms. And in so called equilibrium nobody can become happier or more profitable without somebody else becoming less happy or less profitable. And the ideology behind this — not behind the mathematics because mathematics doesn’t have an ideology — but behind the arguments that were made and still are made from this model is that markets don’t need regulation because they have these natural equilibria where everybody benefits to the maximum possible. And if you’re in equilibrium you can’t do better.

Now there’s a fault with this and it’s an obvious fault and it’s been known since the 1970s from some theorems proved by some economists including some of the founders of this field of mathematical economics, which is that there’s not one equilibrium, there are many equilibria. In fact, there’s a vast number of equilibria. And so which equilibria, even assuming that this is a decent model of the economy which is not clear, but even assuming it’s a good model, which equilibria you’re in depends on the past history, it depends on regulation, it depends on politics, it depends on taste, it depends on changing taste, changing preferences. And so history matters and what’s called path dependence matters.

This takes us outside the neoclassical model of economics but it doesn’t take us outside of economics because some wiser economist, for example, Brian Arthur had for years been developing models and theories of path dependent economy where the history does matter. People from the area of complex systems like Stu Kauffman, Prubac in developing models of markets where the history matters, where there’s not a single equilibrium, where there are many equilibria. And where change is paramount.

Another symptom of this is the idea that arbitrage isn’t, I mean, in these neoclassical models when you go to equilibrium, arbitrage is impossible. Arbitrage is making a profit from trading around a circle of goods or a circle of currencies without actually producing anything. And in equilibrium that’s supposed to be impossible but lots of firms and investment banks made fortunes off of currency trading, so why is that? It turns out because you’re never really at equilibrium… Remainder of transcript: http://bigthink.com/videos/how-bad-sc…


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