Physics, finance, regulation and faulty models

Jean-Philippe Bouchaud, head of research of Capital Fund Management - read below before investing there - and a physics professor, writes:

Compared 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?

Bouchard first says that economists are much less smart than physicists. Economists believe in unproven efficient-market axioms put forward in the 1950s and 1960s as propaganda against communism.

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.

But then he says that, as soon as they have the opportunity to apply their skepticism to become billionaires, physicists lose their cool.

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.

The methodology of the natural sciences is so easy to forget, isn't it? Unlike his imaginary economists and suddenly-dumb physicists, Bouchard has made the "revolutionary" observation that

markets are not efficient, humans tend to be over-focused in the short-term and blind in the long-term, and errors get amplified, ultimately leading to collective irrationality, panic and crashes.

However, he fails to apply this logic to political action.

While work is done to enhance models, 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).

Having absorbed the existing political lore he follows the axiom that politicians and bureaucrats are more far-sighted than common humans. He believes that the political system is more efficient than free markets and will lead to collective rationality, calmness and stability.

Financial engineers have put too much faith in untested axioms and faulty models.

Indeed.