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Schrödinger’s hedge fund

What economics can learn from science

Bill Hanage 28 December 2008

Taking the plunge: more objective studies of the financial markets could yield a more stable economy

The behaviour of the financial sector, if you look at it long enough, comes to resemble nothing more than a convention of alien abductees

Economics is famously the dismal science, and rarely has its own stock been as low as it is today. Many would question whether it deserves to be called a science at all, being grounded as it is in assumptions which are rarely tested or even questioned. And yet, economists and market theoreticians produce reams of intimidating equations, and their ranks are filled with learned refugees from the natural sciences in search of pastures new, or at least more profitable. The reasons why this has not produced a more rigorous study of the movement of money, the generation of profits, and how it can be improved, is a mystery addressed by Jean-Philippe Bouchaud in an essay published recently in Nature.

Bouchaud points out, rightly, that the problems of economics should not be impossible to address in a scientific fashion. The behaviour of large populations within which there may be considerable variation between individuals is a mainstay of evolutionary biology (which has been substantially enriched by concepts imported from economics, such as that of Nash equilibria). Bouchaud’s great problem is with the axioms and assumptions of economic theory which have "solidified into dogmas”.

Just one such assumption is that individuals act rationally, to maximize their economic success. This cannot easily survive the observation that the relatively less well off vote in droves for political agendas which consistently offer greater benefit to the rich (a phenomenon described in detail by Larry Bartels in his recent book Unequal Democracy. While I agree that our understanding of how humans make decisions can be much improved, to my mind the dismal nature of economics arises from another problem. It is a problem held in common with the ‘harder’ sciences, but which is amplified by conditions that are particular to the study of money and its making.

A few years trying to publish papers in any field should be enough to convince anyone that it is far harder to publish an observation which does not agree with current orthodoxy than one which does. This is because, rightly, extraordinary claims require extraordinary evidence. In economics, however, this trend is exacerbated by the way its scholars interact with the system under study. At any time, the task at the coal face of wealth generation is to ride the wave and maximize profit. In a boom, whether or not the factors giving rise to the good times are understood, those that agree with the orthodoxy are likely to be rewarded, and those that do not are likely to find themselves out of work. However ruthless the other sciences may be, it is more so when the scoring system is cold hard cash. The problem is that the markets and the economy are not an objectively observable system. Their behaviour is determined by the actions of a multitude of not-necessarily rational individuals, is prone to bias, and is exaggerated by self-sustaining feedback loops which only end when the cognitive dissonance produced by the difference between reality and the moneymaking myth becomes too great to ignore. George Soros describes this aspect of market behaviour as 'reflexivity'.

Market theory, rather like quantum theory, has to overcome the difficulty that the observer can interact with the experiment. But whereas in physics this is recognized and accounted for as best we can, in economics it is a dirty truth to be hidden in the attic. The shrieks and knockings from upstairs were getting louder for years before the current crisis. And yet short-term profit remained to be made by the people with the power to mitigate the damage. So they did nothing. And they have certainly profited enough from the boom to make the consequences of culpable inaction relatively palatable.

To state it once more plainly: we have no theory of market behaviour worthy of even half serious consideration by any genuinely disinterested observer. The current crisis demonstrates this, because it was produced by the nature of the market itself, rather than by a blow from outside to which the market could not adjust. Within the framework of the current orthodoxy, nobody saw it coming. The promoters of that orthodoxy, who have become fabulously wealthy by parroting untested platitudes, are rather like homeopaths. Just as most people suffering from most minor ailments will undergo regression to the mean (statistician talk for ‘get better’) independently of the mumbo jumbo their alternative practitioner of choice befuddles them with, stock markets have tended to go up over the last few decades, and the masters of the universe have taken the credit. Soros believes that something even more insidious is at work, in that previous flirtations with disaster (such as the collapse of the Long Term Capital Management hedge fund in 1998), were reinterpreted to fit into the theories of the day rather than seen to demonstrate the frailties of the market. This happened despite the fact that they were rescued by interventions from outside the market.

The behaviour of the financial sector, if you look at it long enough, comes to resemble nothing more than a convention of alien abductees. But the capacity for such collective self-delusion in this case is rewarded by six figure salaries rather than ridicule.

Of course, there are scholars who set their stall somewhat apart from the hubbub, hyperbole and horse-trading of the market. And they deserve respect, many of them. But it should not be forgotten that some of the voices which are loudly declaiming that they told us so, Soros and Warren Buffet among them, have enjoyed the luxury to do so by virtue of already being fantastically rich. As we rebuild the shattered financial edifices, we need a theory that is more scientific and predictive, rather than merely a way of making sense of what went before. Things are a lot easier under the retrospectoscope. History shows us that this has happened before, and I find it hard to believe that it will not happen again, a few decades from now. Then, as now, the people who will suffer most will not be those working in the financial industry, but people in other sectors of the economy, sectors in which a Christmas bonus is neither guaranteed nor expected, especially if your main contribution to your business that year has been to catapult your fellow citizens onto the dole queue. How can I put this? A concern for fellow citizens is not what you would call exactly common among those who deal with finances for a living. It is this reason that we need a new economics, preferably one driven by people who are in it for more than the money.