Encefalus

The recent economic crisis made me think a lot about the subject of economics. As I’ve said in earlier posts, I’m very interested in economics, and I believe them to be an integral part of cognitive science, or any science that aims to comprehend the human behavior and civilization (Some thoughts on a new micro-economic model and paradigm, through the integration of psychology into economics, Lotteries, poverty AND credit cards this time along with the proper social and scientific analysis , Lotteries, poverty and social implications , Neurons, politics and economics). The current problems that the economy faces make pretty obvious that the economic theories we have are weak. In this article we will discuss various articles and voices that have appeared in the last years that speak about a paradigm shift in economics.

It is pretty obvious that a main interest of economics is how to predict economic behavior, for example stock market behavior. A common approach to this is technical analysis which is really a mathematical analysis and prediction thereof, of a stock’s future direction, based on some premises. However, it is evident that the math that economists use, in this case, failed them.

Here we are faced with the following dilemma: The math approach is wrong all together, or we need new math.

The first approach, the math are wrong all together, is taken by Nouriel Roubini. Nouriel Roubini is the man who predicted the current recession in 2004. He criticises the mathematical approach to economics, using instead a historical analysis. Wikipedia quotes 

In the 1990s, Roubini studied the collapse of emerging economies. Consistent with the unusual talent noted by Sachs, he used an intuitive, historical approach backed up by an understanding of theoretical models to analyze these countries and came to the conclusion that a common denominator across examples was the large [current account] deficits financed by loans from abroad. Roubini theorized that the United States might be the next to suffer, and in 2004 began writing about a possible/future collapse. 

Professor Nouriel Roubini

This can be said to be true to some extent. Certainly, mathematics can’t predict completely abnormal behaviors, when will happen and what their exact effect will be. On the contrary, a historical analysis can provide common patterns that could indicate common causes and future effects. 

On the other hand, we got the second view we mentioned above, that we need new math. This view has been expressed in many articles in Scientific American. The oldest (I think) and, probably, the most important is this: How Fractals Can Explain What’s Wrong with Wall Street written by Benoit B. Mandelbrot himself, the mathematician who discovered the famous Mandelbrot Set.

Mandelbrot Set

In this article he discusses how portfolio theory has been based on the wrong assumptions (like the normal distribution curve) and therefore, provides wrong results. He proposed the use of fractal geometry instead, which can explain extreme events. In portfolio theory extreme changes are considered unlikely and, therefore, not worth mentioning. In fractal analysis, extreme events are considered a part of the system.

Mandelbrot’s article was written in 1999. This article in Scientific American was written the previous month, almost after a decade of Mandelbrot’s idea of using fractals to analyse market behavior: Mathematicians predicted stock market volatility years ago. The article cites 

Mandelbrot, 83, contends that portfolio theory, which tries to maximize return for a given level of risk, treats extreme events (like, say, yesterday’s market shockers) with “benign neglect: it regards large market shifts as too unlikely to matter or as impossible to take into account.” The faulty assumption of modern portfolio theorists, in Mandelbrot’s view, is that price changes do not drift far from the mean when observing daily ups and downs—so extreme events are exceedingly rare. “Typhoons, in effect, are defined out of existence,” he wrote. 

……..

Perhaps the most telling criticism of Mandelbrot’s work comes from the markets themselves. In the decade or so since his article was published, the use of multifractal market analysis is still largely an academic endeavor. But Mandelbrot should not be judged too harshly. Multifractals may not be in routine use on the trading floors. But Mandelbrot’s work on market extremes has served to broadcast to the Street a notion that has been known forever on the street: Yes, Virginia, sh*t really does happen. 

Benoit Mandelbrot

Well, as it seems the market didn’t absorb Mandelbrot’s ideas. However, this doesn’t mean he was wrong. Moreover, this doesn’t end our discussion here. The need for change in economics is pretty much self-evident, now that the scientific tools we use couldn’t predict or help in the crisis.

This need for change is expressed in many ways. Take another article in Scientific American: The Economist Has No Clothes. In the article we read

The 19th-century creators of neoclassical economics—the theory that now serves as the basis for coordinating activities in the global market system—are credited with transforming their field into a scientific discipline. But what is not widely known is that these now legendary economists—William Stanley Jevons, Léon Walras, Maria Edgeworth and Vilfredo Pareto—developed their theories by adapting equations from 19th-century physics that eventually became obsolete. Unfortunately, it is clear that neoclassical economics has also become outdated. The theory is based on unscientific assumptions that are hindering the implementation of viable economic solutions for global warming and other menacing environmental problems.

