“I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works.” This, infamously, was uttered by former chairman of the Federal Reserve Alan Greenspan, who admitted that his view of how economies work was deeply flawed, and yet refused to issue an apology for years of federal intervention (or lack thereof) based on his “flawed” model. Hundreds of millions of people worldwide are suffering economic hardship as a result of someone making policy decisions on the basis of a flawed assumption.
How is this possible? Economics is supposed to be a solid discipline, founded on complex mathematical models (and we all know math is really, really difficult). They even give Nobel prizes to economists, for crying out loud! And yet, economics has always had to fight off the same reputation of being a “soft” science that has plagued sociology, psychology, and to some extent even some of the biological sciences, like ecology and evolutionary biology. Indeed, like practitioners in those other fields of inquiry, some economists admit of being guilty of “physics envy,” that is, of using the physical sciences as the model for what their field ought to be like. Turns out even the assumption that a good science should be modeled on physics is “flawed,” to use Greenspan’s apt phrase.
A recent article by Chelsea Wald in Science (12 December 2008) puts things in perspective by asking how it is possible that so many smart people in the financial sector made irrational decisions over a period of years, despite clear data showing there was a problem, and eventually leading to a worldwide economic crisis that is at the least poking at, if not shaking, the foundations of capitalism itself.
Part of the answer is to be found in the persistent idea in economics that “markets” work because people are rational agents who act in their own self-interest and have perfect, instantaneous access to relevant information about the businesses they are considering investing in. Economists are not stupid, and they know very well that perfect rationality, complete information and instant access are all light years away from the reality of how markets operate. And in fact recent models have relaxed these assumptions to some extent. But it is so much more tractable to model things that way! After all, physicists do it too: remember those problems in Physics 101 that started “consider a spherical cow…”?
But now there is a new kid on the block: “behavioral finance” takes seriously the idea that people act somewhat rationally some of the time but can spiral into downright panic at other times. The new approach draws from an interdisciplinary milieu that includes “soft” sciences like psychology and sociology, since those are the fields that tell us the most about the idiosyncrasies of human behavior. Perhaps not surprisingly, there is another science that has been inspiring economists for some time now: evolutionary biology. The old “efficient markets hypothesis” underlying classical models is being replaced by the “adaptive markets hypothesis,” where Adam Smith’s invisible hand becomes more directly analogous to natural selection.
As evolutionary biologists have found out, natural selection is not an optimizing process, but a satisficying one, meaning that it produces whatever outcome happened to be achievable at a particular historical moment and that works “well enough” for the problem at hand. Moreover, it does so while “wasting” a lot of resources and often marching straight into dead ends (just think that over 99% of the species that ever existed went extinct). The emerging picture is much more realistic than the rationalist paradigm, but it sure is a lot more messy too.
There is another lesson to be learned from evolutionary biology that will not make economists, or the public at large, particularly happy: when complex systems evolve over time the paths they take is contingent on historical accidents (as opposed to being deterministic, like the laws of macro-physics, outside quantum mechanics). Sociologists, psychologists, ecologists and evolutionary biologists will readily tell their economic colleagues that it is certainly possible to explain past events (the extinction of the dinosaurs, the dot-com bubble) by the use of sufficiently complex causal-historical models. What seems to be out of reach, however, is precisely what economists want most: predicting the future, the hallmark of “good” science.
I’m talking here about specific, actionable predictions, not general ones. Meteorology, for instance, is predictive in the sense that it will tell you that there is a high probability of low temperatures in New York City in the period December-February, no matter what the year. But it is barely capable of telling you whether tomorrow you’ll need a heavy coat or an umbrella. Similarly, ecologists can say that the likelihood of extinction goes up when certain environmental parameters change, for instance the size of the available territory, or its links to similar territories nearby (which affects metapopulation dynamics). But they will be hard pressed in predicting which individual species will go extinct when and where.
Similarly, the new economic models “work” in the sense that they can say, for instance, that stocks that are difficult to value will do well in “optimistic” times, while easy to value stocks will do better in “pessimistic” times. Heck, they can even predict that the variance in how well stocks do is higher for the first type than for the second one. But none of that is going to be of any use when you talk to your broker later today and have to make decisions about what to buy or sell here and now.
