Tuesday, October 27, 2009

On offer: laws of nature

http://www.flickr.com/photos/mukumbura/ / CC BY-SA 2.0
Econophysics asks how individual actions give rise to large-scale phenomena.
In yesterday's post I asked why economics doesn't have a few laws of nature that could prevent people from basing decisions on the financial equivalent of a perpetual motion machine. Enter the econophysicists, academics, (usually physicists delving outside the field and not economists borrowing from physics), who want to apply the rigorous mathematical methods of physics to understanding the economy. By modeling the economy as a collection of minor actors, like the molecules of gas, they hope to uncover how individual actions give rise to the emergent, large-scale phenomena that have sweeping effects—the booms and busts that take us by surprise.

The term "econophysics" was coined by Gene Stanley, who trained as a solid-state physicist and directs the Center for Polymer Studies at Boston University. Stanley championed the idea that approaches from physics could bring clarity to phenomena ranging from the flight paths of albatrosses to the patterns of heartbeats. In an article in APS News last year, Stanley talked about how economics needs to face up to important features of the market and the economy that had been brushed under the carpet. Price fluctuations, for instance, are assumed to take on a Gaussian distribution, where extreme events taper off in frequency and are considered rare enough to be ignored. But in reality, sudden drops or leaps do occur and send tremors through the rest of the financial system. Rather than asserting one can safely ignore these events or discount them as outliers, economists need to figure out how and why they occur. They need, he says:

to be eternally skeptical of everything–especially in this case of the practice of calling something that does not agree with a theory an “outlier” or “tsunami.” And, perhaps most importantly, to collect as many data as possible before making any theory to interpret them.

Luckily for would-be econophysicists, data about the economy—price changes, mergers, interest-rate fluctuations—are already painstakingly recorded. Perhaps economists of the future will resemble particle physicists, mining large troves of data for fundamental insights.

Writing in American Scientist
, Brian Hayes explores the econophysics-based evidence for one possible fundamental law, popularly expressed in the maxim, "The rich get richer, and the poor get poorer." One team held wealth as a conserved quantity like energy, something that can't be created or destroyed. So how does this quantity become distributed? Economists generally believe that the price of a good is always fair; it is where supply and demand naturally converge. But what if the price of a good isn't entirely fair? A thousand transactions later, and wealth will slowly pile up on one side, either with the buyer or the seller. With toy model worlds laid out in code, econophysicists can play out scenarios like this involving many different actors:
If trading continues long enough, essentially all the wealth winds up in the hands of one person. The yard-sale economy, as formulated in this model, is a winner-take-all lottery. The traders might just as well put all their goods in one big pile, and then roll the dice to decide who keeps it all.

Economists are still largely suspicious of cross-disciplinary academics trying to stake claims on their territory in ways like these; econophysics papers are usually published in physics journals rather than economic ones. But if you think about it, a marriage between physics and economics seems entirely natural. First of all, neither physicists nor economists seem to be able to think without a piece of chalk and a scrap of black board space. Or physicists and economists could bond over their love of specialized jargon, which can get so hairy that the Economist magazine handily maintains an online glossary of the economic buzzwords that get bandied about in the media. Then there's the acronyms, whether for large groups or projects—CERN and the WTO, the LHC and the SEC—or jargon words that have gotten too long. CDO: cadmium oxide thin-film or collateralized debt obligation? Ask the relevant expert to explain either, and they're likely to make your head spin.



But as Daniel Holz at Cosmic Variance puts it, there is "one crucial difference":

...what economists do and say really matters, in an immediate and tangible way. They engage in abstruse arguments about the money supply and the subprime market, but at the end of the day, someone somewhere listens to them, and makes a decision about the interest rate, or whether to bailout a troubled bank. Suddenly, millions of people may be out of work. Trillions of dollars may evaporate. A large fraction of the population of the planet may be affected.

No one saw the current financial crisis coming: a few years ago Ben Bernanke, the chairman of the Federal Reserve Board, gave the economy a clean bill of health and applauded economic policies as salutary. Paul Krugman, a Nobel prize-winning economist, wrote in the New York Times last month:

During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

Maybe the failure of classical economics to predict or explain the recent crisis will allow new ways of thinking to get a word in and construct some much-need laws of nature for the so-called dismal science.

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