Why Econophysics Will Never Work

First we have the issue of the debate about the differences between Economics and Econophysics. Then there's an argument on why Economics will never be like Physics. Now comes an argument on why Econophysics will never work!

The markets are not physical systems. They are systems based on creating an informational advantage, on gaming, on action and strategic reaction, in a space that is not structured with defined rules and possibilities. There is feedback to undo whatever is put in place, to neutralize whatever information comes in.

The natural reply of the physicist to this observation is, “Not to worry. I will build a physics-based model that includes feedback. I do that all the time”. The problem is that the feedback in the markets is designed specifically not to fit into a model, to be obscure, stealthy, coming from a direction where no one is looking. That is, the Knightian uncertainty is endogenous. You can’t build in a feedback or reactive model, because you don’t know what to model. And if you do know – by the time you know – the odds are the market has changed. That is the whole point of what makes a trader successful – he can see things in ways most others do not, anticipate in ways others cannot, and then change his behavior when he starts to see others catching on.

It will be interesting to see if the writer has actually read Christophe Schinckus AJP's paper (my guess is he hasn't), and if Schinckus has a response to this.

The question whether something works or is valid in field of studies such as economics, social science, politics, etc. is rather interesting. In the physical sciences, there's usually no ambiguity because we can either test it out, or go look for it. Something works when what it predicts can be observed and reproducible. So how does one determines if the various principles and models in economics, social science, politics, etc. are valid and do work? Simply based on previous data and observation that somehow fit into the model? But as this writer has stated, there's no model to fit because the model keeps changing due to such model-changing feedback. It appears that the whole field is more based on "intuition" than on any rational reasoning.

If that's the case, then it truly isn't a science but more of an art. So why do people who graduate with a degree in economics, social "science", or politics, sometime get a "Bachelor of Science" degree?

Zz.

Economics and Econophysics

In an earlier blog entry, I pointed to an essay that argues why economics will never be like physics, no matter how much it tries to assimilate concepts and mathematical models of physics. Now comes an article in the latest issue of Am. J. Phys. that argues that even in two areas of study that deals with the economy, even they are not like each other. Christophe Schinckus of the University of Quebec argues in an opinion piece on why the fields of econophysics is a rather completely separate field of study that economics[1].

Are econophysics and economics complementary fields or totally separated disciplines? In this paper I argue that econophysics is not a subfield of economics, and these two fields are separate disciplines.

There are two kinds of gaps between economics and econophysics. The methodological gap refers to a way of doing science. Although economists base their work on a priori methodology, econophycisists use a data-driven methodology. The other gap concerns the way they think about reality. Econophycisists and economists do not see the world in the same way.

In contrast to econophysics, economics is not an empirical discipline. Even if there are debates about the empirical dimension of economics, the empirical dimension in economics is exaggerated. According to econophysicists, complexity studies need an empirical basis. “The real empirical data are certainly at the core of this whole enterprise econophysics and the models are built around it, rather than some non-existent, ideal market as in economics.” This empirical dimension is frequently mentioned in econophysical research and is often presented as the main difference with economics.

Well, there ya go. If economics is not even similar to a field of study in physics that also deals with the same subject matter, then it is even further away from other fields of physics. There are some who don't even think it is a science.

Zz.

[1] C. Schinckus, Am. J. Phys. v.78, p.325 (2010).

So You Want To Be A Quant - Follow-Up

Physics Today blog covered this NY Times piece on Quants and their role (or non-role) in the current economic crisis. The blog had some rather interesting quotes:

Lee Smolin, a physicist at the Perimeter Institute for Theoretical Physics in Waterloo, Ontario, said, "What is amazing to me as I learn about this is how flimsy was the theoretical basis of the claims that derivatives and other complex financial instruments reduced risk, when their use in fact brought on instabilities."

Quants say that they should not be blamed for the actions of traders. They say they have been in the forefront of pointing out the shortcomings OF modern economics.

"I regard quants to be the good guys," said Eric R. Weinstein, a mathematical physicist who runs the Natron Group, a hedge fund in Manhattan. "We did try to warn people," he said. "This is a crisis caused by business decisions. This isn't the result of pointy-headed guys from fancy schools who didn't understand volatility or correlation."