The moral of the story is that all of the above is not a failure of economics, sociology, psychology, ecology or evolutionary biology. It is the predictable outcome of the fact that these sciences deal with complex, historical systems, unlike much (though not all) of physics. The real assumption we need to get rid of is the highly persistent and pernicious one that physics is the golden standard by which all other sciences ought to be measured. Now if we only could convince federal funding agencies of that...
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Rationally Speaking is a blog maintained by Prof. Massimo Pigliucci, a philosopher at the City University of New York. The blog reflects the Enlightenment figure Marquis de Condorcet's idea of what a public intellectual (yes, we know, that's such a bad word) ought to be: someone who devotes himself to "the tracking down of prejudices in the hiding places where priests, the schools, the government, and all long-established institutions had gathered and protected them." You're welcome. Please notice that the contents of this blog can be reprinted under the standard Creative Commons license.
Tuesday, December 23, 2008
Economics learns a thing or two from evolutionary biology
Posted by Unknown at 11:10 AM
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Quite. I've met a few physicists who have tried to do biology. My conclusion from observing them is that the successful ones are the ones who learn their biology first or link up with a biologist. Physics seems to be a different beast to the messier sciences, but this is something I don't think a lot of people appreciate.ReplyDelete
Anyway, we have our answer to the physicists.
And have a good Christmas!
"A recent article by Chelsea Wald in Science (12 December 2008) puts things in perspective by asking how it is possible that so many smart people in the financial sector made irrational decisions over a period of years..."ReplyDelete
I just checked my e-mail and saw that the latest eSkeptic features an article from a guy who wrote a book on Ponzi schemes who fell victim to Madoff's Ponzi scheme!
The new eSkeptic isn't up on the web yet, but Shermer talked about the author, here.ReplyDelete
I would agree that economics (and other "soft" social sciences) deserves as much respect as physics and should be judged according to the difficulties and complexities inherent in its subject matter.ReplyDelete
But I would say that many economists deserve to be treated with a little more caution (relative to physicists, e.g.) for the influential roles they play in our society. After all, it's not like they merely describe how economies work — in their common advisory roles, they also prescribe how they should work. (To some extent, I suppose this is analogous to climate scientists advising government on pollution control, although, thanks to the strong influence of polluting industries on environmental policy, their degree of influence seems comparably weak.)
While there are certainly exceptions (e.g. neo-Keynesians, not to mention orthodox Marxists), the dominant prescription (at least up until the very recent economic crisis) is something along the lines of: Keep the politicians out of the way and just allow the "Invisible Hand of the Market" to "work" (read: deregulation/laissez-faire economic policy). [See here for an historian's treatment of the subject.]
In that sense, the popular urge to tar & feather the likes of Greenspan & his acolytes in banking, government, & academia is at least understandable (if crude and unconscionable), given the pain that many of us are now experiencing as a result of our political leaders' having trusted their counsel.
Surely it is important to note that Alan Greenspan was a Randian Libertarian (I say "was" since maybe he no longer is - having recognised the fatal flaw in that ideology?) and so an extreme supporter of laissez faire capitalism, maybe not the best person to have as the leading financial regulator in the world's largest economy...ReplyDelete
The Nobel Prize in Economics is not one of the five Nobel Prizes established by Alfred Nobel but is "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel". Just wanted to blow up that misconception, whilst we watch the world economy blow up ;-)
I worked in a grocery store for many years, and was talking to a regular customer in my line once. I told him that, given that the simplifying assumptions of economics are all BS, it becomes so ideologically loaded that you get out of it whatever you want to.ReplyDelete
He said that he was a retired professional economist, and it took him all of his career to realize that. He asked me how I had "come by such wisdom."
I simply said that, as a science teacher, I think a lot about how we know what we know.
