by Cheryl Rofer
Economics uses mathematics, but it is quite different from the physical sciences. Whereas the physical sciences describe reproducible phenomena, what economics describes contains a great deal of human behavior, which varies in unpredictable ways. Or at least unpredictable at our current level of understanding.
My training is in the physical sciences, as regular readers of WhirledView know. I have never taken an economics course, which I am presenting as a fact. You may make your own value judgement as to the reliability, therefore, of what I am about to say.
Wired has a long article about what another physical scientist did for, or possibly to, the markets with his foray into economics. Besides the limitations the article cites that were ignored all too often, I would add that I find it circular to use CDSs to judge the risk of CDOs. This would be part of the broader picture that the article is talking about:
In the world of finance, too many quants see only the numbers before them and forget about the concrete reality the figures are supposed to represent.To miss this or the other factors that the article lists is a severe failing, but I wonder if it is really due to the physical-science background of the quants or if it is more wishful thinking, one of those human factors that intrudes on economics.
Recent Nobel Prizes in Economics have rewarded practitioners in the field of behavioral economics, which tries to account for these human factors. Some practitioners in that field have called for major reconsiderations of how economics does its work.
I've been thinking about economics lately and wondering how it might be improved. I'm moving in a different direction from behavioral economics, toward more rigor along the lines of the physical sciences. If nothing else, such rigor might help to show the limitations of an economic approach, whether traditional or behavioral.
I have two questions, which may simply illustrate my ignorance of economics.
1. Does economics have a conservation principle?
Chemistry and physics (and of course biology and everything else that uses chemistry and physics) have a very basic principle: matter and energy are neither created nor destroyed. This makes for a very basic sort of bookkeeping that led, for example, to Einstein's famous E = mc2. What is neither created nor destroyed in economics? Certainly not money, as we are seeing to our very great distress. Value? One might take an Aristotelian view that there is some absolute value that we approximate sometimes well and sometimes poorly in our human transactions. We then might consider why and how we deviate from that Aristotelian value.
I suspect that the gold standard was an attempt at a conservation principle, but it proved inadequate in practice. Was that because of deviations from Aristotelian value?
2. Does economics insist on a definition of the system?
This is a requirement that goes along with the conservation principle. It becomes particularly evident (or did to me, anyway) when one is faced with problems involving entropy. Entropy looks almost like energy that is destroyed. And you can come up with the appearance of energy created or destroyed if you don't define your system carefully enough. If you define your car as a system, you will find that it is capable of running for a limited number of miles. If you want it to run further, you must define outside sources of gasoline as part of the system. We've also, societally, been ignoring the product of burning that gasoline as part of the system. This sounds like the system will always grow to include everything, but that's not the case. You do have to be clear about your objectives, though, when you define the system, and you have to consider that your definition may be part of the problem when you get a funny result.
So in economics, depending on one's objectives, a single bank might be defined as the system, or all banks in the United States, or all institutions that perform the function of lending money. A definition in terms of functions, like that last, might have led to a better understanding of the risks that were out there.