Tuesday, April 10, 2012

Worth Thinking About

Mark Buchanan, a theoretical physicist, is the author of "The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You". A former editor of Nature and now a columnist for Nature Physics, Buchanan writes about efforts to use physics concepts to understand dynamics of biology and the social sciences, and is at work on a new book about the physics of finance. He writes (8 April) on Blomberg HERE

“Economists Have a Lot to Learn From the Weather”

“Almost five years after a financial crash nearly thrust the world into depression, a peculiar paradigm still dominates economic thought.

Known as the neoclassical school, it aims to give Adam Smith’s notion of the invisible hand its mathematical form. It asserts that markets naturally seek an equilibrium that harnesses individual self interest to allocate investment capital in an optimal way. Even if that perfectly efficient ideal is never reached, the logic goes, markets work better insofar as they approach it.

Anyone who thinks our recent financial travails would have discredited this vision is underestimating the mental inertia of theoretical economics. To this day, the Federal Reserve and the European Central Bank go right on making plans using so-called general equilibrium models of the economy. In these models, financial firms don’t exist, asset bubbles are inconceivable and there’s no such thing as an international market in derivatives -- despite the obvious reality of one with a total notional value of around $700 trillion.

The economics profession hasn’t tried too hard to develop more realistic alternatives. But history tells us they can be found. In the 1950s, even as economists lashed themselves to the mast of equilibrium thinking, scientists studying the movement of air in the atmosphere turned in a very different direction.

Dominant Paradigm
How does air move around the planet? Back in 1735, an English lawyer and amateur scientist named George Hadley suggested a model that became the dominant paradigm: Warmer air near the equator should rise skyward, flow toward the poles in the upper atmosphere, and then descend and cool near the poles, afterwards flowing back toward the equator at the surface.

This balanced equilibrium explained many observations, such as the trade winds -- steady westerly flowing winds near the equator -- on which navigators had depended for centuries. Indeed, Hadley’s balance was so satisfying that it took about a century for scientists to notice that it was mostly wrong, or at least seriously incomplete.

In fact, the looping flow Hadley described stretches only from the equator out to about 30 degrees latitude -- that’s around Florida in the northern hemisphere, and South Africa in the southern. In the mid latitudes beyond, there’s no stable balance, but ceaseless change, storms and weather fronts, meandering cyclones and anti-cyclones.

The basic story identifying the source of all this turbulence emerged only in the 1950s … The weather is a tough problem, because nothing in it can be reduced to a state of balance or equilibrium (as a simple atomic nucleus can). Therein lies the key insight for atmospheric flow.

Storms and weather fronts aren’t accidental and unimportant “details” of the atmospheric flow at all. They are central to the way the Sun’s energy, once absorbed on Earth, flows about the planet. … Ultimately, this phenomenon, arising from something called baroclinic instability, creates large swirling vortices of air that drift through the middle latitudes, transporting huge quantities of heat and water all over the planet, and causing our unpredictable weather.

No mathematician can “solve” the complex equations for air in the atmosphere. … I]n 1955 … Norman Phillips used an early computer to simulate a virtual atmosphere based on a crude approximation of the equations of fluid dynamics. …

The simulation, which took 12 hours to run, showed that baroclinic instability really does account for the fundamental character of atmospheric flows. Stable flows always fell apart, creating cyclonic storms and weather fronts just as we see.
It’s natural to wonder if a similar mechanism might be driving the financial crises and business cycles that typify the economic “weather” we’ve experienced over the centuries. Unfortunately, today’s equilibrium theories refuse to entertain the possibility.

… One year before Phillips’ experiment, economists Kenneth Arrow and Gerard Debreu offered mathematical proofs that an abstract market model really does have an equilibrium with certain “optimal” properties. Yet when studies in the 1970s found that this equilibrium is generally unstable -- and so should tend to fall apart just like Hadley’s looping flow -- theorists for the most part simply ignored this inconvenient fact and went on as before. Most still do.

American economist Milton Friedman set the tone. “The study of the stability of general equilibrium is unimportant” because “it is obvious that the economy is stable,” he was quoted as saying. … I’m not sure [Friedman] really believed what he said. But most economists today act as if they do.

This is too bad, because a focus on the origins of instability just might help financial economics achieve a conceptual liberation akin to that which atmospheric scientists achieved in the 1950s. Economists might come to accept that equilibrium doesn’t describe everything, or even very much, and that natural elements of instability and turbulence drive the outcomes that matter most.”

I long since ceased believing in “equilibrium” economics. Even Adam Smith is alleged to have believed in equilibrium economics, though the evidence is muted, and if he did believe it in the abstract, he did not describe it in practice. He was a long way from Pareto’s Welfare theorems and Debreu’s General equilibrium (Mark Blaug) and he described a British economy that was also a long what later economists called ‘perfectly competitive’. For Smith, a freer economy compared to the existing mercantile economy, was an aspiration, not a description of reality. He described “market” prices (“the central price”) “continually gravitating” towards “natural” prices, and “continually tending towards it”, either from above or below them (WN I.viii.15: 75).

But this is a long way from the real economy generating equilibrium in all markets for all commodities. Modern economics aspires to scientific rigour, but fails because it treats economic variables as well behaved, when in practice they are anything but well behaved or mathematically predictable. Our universities turn out economists who are brilliantly conversant with a model economy that does not exist, and, sadly, are often woefully ignorant of the real world (bang goes some more Christmas lists that I am dropped from).

I am mindful of reading a book in the 1960s by Norman Macrae of The Economist, called "Sunshades in October" (I think) which captured the errors of government economists at the time. Follow the link for Mark Buchanan's full argument.



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