Wednesday, December 31, 2008

A Physicist Finds the Invisible Hand Ain't There

A book is reported on the credit books Blog (HERE):

Dynamics of Markets or Perspectives on Positive Political Economy:
econophysics and finance
” by Joseph L McCauley, Cambridge University Press, 2007

Standard texts and research in economics and finance ignore the absence of evidence from the analysis of real, unmassaged market data to support the notion of Adam Smith's stabilizing Invisible Hand. In stark contrast, this text introduces a new empirically-based model of financial market dynamics that explains the volatility of prices options correctly and clarifies the instability of financial markets. The emphasis is on understanding how real markets behave, not how they hypothetically 'should' behave.”

Professor McCauley is Professor of Physics at the University of Houston.

Modern economists like laud it over its sister social sciences because they regard our discipline as being akin to hard sciences like physics and not part of the sloppier ‘word’ sciences like sociology, psychology, anthropology, and such like (though there is in fact a great deal of quantitative work using hard data in these 'inferior' disciplines).

Well, hubris is well known to be an uncertain friend, especially when physicists begin to look over the advanced mathematical texts of modern economics and find them ‘primitive’ compared to where the hard sciences have moved on to since the 19th century (where economics is still stuck).

The first sentence ("Standard texts and research in economics and finance ignore the absence of evidence from the analysis of real, unmassaged market data to support the notion of Adam Smith's stabilizing Invisible Hand") summarises brilliantly the obvious problem, which Lost Legacy warns about daily:

‘how does the metaphor of an invisible hand actually work?’, or, more pointedly, ‘where is the invisible hand in the equations of, say, general equilibrium?’

Of course, there isn’t any such role for the invisible hand in their equations, not just because it cannot be modeled, but because it was always a literary metaphor and not a variable.

Smith treated the metaphor as such (he lectured in rhetoric too), as did most of his contemporaries and readers through to the late 19th century, when political economy slid into naked economics and finally into pure mathematics in mid-20th century.

From this, its exponents and popularisers found in the lonely metaphor a lovely magical allusion to something sacred and ‘nice’ to justify their version of the efficacy of markets.

The intention was perfectly worthy; markets were under the assault of the Soviet/Chinese ‘alternatives’ of full state control; of leftwing social democratic governments in Europe nationalizing the ‘commanding heights’ of the economy, with ambitions for state planning, and the Cold War was in earnest (Khrushchev, remember, threatened to ‘bury’ capitalism).

Any edge that economists could offer that favoured markets was welcomed by those not enamoured by the prospect of socialist state planning.

But, by grasping at ‘invisible hands’, falsely crediting them to Adam Smith, still a revered name in economics, and sliding over the absurdity of the notion, contradicted many times in Wealth Of Nations (over 50 times in Books I and II) – when markets were corrupted they were done so by humans, including by ‘merchants and manufacturers’, let alone capitalist-state interventions – they left the discipline open to ‘the Emperor is bare’ refrains when the hard sciences took a look at what such notions actually implied. Like Joseph L McCauley they findd them wanting.

Human behaviour does not comply with the hard sciences of physics, chemistry, atoms, electrons, orbits of planets or galaxies, gravity and space travel.

Smith warned about such illusions anout how human behave in Moral Sentiments when he talked of people not complying like wooden chess pieces, which are moved about the chess board by the hand that moves them. People have “a principle of movement of their own”. (TMS VI.ii.2.17: p 234; 1972 ed. Kessinger Rare Reprints, p 207)

Socialists and social democrats have never understood or accepted that basic flaw in their reasoning.

The real beauty of markets is not that there is an invisible hand – they don’t need one, and Smith never said they did – but that they work without the need for central direction; they need only the coordinating signals from relative prices, and while there are flaws and defects in them (after all, they are operated by humans) they are much better than all known and tried alternatives.

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Anonymous Anonymous said...

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