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Do Economists Suffer From Physics Envy?

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India’s central bank governor Duvvuri Subbarao said that economics should give up the pretense of being an exact science and stop striving for false precision.

Are economists nothing but wannabe physicists? And did their overconfidence in scientific models pummel the global economy and lead to their fall from grace?

India’s central bank governor Duvvuri Subbarao, himself a physics student, recently added to the debate, when he said that economics should give up the pretense of being an exact science and stop striving for false precision.

Physics deals with the physical universe which is governed by immutable laws, Mr. Subbarao said. Economics, in contrast, is a social science whose laws are influenced by human behavior.

“I cannot change the mass of an electron no matter how I behave but I can change the price of a derivative by my behavior,” he said in a speech at India’s premier science institute in Bangalore last week.

There has long been a debate whether human behavior can be simplified into a scientific model. One camp says financial decisions are best left to individuals. There is an equally compelling opposite view, which argues that markets are efficient so models can be used to predict and price them.

In a working paper titled, “WARNING: Physics Envy May Be Hazardous to Your Wealth!” Andrew W. Lo and Mark T. Mueller say economists have aimed to follow physicists from the time of Paul Samuelson, the father of modern economics.

The paper points out that prior to Mr. Samuelson’s “Foundations of Economic Analysis” most of the literature was based on informal discourse and diagrammatic representation. He was the first to develop a formal mathematical framework for economic analysis.

Economics gradually moved away from merely being a branch of moral philosophy pursued by gentlemanly scholars to being a rigorous, deductive process. Game theory, general equilibrium theory and option pricing have all been mathematical breakthroughs which have facilitated the understanding of economics and helped frame policy.

By 1980s, with its flashy bond sellers made famous by Michael Lewis’s “Liar’s Poker,” economists were flocking to Wall Street to churn out models used to make money. The resulting collapse of Long-Term Capital Management–a hedge fund that used the Nobel Prize in Economics winning Black-Scholes options model–is now folklore.

Despite the problems, the flirtation between physics and economics has gained new traction with a branch called “econophysics,” a field, which applies theories and methods originally developed by physicists to solve problems in economics. There is also a small but growing group of academics pursuing another field called “biophysical economics,” that believes economists lost their way because they violated the laws of physics.

Their argument is that the neoclassical school, which assumes constant economic growth, ignores the world’s diminishing supply of energy. It fails to take note of the principle of net energy return on investment. A Scientific American article gives the example of a squirrel which burns energy eating nuts. The nuts need to give the squirrel more energy than it expends to collect them or the squirrel will die.

While Mr. Lo and Mr. Mueller say the crisis doesn’t mean economists have to discard their forecasting models, Gov. Subbarao’s solution is that economists should use more judgment to understand economic phenomena. He suggests they return to “getting their hands dirty’ with empirical work.

With the right model, science or empirical study behind them next time, maybe economists won’t be quite so stumped by the simple question England’s Queen Elizabeth II posed when she visited the London School of Economics last year. “How come none of the economists saw the crisis coming?”

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