02 November 2008

Economics Needs a Reality Check

Apart from the editorial recommending Obama for President, the last issue of Nature also featured an interesting essay entitled "Economics needs a scientific revolution" by a certain Jean-Philippe Bouchaud, apparently a physicist with close links to research in finance. Bouchaud makes some really interesting statements, at least for a physicist like me who is slightly disturbed by recent events in the world of finance. Most important is probably his critique of the fact that economists seem to belief in some assumptions without even caring about empirical verification. As I can't add anything substantial, I just present some clippings from the essay:

"Classical economics is built on very strong assumptions that quickly become axioms: the rationality of economic agents (the premise that every economic agent, be that a person or a company, acts to maximize his profits), the 'invisible hand' (that agents, in the pursuit of their own profit, are led to do what is best for society as a whole) and market efficiency (that market prices faithfully reflect all known information about assets), for example. An economist once told me, to my bewilderment: "These concepts are so strong that they supersede any empirical observation." As economist Robert Nelson argued in his book, Economics as Religion (Pennsylvania State Univ. Press, 2002), the marketplace has been deified.
The supposed omniscience and perfect efficacy of a free market stems from economic work done in the 1950s and 1960s, which with hindsight looks more like propaganda against communism than plausible science. In reality, markets are not efficient, humans tend to be over-focused in the short-term and blind in the long-term, and errors get amplified, ultimately leading to collective irrationality, panic and crashes. Free markets are wild markets.
Crucially, the mindset of those working in economics and financial engineering needs to change. Economics curricula need to include more natural science. The prerequisites for more stability in the long run are the development of a more pragmatic and realistic representation of what is going on in financial markets, and to focus on data, which should always supersede perfect equations and aesthetic axioms."

All in all, I think the scientific revolution that Bouchaud calls for is nothing else than a reality check. And I agree that economics (plus the banking and finance sector) really seems to need it!

1 comment:

  1. I haven't read the Nature piece, but I strongly recommend Bob Ayres's work, such as:

    How Economists have misjudged global warming and a few years later Economic Growth (and Cheap Oil).

    Among other things, he's got a much more intuitive model for the ~60% of growth called {Solow residual, technology progress, or Total Factor Productivity}, i.e., he used work = efficiency * energy, and gets pretty good fits.

    To see what happens when peak Oil&Gas hit, look at last page of the second reference.

    I'm no economist, but Ayres' work makes a lot more sense to me so far than regular neoclassical economics.