Econophysics

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Econophysics

• Will it improve upon the policy guidance given by
  economists?

2
Modern Economics

• Highly sophisticated theory complex concepts,
  very mathematical arguments

• Yes!

• Can the new approach of econophysics
• Give us greater insights into the economy?
• Reach different conclusions than modern economics?

3
Modern Economics

• Goes back a long way! Some foundations laid in
  late-18th early 19th centuries
• Smith and the invisible hand
• he is in this, as in many other cases, led by
  an invisible hand to promote an end which was no
  part of his intention. By pursuing his own
  interest he frequently promotes that of the
  society more effectually than when he really
  intends to promote it.
• Ricardo and comparative advantage
• Under a system of perfectly free commerce, each
  country naturally devotes its capital and labour
  to such employments as are most beneficial to
  each. This pursuit of individual advantage is
  admirably connected with the universal good of
  the whole

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Modern Economics

• Other foundations laid in late 19th, early 20th
• Marginal utility theory of value (Jevons UK)
• General equilibrium (Walras France)
• Marginal productivity theory of production
  (Marshall UK) distribution (Clarke UK)
• Only a few completely new concepts in 20th
• Game theory (but see Cournot France 1838!)
• Finance theory (Sharpe/Modigliani)
• Asymmetric information (Stigler)
• 20th century additions attenuate case somewhat,
  but
• In general, theory portrays market system as
• Stable equilibrating system
• Best planning/distributive mechanism available

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Modern Economics

• As a result
• Policy advice almost always for market-oriented
  solutions
• Deregulate, privatise, remove subsidies
• Long-run efficiency gain worth temporary
  transition pain
• Has the market system behaved as economic theory
  predicts?

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Stability?

• Not if the Asian Crisis is anything to go by

• But that can always be blamed on Asian crony
  capitalism
• Surely the home of capitalism is better
• Take for example the Nasdaq

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Stability?

• Whoops!
• (almost) Makes the Rupiah look stable!
• So has reality failed to live up to theory?

• Not really
• Theory predicts market economy will be unstable
• Then why the assumption of equilibrium?

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Why assume equilibrium?

• Early economists
• Made equilibrium a core concept for two reasons
• Ideological juxtaposing equilibrium of market
  economy to enforced order of feudal system
• Technical equilibrium methods well established
  in 19th century when economics founded
• Knew they should use dynamic methods
• If we wished to have a complete solution we
  should have to treat it as a problem of dynamics.
  But it would surely be absurd to attempt the more
  difficult question when the more easy one is yet
  so imperfectly within our power. (Jevons 1871)

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Why assume equilibrium?

• Hoped subsequent economists would develop
  economic dynamics
• A point on which opinions differ is the capacity
  of the pure theory of Political Economy for
  progress Will the pure theory of Economics
  have further and large achievements immediately
  before it? There seems to be an impression that
  it will not. It is with this view that I take
  issue. The great coming development of economic
  theory is to take place, I venture to assert,
  through the statement and solution of dynamic
  problems. (J.B. Clark 1898)
• This did not happen
• Instead development dominated by desire to prove
  what early economists assumed

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A failed venture

• Early economists assumed market would converge to
  equilibrium
• This will appear probable if we remember that
  the change from pb to pb exerted a direct
  influence while the changes from pc to pc,
  pd to pd, ..., exerted indirect influences
  Hence, the new system of prices is closer to
  equilibrium than the old system of prices and
  it is only necessary to continue this process
  along the same lines for the system to move
  closer and closer to equilibrium. (Walras 1874)
• 20th century economists tried to prove system
  would converge

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A failed venture

• Instead, proved that Walras model would not
  converge to equilibrium (Jorgenson 1960, 61, 63
  McManus 1963 Blatt 1983 Ch. 6)
• Dilemma Economics assume equilibrium, but models
  (let alone real economies!) wont converge to it
• Reaction by economists?
• Minority abandon statics (evolutionary
  economists)
• Majority ignores dynamics, assumes can apply
  equilibrium models (to non-equilibrium systems)
• The capitalistic economy is stable, and absent
  some change in technology or the rules of the
  economic game, the economy converges to a
  constant growth path with the standard of living
  doubling every 40 years. (Prescott 1999)

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Does it matter?

• What happens if you apply equilibrium guidelines
  to non-equilibrium system?
• Consider data set

• Generated by economy therefore assume a stable
  equilibrating process. Standard statistical tests
  show
• mean 0.666

• 2/3rds of data here

• standard deviation 0.205.

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Does it matter?

• Data assumed to follow standard normal
  distribution

• Use normal distribution to calculate odds

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Does it matter?

• Chance of value less than 0.4 is 1 in 10

• Use these odds to insure against outcome below
  0.4

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Does it matter?

• Odds of lt0.4 10 of the time
• Insurer profits if lt0.4 occurs (say) 15 of the
  time
• With this actual distribution, lt0.4 occurs 17.6
  of the time

Logistic function

• Generates chaotic data set where
• Extreme events much more likely than normal
  distribution

• Within range events much less likely

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Does it matter?

• Insurance company assuming normal risk would go
  broke via unexpected occurrence of large events
• What if economists treat economies this way?
  Would
• Exaggerate stability of actual economy
• Encourage policies that make economy more fragile
  because of excessive belief in robustness
• Unfortunately, economists do behave this way
• there is little agreement about the existence of
  chaos or even of nonlinearity in economic data,
  and some economists continue to insist that
  linearity remains a good assumption for all
  economic time series, despite the fact that
  economic theory provides little support for the
  assumption of linearity. (Barnett et al. 1996)

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To the rescue

• Much more to econophysics than just non-reliance
  on equilibrium analysis, but dropping belief in
  equilibrium key to potential advances

• Main different results (contra modern economics)
• Time-based policies
• Economics tends to give always everywhere
  answers to policy questions

• Free trade is always better than protection
• Market prices are always better than subsidised
  ones
• Private is always better than public

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To the rescue

• Econophysics likely to give time-based answers
• Hypothetical
• The economy may grow faster with a regime of
  initial protection that is gradually reduced
• Subsidised prices may be necessary until income
  distribution becomes fairer
• Industries with large externalities economies
  to scale may be better in public hands until
  technology changes
• Econophysics might finally
• Divorce ideology from economics
• Make economics more realistic.

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