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Time for economics to shed its fanciful past

Stephen Battersby, consultant


(Image: Jean-Luc Bertini/Picturetank)




This new science is battling to escape the dominant theory of neoclassical economics. That "almost psychotic fantasy", as Buchanan puts it, is as absurd as a theory of weather that says storms do not exist. Its adherents see only equilibrium where there is dynamism, its edicts have made markets and the global economy more unstable.

In the 1930s and 40s, Buchanan recounts, American economist Irving Fisher and others advanced a view of the economy as a dynamic, unstable beast, but over the following decades others worked hard to bury the insight. Milton Friedman and his allies in the Chicago School promoted the idea of equilibrium in markets and economies.

With forbiddingly intricate equations, they proved that a perfect market of rational people, coolly calculating how to maximise their gains, reaches an equilibrium where all goods are priced at the optimum level. In this best of all possible worlds, says Buchanan, any change would reduce the overall wealth. Adam Smith's invisible hand was drawn in rigorous mathematics.

Of course, we do not act like rational automata. If we did, only the literally starving would choose to take out a "payday loan" at 2000 per cent interest. Instead, we guess, panic and follow whims, hormones or herds. Psychologists have long known how much other people affect our perceptions and behaviours.

But in a remarkable feat of logic, Friedman argued that for a hypothesis to be important, it "must be false in its assumptions". Which makes neoclassical theory sound very important indeed.

And the theory fails to account for bubbles or market crashes. No matter, say proponents: external shocks, from outside economics, are behind all those unfortunate events. So the "equilibrium delusion", as Buchanan calls it, has persisted. Now deregulation and derivatives have moved us closer to that perfect market in which anything can be traded with anyone at any time.

As you may have noticed, this did not turn out well. The global economic crisis, writes Buchanan, now looks like "an unusually powerful hurricane that was brewing... for half a dozen years while economists - their textbooks on financial weather dealing only with the theory of calm blue skies - insisted that everything was fine".

His attack on the Chicago School is unmerciful, but the book's main aim is more positive, describing how physicists become financial storm-chasers. Buchanan is not afraid to use a few graphs, but that is no bad thing, and he tells a lucid, absorbing story. In short, physicists saw that markets follow statistical patterns called power-law distributions, which also crop up in complex systems, from earthquakes to the weather, and in simpler things such as avalanches in a rice pile. These systems tend to organise themselves into critical states, where large and violent events can have small and ordinary origins.

A new breed of financial models does the same. Based on simple, interacting agents that chop and change strategies based on past performance, the models show that the largest market crashes can be triggered by a single trade. And they can explain oddities, too, such as how markets change phase, like melting ice, when they get too crowded.

The models also show how proliferating derivatives and increased leveraging (borrowing to invest) make a market less stable. Just as we have driven the weather to be more extreme, so we have driven markets to be more violent. In future, Buchanan hopes similar models will help head off trouble.


In The Physics of Finance, James Weatherall takes a more winding road, through tales of scientists drawn into finance. He runs from the 19th-century Louis Bachelier's work on the randomness of market prices to today's "quants", the quantitative analysts, often recruited from physics, who devise complex trading algorithms. He covers critical phenomena, too, but ranges more widely than Buchanan, telling of physicists' bids to beat casinos at roulette, and how theories from particle physics could measure inflation.

This is all very engaging, and makes an easy, informative read. But it can also be a little frustrating as we skim the surface of ideas without gaining the same sense of insight that we do from Forecast.

Some of the converts to "econophysics" have called for a new Manhattan Project for economics. It may be a good plan, but the name carries radioactive connotations - and physicists must recognise the danger of radical new tools and theories.

Weatherall argues, reasonably, that quants alone cannot be blamed for the recent crisis. Even so, the input of physicists has clearly helped destabilise markets. Take the Black-Scholes equation: based on diffusion equations in physics, it has been used to price arcane derivatives. And recently, high-frequency algorithmic trading has led to "flash crashes", where a stock dips massively for under a second. If physics inspires more effective economic theories, they may in turn change the nature of markets in profound, possibly dangerous ways.

This is reason for caution, but wilful ignorance is not an option. Some hedge funds use the latest physics-inspired dynamic models, and the light is dawning even in government institutions. While the European Central Bank still uses equilibrium models to make growth predictions, its president, Jean-Claude Trichet, has admitted that existing models failed during the crisis, and that central banks could learn from the new models.

Economics may be reaching its age of enlightenment, becoming a rational science by abandoning the idea that we are perfectly rational. The field may even warrant its own Nobel one day.

Book information
Forecast: What physics, meteorology, and the natural sciences can teach us about economics by Mark Buchanan
Bloomsbury Publishing

The Physics of Finance: Predicting the unpredictable by James Owen Weatherall
Short Books

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