The Current State of the Science of Economics
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Financial crises are different from natural crises. In an earthquake, people trying to respond to the earthquake do not make the earthquake more powerful. Financial crises, on the other hand, are caused by people trying to run away from them. A person selling stock pushes the price of the stock down. People sell stocks when they think the price will be going down. So financial crises are essentially self-fulfilling prophecies.
How financial crises are created by people who fear them is an interesting topic. Whether there is a widespread misunderstanding of economics and finance is an even more interesting topic. My theory is that the development of economic and social sciences is problematic, and that these problems are behind the frequency and intensity of financial crises.
If we observe the development of natural sciences, we observe that they all arose from practical concerns of people. What interested people the most in medicine was prolonging one’s life. It was accomplished. What interested people the most in physics and engineering was how to make fast and comfortable machines to traverse the seas and conquer the air. It was accomplished. What interests people in economics is why booms and crises happen. The “social” science of economics and quantitative cousin finance are not even focusing on this topic. No wonder why ordinary people are astounded by the clear and comprehensive uselessness of modern economics.
Scores, hundreds, thousands of economists are busy proving auto-correlation between stock returns. There seems to be an obsession about gathering data. As natural sciences are very data intensive, economics has tried to prove itself as just as data intensive. The problem with this approach is that it fails to recognize the real reason of the superior legitimacy of natural sciences: addressing popular demand. Economics today seems like a natural science that has brought up its Aristotle, but tried to skip to 20th century without producing a Galileo. Aristotle speculated wildly without inhibition. Galileo reasoned first, an experimented later. By the time we reached the 20th Century, most of the philosophical issues surrounding natural sciences were resolved, so scientists could focus primarily on experimentation. Economics, on the other hand, has jumped from wild speculation to wild experimentation. Let us remeber that Galileo disproved Aristotle’s claim that larger objects fall faster not only by experiment but by proving its logical fallacy. Economics had and continues to have its share of Aristotle’s without the fortune of being saved by its Galileo’s. In the field of economics, let us first question the fundamental logical basis of our goals, axioms and methodology and then gather heaps of data.
Natural sciences can afford to act as if the scientist is a disinterested observer. The behavior of atoms or bacteria is not dependent on what scientists think of them. But the behavior of economic agents depends very much on what economic “scientists” think of them and their surrounding. When people treat market crises as earthquakes, they make a fundamental mistake. In an earthquake, one should save oneself by running away. Each man trying to save his own skin does not constitute a problem because the earthquake process does not care what each man versus the whole of society is trying to do. To give another example, to get a whole society flying is accomplished by flying all its members one by one. However, markets crises are different. There is a directly link between the crisis and the behavior of the players in it. The connection is beyond a direct link - a market crisis consists of people trying to avoid it. There is nothing else. This is where the hypothesis of an objective observer fails. No matter how much quantitative analysis one does, one cannot change the reality that a market crisis is the sum of all actions of people trying to avoid it. Therefore, as long as finance theory and practice focuses on how individuals can avoid crises, crises will not be avoided.
Economics graduate school textbooks begin by formulas. Why? Have we established what we are using the formulas for? In economics recently, intellectual rigor has been confused with quantitative rigor. Intellectual rigor is not limited to quantitative rigor. Economics deals with people’s behavior. Without understanding the connection between people’s psychology and their actions, it is not useful to collect worldwide data on markets. In processes like chip design, intellectual rigor depends on quantitative rigor from step one. The desired outcome is clear, so one can gather heaps of data and figure out the best materials and design. In financial markets, quantitative rigor is not sufficient. Financial markets are driven by what people know, what they expect of each other. The focus should be on the sanity of people rather than the statistical tests on the correlation of stock prices with each other.
***
Financial crises are different from natural crises. In an earthquake, people trying to respond to the earthquake do not make the earthquake more powerful. Financial crises, on the other hand, are caused by people trying to run away from them. A person selling stock pushes the price of the stock down. People sell stocks when they think the price will be going down. So financial crises are essentially self-fulfilling prophecies.
How financial crises are created by people who fear them is an interesting topic. Whether there is a widespread misunderstanding of economics and finance is an even more interesting topic. My theory is that the development of economic and social sciences is problematic, and that these problems are behind the frequency and intensity of financial crises.
If we observe the development of natural sciences, we observe that they all arose from practical concerns of people. What interested people the most in medicine was prolonging one’s life. It was accomplished. What interested people the most in physics and engineering was how to make fast and comfortable machines to traverse the seas and conquer the air. It was accomplished. What interests people in economics is why booms and crises happen. The “social” science of economics and quantitative cousin finance are not even focusing on this topic. No wonder why ordinary people are astounded by the clear and comprehensive uselessness of modern economics.
Scores, hundreds, thousands of economists are busy proving auto-correlation between stock returns. There seems to be an obsession about gathering data. As natural sciences are very data intensive, economics has tried to prove itself as just as data intensive. The problem with this approach is that it fails to recognize the real reason of the superior legitimacy of natural sciences: addressing popular demand. Economics today seems like a natural science that has brought up its Aristotle, but tried to skip to 20th century without producing a Galileo. Aristotle speculated wildly without inhibition. Galileo reasoned first, an experimented later. By the time we reached the 20th Century, most of the philosophical issues surrounding natural sciences were resolved, so scientists could focus primarily on experimentation. Economics, on the other hand, has jumped from wild speculation to wild experimentation. Let us remeber that Galileo disproved Aristotle’s claim that larger objects fall faster not only by experiment but by proving its logical fallacy. Economics had and continues to have its share of Aristotle’s without the fortune of being saved by its Galileo’s. In the field of economics, let us first question the fundamental logical basis of our goals, axioms and methodology and then gather heaps of data.
Natural sciences can afford to act as if the scientist is a disinterested observer. The behavior of atoms or bacteria is not dependent on what scientists think of them. But the behavior of economic agents depends very much on what economic “scientists” think of them and their surrounding. When people treat market crises as earthquakes, they make a fundamental mistake. In an earthquake, one should save oneself by running away. Each man trying to save his own skin does not constitute a problem because the earthquake process does not care what each man versus the whole of society is trying to do. To give another example, to get a whole society flying is accomplished by flying all its members one by one. However, markets crises are different. There is a directly link between the crisis and the behavior of the players in it. The connection is beyond a direct link - a market crisis consists of people trying to avoid it. There is nothing else. This is where the hypothesis of an objective observer fails. No matter how much quantitative analysis one does, one cannot change the reality that a market crisis is the sum of all actions of people trying to avoid it. Therefore, as long as finance theory and practice focuses on how individuals can avoid crises, crises will not be avoided.
Economics graduate school textbooks begin by formulas. Why? Have we established what we are using the formulas for? In economics recently, intellectual rigor has been confused with quantitative rigor. Intellectual rigor is not limited to quantitative rigor. Economics deals with people’s behavior. Without understanding the connection between people’s psychology and their actions, it is not useful to collect worldwide data on markets. In processes like chip design, intellectual rigor depends on quantitative rigor from step one. The desired outcome is clear, so one can gather heaps of data and figure out the best materials and design. In financial markets, quantitative rigor is not sufficient. Financial markets are driven by what people know, what they expect of each other. The focus should be on the sanity of people rather than the statistical tests on the correlation of stock prices with each other.
posted by Ümit Kumcuoğlu at 11:02 PM
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