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Wednesday, April 27, 2011
Where modern financial theory is worse than Ptolemaic
Matt Bodie wants to know whether I think "modern financial theory is more like the theory of evolution, Newtonian physics, or the Ptolemaic universe." (I was stumped by the Ptolemaic bit at first, but he explains it well.) Matt also figures that I'd probably say Newtonian physics—that is, it delivers a lot of useful answers, but it fails to explain a lot of important phenomena. Sounds about right.
This happens to be the parallel that people in academic finance prefer, too. So I do worry that maybe it's a little too generous. Modern finance and economics seem to be quite useful in answering small, focused questions. They don't do so well on big-picture stuff. That means somebody exclusively trained in mathematical finance or economics probably won't do a better job of predicting the course of the economy or the stock market than somebody with knowledge of history, politics, psychology, etc. Of course, a monkey throwing darts may outperform both—which would make the efficient markets guys happy. But models that make no room for business cycles or market bubbles maybe aren't the best models to use in trying to understand business cycles and market bubbles.
The most troubled aspect of modern financial theory is probably its approach to risk. Since the 1960s, the argument has been that while it's almost impossible to predict the future price of a stock or other financial instrument, it is possible to say something meaningful about the riskiness of that instrument (that is, the bounds within which that price will fluctuate). This is true, most of the time. It's just never true when it matters most—in times of crisis. And it's not just that financial risk models have a habit of failing to capture these fat-tailed risks. It's that the widespread adoption of risk-management techniques based on these models seems to bring on the very crises that invalidate those models. So in that aspect, modern financial theory seems worse than Ptolemaic. (Help me out here, people: what's a worse-than-Ptolemaic example from the history of science?)
Posted by Justin Fox on April 27, 2011 at 01:14 PM in Books | Permalink
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Comments
I think the first step toward a better "science of finance" is recognizing that the old "markets vs. regulation" divide is useless. Critical players are, for all intents and purposes, government-backed.
I've found the debate among Roosevelt Institute fellows consistently productive. This report is a good first step toward progress:
http://makemarketsbemarkets.org/report/MakeMarketsBeMarkets.pdf
The Hyman Minsky conference at the Ford Foundation a few weeks ago was also good.
Finally, I hope we reconsider some ideas from political economists. For example, at the Roosevelt Institute's recent Future of the Fed event, Jane D'Arista argued that capital requirements can be harmfully pro-cyclical. I think her work is generally underutilized. Jennifer Taub's "Enablers of Exuberance" & Yves Smith's Econned also do a lot to deconstruct the usual assumptions the crisis.
Posted by: Frank Pasquale | Apr 28, 2011 8:24:46 PM
Bleeding in medicine to purge the body of vile humours seems, in retrospect, more counterproductive than cutting edge science, too.
Posted by: David Zaring | Apr 28, 2011 1:55:29 PM
Let me make one other suggestion - namely that it's not about evolution per se - but rather in the approach to physics suggested by Stephen Hawking in his recent book, The Grand Design, that it is more about model dependent realism. Justin, if you'd care to tip yourself into the world of physics (always an exciting thing!), Hawking and Mlodinow offer some key arguments the value of comparative modeling and its evolution in physics. There are a few choice quotes from the start of the book (forgive me for having listened to it as a book on tape - just as I did with Justin's book last spring):
"There is no picture- or theory-independent concept of reality. Instead we will adopt a view that we will call model-dependent realism: the idea that a physical theory or world picture is a model (generally of a mathematical nature) and a set of rules that connect the elements of the model to observations. This provides a framework with which to interpret modern science."
"It might be that to describe the universe, we have to employ different theories in different situations. Each theory may have its own version of reality, but according to model-dependent realism, that is acceptable so long as the theories agree in their predictions whenever they overlap, that is, whenever they can both be applied."
And my personal favorite: "It follows that a well-constructed model creates a reality of its own."
Posted by: Susan Franck | Apr 28, 2011 2:35:38 AM
And one could reasonable compare some economic notions to Lysenkoism.
Posted by: Max Kaehn | Apr 27, 2011 6:11:18 PM
I generally stick with "Lamarckian" to describe the relationship between economics as it is taught and science.
Posted by: Ken Houghton | Apr 27, 2011 6:06:56 PM
To really appreciate the headaches involved in the Ptolemaic system, you need to wrap your brain around epicycles. Epicycles managed to be approximations that never quite got it right, requiring more and more complication to the theory as observations got better. Newtonian theory made it possible to do much more exact calculations about the sun-centered Copernican system, and it took a while for oddities (like the precession of Mercury’s orbit) to accumulate enough that we needed Einstein’s theory of general relativity to explain them.
If you compare modern financial theory to the Ptolemaic system, you’re calling it a horribly convoluted theory developed to cope with basic assumptions that are fundamentally wrong. If you compare modern financial theory to Copernicus+Newton, you’re calling it highly accurate with variances from reality that require careful observations to measure. Are you sure you need something worse than Ptolemaic? (There’s always phlogiston theory...)
Posted by: Max Kaehn | Apr 27, 2011 5:28:48 PM
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