Whether it is true or not hasn't changed my view of the field of finance and economics, which I do not consider to be a "science". It is more of an after-the-fact quantitative analysis with vague predictive power. That probably is an ignorant view of it, but I haven't heard, read, or seen enough evidence to the contrary.

Zz.

Economics Needs a Scientific Revolution

Continuing my argument on why economics isn't physics (or in the earlier case, why economics will never be like physics), this is such a delicious essay written by Jean-Philippe Bouchaud, head of research of Capital Fund Management and a physics professor at cole Polytechnique in France. The essay appeared in the Oct. 30 issue of Nature.

In the essay, he argued that economists have somehow adopted assumptions into axioms. He illustrated this in a number of ways. I'm trying very hard not to quote almost the whole essay, because it is THAT good, but I'll quote the very pertinent paragraphs that should be of interest:

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. An economist once told me, to my bewilderment: "These concepts are so strong that they supersede any empirical observation." As economist Robert Nelson argued in his book, Economics as Religion (Pennsylvania State Univ. Press, 2002), the marketplace has been deified.

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.

Try to read the whole essay if you have the chance. It should cause blood to boil among a group of people that shall remain nameless. :)

Zz.

Why Economics Will Never Be Like Physics

I try to post something that often reflects the "times". And the times of lives right now has mostly been about the economic meltdown, especially driven by the spectacular collapse of the US financial markets.

It is during this time that, as scientists, when we try to make sense out of how things occur in economics, that we continually realize that it doesn't make sense, and that many of the things that occur often do not have clear rules and patterns. So I guess an article like this one, arguing why economics will NEVER be like physics no matter how hard it tries, really is a no-brainer.

My bet is that economics will always remain as squishy as anthropology, political science, history and other social sciences. The physical sciences address phenomena-ranging from electrons, elements and the nuclear forces up to stars, galaxies and gravity-that are relatively stable and well-defined. In contrast, economies vary wildly across space and time. The U.S. economy today is radically different than it was a decade or even a month ago. Economists are chasing a rapidly moving and mutating target.

It gets worse: Protons, plasmas, planets and other strictly physical systems don't care what scientists think about them. Social systems, on the other hand, consist of objects that read newspapers, journals, books and blogs and change their behavior as a result. Newton's model of planetary motion did not affect Jupiter's course, but an initially persuasive model of dollar-yen exchange rates may affect those rates in a way that soon renders the model totally obsolete.

In other words, the effort to understand economies or indeed almost any human social system changes the system! I'm not talking about some subtle quantum-observer effect but something much more dramatic. Marx creates Marxists, Keynes Keynesians, Hayek Hayekians, leading to wars and depressions, bubbles and recessions.

It is because of this that it irritates me whenever politicians (and even economists) can talk about many policies with such utter certainty. You see politicians arguing about this policy versus that policy which can (or cannot) create jobs, or doing such-and-such will cause taxes to fall, or people to lose jobs, etc, etc. And of course, the public will buy it, details unseen as always. It certainly is ironic that fields in "hard" sciences are more concerned about uncertainty and "error bars" in our work and experimental data, while "soft" science such as politics, economics, and social sciences that deal with less-verified principles are presented with such definite certainty.

Go figure.

Zz.

Rising Cost of Oil 'Due to Speculation'

Finally, a research work done in the field of econophysics that I've actually found to be "relevant" and interesting! :)

This is a preprint by a group from ETH Zurich and the East China University of Science and Technology. In it, they claim that the rising cost in oil cannot be explained simply via supply and demand, that the major cost for the increase is due to oil speculation. You can read a review of this preprint at the Physics World website (free registration is required).

In an economy without speculation, the price of commodities tends to grow by a fixed percentage every year; this is an exponential rate of growth. But when an economy is influenced by speculation, the percentage increase can grow too. This gives rise to a power-law growth or, as the researchers call it, a “super-exponential growth”.

Sornette’s group has looked at three different models to see if oil prices exhibit super-exponential growth. Each of these models is based on a “log-periodic power law”, which characterizes the super-exponential growth, and contains three main parameters: the time when the bubble is expected to end; the exponent of the power law; and a scale factor. The researchers found that all three models fitted the oil-price data well, implying that the growth has indeed been a bubble.

Apparently, this group also predicted back in 2005 of the burst of the US housing market. And look at where we are now?

Zz.