... in the wake of a financial crisis brought on (partly) by a reliance on the financial community's consensus statistical modeling, it's not a bad time to question the reliability of these models in the first place.
Tuesday, November 18, 2008
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Financial engineers have put too much faith in untested axioms and faulty models, says Jean-Philippe Bouchaud, head of research of Capital Fund Management and a physics professor at cole Polytechnique in France, in a Nature Essay (455, 1181; 2008). To prevent economic havoc, that needs to change. From the Essay:
ReplyDeleteCompared with physics, it seems fair to say that the quantitative success of the economic sciences has been disappointing. Rockets fly to the Moon; energy is extracted from minute changes of atomic mass. What is the flagship achievement of economics? Only its recurrent inability to predict and avert crises, including the current worldwide credit crunch. Why is this so?
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. Physicists, on the other hand, have learned to be suspicious of axioms. If empirical observation is incompatible with a model, the model must be trashed or amended, even if it is conceptually beautiful or mathematically convenient. So many accepted ideas have been proven wrong in the history of physics that physicists have grown to be critical and queasy about their own models.
Unfortunately, such healthy scientific revolutions have not yet taken hold in economics, where ideas have solidified into dogmas. These are perpetuated through the education system: students don’t question formulas they can use without thinking. Although numerous physicists have been recruited by financial institutions over the past few decades, they seem to have forgotten the methodology of the natural sciences as they absorbed and regurgitated the existing economic lore.
Regulation also needs to improve. Innovations in financial products should be scrutinized, crash-tested against extreme scenarios outside the realm of current models and approved by independent agencies, just as we have done with other potentially lethal industries (chemical, pharmaceutical, aerospace, nuclear energy).
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.
Well, that about says it all, doesn't it?
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