It seems, that the author of the article, Robert Nadeau, is not the sole believer in a different kind of economics. Take a look at this site, Post Autistic Economics, which is dedicated to creating an alternative to classical economics. In their history we read 

In March 2003 economics students at Harvard launched their own petition, demanding from its economics department an introductory course that would have “better balance and coverage of a broader spectrum of views” and that would “not only teach students the accepted modes of thinking, but also challenge students to think critically and deeply about conventional truths.”2 

Students have not been alone in mounting increasing pressure on the status quo.  Thousands of economists from scores of countries have also in various forms taken up the cause for broadband economics under the banner “Post-Autistic Economics” and the slogan “sanity, humanity and science”  The PAE movement is not about trying to replace neoclassical economics with another partial truth, but rather about reopening economics for free scientific inquiry, making it a pursuit where empiricism outranks a priorism and where critical thinking rules instead of ideology. 

Robert Nadeau has another article on Scientific American expressing similar views and anxiety about how classical economics have caused, and can’t deal with, the current environmental problems: Brother, Can You Spare Me a Planet? (Extended version)

The physics that the economists used as the template for their theories was developed from the 1840s to the 1860s. During this period, physicists responded to the inability of Newtonian mechanics to account for the phenomena of heat, light and electricity with a profusion of hypotheses about matter and forces. In 1847 Hermann-Ludwig Ferdinand von Helmholtz, one of the best known and most widely respected physicists at this time, posited the existence of a field of energy that could unify these phenomena. This proposal served as a catalyst for a movement called "energetics" in which physicists attempted to explain very diverse physical phenomena in terms of a vaguely defined protean field of energy that fills all space.

The strategy used by the creators of neoclassical economics was as simple as it was absurd—the economists copied the physics equations and changed the names of the variables. In the resulting mathematical formalism, utility becomes synonymous with the amorphous field of energy described in the equations taken from the physics, and the sum of utility and expenditure, like the sum of potential and kinetic energy in the physical equations, is conserved. Forces associated with the field of utility (or, in physics, energy) allegedly determine prices, and spatial coordinates correspond with quantities of goods. Because the physical system described in the equations of the theory in physics is closed, the economists were obliged to assume that the market system described in their theory is also closed. And because the sum of energy in the equations that describe the physical system is conserved, the economists were also obliged to assume that the sum of utility in a market system is also conserved.

Robert Lucas, Jr. is another economist who has a different view on which path economics should take. In Wikipedia we read the following 

One of the most influential economists since the 1970s, he changed the foundations of macroeconomic theory (previously dominated by the Keynesian economics approach), arguing that a macroeconomic model should be built in analogy with microeconomic models. He is well known for his investigations into the implications of the assumption of rational expectations. He developed the "Lucas critique" of economic policymaking, which holds that relationships that appear to hold in the economy, such as an apparent relationship between inflation and unemployment, could change in response to changes in economic policy. He also developed the Lucas-Islands model, which suggests that people are tricked by unsystematic parts of monetary policy, the Lucas-Uzawa model (with Hirofumi Uzawa) of human capital accumulation, and stated the "Lucas paradox" why not more capital is flowing from developed countries to developing countries.  

Does this remind you something? Those of you who read Encefalus will remember my somewhat awkward attempt to discuss the possible principles of a new theory of economics based on psychology at Some thoughts on a new micro-economic model and paradigm, through the integration of psychology into economics. All this also can be conncected with some opinions expressed in another Scientific American article, The Mind of the Market, where Michael Shermer, who’s someone that I respect for his radical views on science and his great articles, discusses how evolutionary theory should be incorporated into economics. Another article on evolution and economics at Scientific American can be found at Evonomics.

Finally, we got some views that might seem a little strange like this: What Can Virtual-World Economists Tell Us about Real-World Economies?  Of course, those of you who read Encefalus, might not be enstraged by this one, since we have expressed similar opinions in previous articles (Seed agrees that video games make you smarter , More proof that video games make you smart , How the Dark Knight, cartoons and video games make you smarter and what this had to do with the Flynn effect. ) . This article explains how the study of virtual economies could help us in the study of real economies.  Of course, it pretty evident that they have their differences, but, nevertheless, you can’t criticize a new approach before you see its results.

So, as you can see, there have been many different views on how economics should change. It’s pretty obvious that this is due to two reasons. First, as science advances, interdisciplinary research becomes even more important, since the boundaries between disciplines are not only blurred, but are withering due to the obvious need for the integration of one science into the other, like for example the integration of psychology into economics. Secondly, the crisis and other global problems, like the climate change, the oil crisis etc. are showing the weaknesses of classical economics. The imperative need for a paradigm shift in economics is becoming even more obvious. In this article I tried to show all of those possible new theories of economics that I know of that could lead to this shift. Should you find anything else, please free to add a comment.

This entry was posted on Saturday, October 4th, 2008 at 6:35 pm and is filed under Economics, Philosophical, Socio-Political. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.