I think the problem with economics is not the logic or models, but the lack of a commensurable property. Value in economics is highly derived - currencies do not represent any physical properties like work and resources. Instead they represent some abstraction of abstractions of properties. So the models cannot be expected to work even if they were tractable.ReplyDelete
I generally agree with your distinction between 'hard' and 'soft' sciences, though I think there is (as you would probably accept) a lot of gray area between the two. Nevertheless, I think your premise, or more mildly, example in this case is off. Even many relatively simple economic models (I'm not informed enough about the models to say exactly what the assumptions are) could have predicted (in a very general sense) the financial bubble and its ramifications. That is why many prominent economists like Stiglitz and Krugman (both Nobel-like laureates, so clearly not radicals in their profession) have long called for regulation of financial markets. I'm not sure that we disagree here, I just wanted to point out that not all, or even a majority, of economists believed in the Greenspan view of the world.
"I just wanted to point out that not all, or even a majority, of economists believed in the Greenspan view of the world."ReplyDelete
But that's the thing. In economics the extent to which one's view of the world changes the way data are interpreted is much greater, ISTM, than in other sciences.
Of course I realize that ideology colors the kinds of questions asked and how things are interpreted in all fields, but in economics, it seems like that's all there is sometimes.
Let's see... economists stir everyone up into an enormous investment bubble frenzy, pocket their huge bonuses, and then are given upwards of a trillion dollars more when the whole thing collapses. Sounds pretty rational to me! Just not very moral.ReplyDelete
Economics is supposed to be a solid discipline, founded on complex mathematical models ...ReplyDelete
Presumably a scientific discipline can be considered "solid" to the extent that it follows the scientific method. In particular, models (complex or otherwise) must be subjected to rigorous empirical verification. To the extent that models become articles of faith, a discipline has wandered from the path of science.
And yet, economics has always had to fight off the same reputation of being a “soft” science ...
It seems to me that economics is fundamentally more difficult (dare I say "harder") than the "hard" sciences. After all, unlike say the behaviour of electrons, economic structures and behaviours change over time. Economic models that work in one context may be completely inappropriate in another.
I'd like to point out that economic advice can also be used to justify government policies that enrich certain strata of society at the expense (not just financial, but also environmental and social) of others. I believe that because of this there is a strong biasing pressure on the discipline of economics. Models that can be used to justify the enrichment of the dominant strata of society have a strong advantage.
Years ago I gave a guest lecture in a quantitative finance graduate program to an audience of 60 people, mostly (on show of hands) with undergraduate degrees in engineering or mathematical physics. The title of the lecture was "Finance is not Physics." I barely escaped with my life. :)ReplyDelete
A published version is here for the morbidly curious.
As evolutionary biologists have found out, natural selection is not an optimizing process, but a satisficying one ...
It may be worth mentioning, in this context, that the optimizing / satisfycing distinction is from Herbert Simon, Nobel Laureate in Economics (so here's a case of biologists learning something from economics).
Yeah, but Simon was really a cognitive scientist. :)ReplyDelete
I remember criticizing one of your posts on Science Blogs for being economically illiterate.ReplyDelete
This post definitely doesn't suffer from that weakness. Very nice essay.
"I'd like to point out that economic advice can also be used to justify government policies that enrich certain strata of society at the expense (not just financial, but also environmental and social) of others. I believe that because of this there is a strong biasing pressure on the discipline of economics. Models that can be used to justify the enrichment of the dominant strata of society have a strong advantage."ReplyDelete
This is very important. Any idea or discovery that challenges accepted presumptions will not be taken lying down. Those with economic, military, civil, or other types of power will be vastly more successful at shooting down theories they do not like. (I'm looking at you, Galileo!)
Given that prudent economic policy can change by context, it's easy to make a break with the past and say with an air of authority that "today's economy" demands X, not Y. Furthermore, because economies are messy processes that are not fully understood by any one individual, theorists are liable to blame past theories wholesale for failures, while there are almost certainly extraneous reasons for the success/failure of the economy at any point in time.
This type of uncertainty prevents economics from having the same kind of rigorous empirical demands placed upon it as other types of sciences, which again, leaves a lot of room for ideology and whimsy.