Monday, October 6, 2008

A Physicist Looks at Economics

It is utterly obvious that classical economics fails to match reality. The notion of an all-knowing homo economicus was introduced to make the math tractable, but economics clings to this and purveys theories like the efficient market hypothesis as if they accurately reflect reality when in fact they don't. Attempts within the field to overcome this include behavioral economics and post-autistic economics, but these fall short of providing a real foundation for the whole field.

Here is an article in the NY Times by Mark Buchanan that argues for a new economics that adopts dynamical principles from physics.
... economists still try to understand markets by using ideas from traditional economics, especially so-called equilibrium theory. This theory views markets as reflecting a balance of forces, and says that market values change only in response to new information — the sudden revelation of problems about a company, for example, or a real change in the housing supply. Markets are otherwise supposed to have no real internal dynamics of their own. Too bad for the theory, things don’t seem to work that way.

Nearly two decades ago, a classic economic study found that of the 50 largest single-day price movements since World War II, most happened on days when there was no significant news, and that news in general seemed to account for only about a third of the overall variance in stock returns. A recent study by some physicists found much the same thing — financial news lacked any clear link with the larger movements of stock values.

Certainly, markets have internal dynamics. They’re self-propelling systems driven in large part by what investors believe other investors believe; participants trade on rumors and gossip, on fears and expectations, and traders speak for good reason of the market’s optimism or pessimism. It’s these internal dynamics that make it possible for billions to evaporate from portfolios in a few short months just because people suddenly begin remembering that housing values do not always go up.

Really understanding what’s going on means going beyond equilibrium thinking and getting some insight into the underlying ecology of beliefs and expectations, perceptions and misperceptions, that drive market swings.

Surprisingly, very few economists have actually tried to do this, although that’s now changing — if slowly — through the efforts of pioneers who are building computer models able to mimic market dynamics by simulating their workings from the bottom up.

The article goes on to highlight the work of three researchers: Yale economist John Geanakoplos (along with two physicists, Doyne Farmer and Stephan Thurner), German economist Frank Westerhoff, and Charles Macal and colleagues at Argonne National Laboratory in Illinois.

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