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Achilles' heels of current economic theories - The debate

Dirk Helbing, ETHZ, Switzerland

posted on 16 May 2011

E-mail of Dirk Helbing on April 10, 2011:

Dear friends and colleagues,

as a first preparation for think tanks on economic challenges, I would like to ask you to send me a list of the greatest deficiencies and challenges of currently applied economic theories (beyond what has been discussed in the attached concept paper Fundamental and Real-World Challenges in Economics).

Thank you very much in advance for your feedback and best wishes,
Dirk

 

E-mail of Dirk Helbing of April 17, 2011:

Dear colleagues,

I would like to thank you very much for the lively discussion in response to my e-mail. Below, I am trying to summarize the main points, because we will eventually use them to derive a research program of grand scientific challenges in economics - a Hilbert program for economics and the social sciences as I call it.

Thomas Lux (Economist, Institute of World Economics):
- the financial crisis reveals the systemic failure of the economic profession (see attached paper)
- after the financial crisis of 2008 and following, it is hard to deny that the financial sector has some relevance for the economy and is maybe not  completely efficient at all times
- the most prominent class of models used by central banks (so-called DSGE Models - Dynamic Stochastic General Equilibrium Models) do not contain a financial sphere at all (which motivated even the Queen of England to inquire, whether it was not a bit particular that central banks completely abstracted from money and finance, when she visited the London School of Economics two years or so ago)
- recent extensions of these models try to introduce financial factors without giving up the prime modeling principles of representative agents and rational expectations (i.e. the agents are still assumed to know how the world works)
- the paradigm of the homo economicus, assuming perfectly optimizing egoists with rational expectations, is an idealization, which does not match empirical observations sufficiently well
- the representative agent model, according to which interactions with other individuals, firm, or banks can be treated as if it took place with an average agent (also known as mean field approximation) neglects the heterogeneity of agents

Matteo Marsili (Econophysicist, International Center for Theoretical Physics):
- the idea of resorting to financial innovation to solve all our problems (as suggested by Robert Schiller and others) has been proven wrong; complexity has clear closts in terms of financial stability
- there is a need of developing a financial mathematics which takes into account impacts of own financial transactions
- financial stability is a public good (as suggested by myself)

Ole Peters (Econophysicist, Imperial College):
- the use of probabilities goes conceptually wrong in the context of leverage, as the ensemble average can not be applied
- the use of mathematics in economics is dangerously naive - it is often used as an element of rhetoric rather than as an instrument of investigation
- in economics, we need more complex models, but even simple models or processes are often not yet properly investigated
- scientific progress is hampered, as only a clique of people is allowed to publish in the established economic journals
- economics is lacking clear standards in terms of terminology

Cars Hommes (Economist, University of Amsterdam):
- the major challenge for economics is formulating an alternative theory of boundedly rational heterogeneous expectations
- an alternative theory of expectations, confidence, trust etc. needs to be developed and tested empirically and experimentally
- but any boundedly rational alternative suffers from the problem of infinitely many possibilities to specify them
- a key difference to statistical physics is that, in economics, atoms can think

Imre Kondor (Econophysicist, Eötvös Loránd University Budapest, previous rector of Collegium Budapest - Institute of Advance Study, previous manager in a bank):
- current economic theories are inadequate, the only possible alternative of today is agent-based modeling
- but the high dimensionality of agent-based models makes them hard to calibrate and validate
- the universality class approach from physics may fail due to the strong heterogeneity in economic systems
- there is an extreme sensitivity to control parameters, a single factor can matter ("butterfly effect")
- we need to pay careful attention to the calibration-overfitting-validation problem

Jean-Philippe Bouchaud (Econophysicists, Ecole Superieure de Physique et de Chimie Industrielles de la Ville de Paris, Cofounder of Capital Fund Management):
- the DSGE models do indeed not include the financial sector, nor the possibility of crises; the economic models need to be fundamentally revised (see also the related quote from European Central Bank President Jean-Claude Trichet below)
- the most pressing subject is to come up with a realistic agent-based model where crisis and complexity arise from simple rules and interactions in a universal way, robust against specific assumptions (I complete agree and have recently submitted a corresponding research proposal)
- from there we need to build policy making devices (a "policy wind tunnel", as Nigel Gilbert would call it, or an "economic flight simulator")
- in the limit of large system sizes, universality classes must appear, and we need to identify and classify them for economics systems
- the equilibrium concept of economics is not applicable to financial markets
- spin glasses might serve as a model for systems with very many equilibrium states that show a slow relaxation, a possibility of crises, and chaos, i.e. features that many complexity scientists claim to be relevant for financial and economic systems

Alan Kirman (Economist, GREQUAM, Universite Paul Cezanne, EHESS):
- the economic crisis is a crisis for economic theory (see attached paper)
- the major failure is to try to reduce the behavior of the system to that of an individual in isolation and to treat all interactions between the individuals and institutions in the system as inconvenient "imperfections", while they are at the heart of any sensible description of the behavior of the system
- not much of an effort will be made to rethink the way we look at macroeconomics, and the social costs of that will be very high

 

Once again, I would like to thank you very much for sharing your interesting analyses with me. I am attaching three further papers, Pluralistic Modeling of Complex Systems and Systemic risks in society and economics and How to Create an Innovation Accelerator, that I think, I have not circulated before.

Best wishes,
Dirk

 

The following contributions are in connection with the above debate:

[1] David Colander, Michael Goldberg, Armin Haas, Katarina Juselius, Alan Kirman, Thomas Lux and Brigitte Sloth, The Financial Crisis and the Systemic Failure of the Economics Profession, Critical Review, Volume 21, Issue 2-3, 2009, Pages 249-267.

[2] Alan Kirman, The Economic Crisis is a Crisis for Economic Theory, CESifo Economic Studies (2010) 56 (4): 498-535.

[3] J. Doyne Farmer and Duncan Foley, The economy needs agent-based modelling, Nature 460, 685-686 (2009).

[4] Jean-Philippe Bouchaud, Economics needs a scientific revolution, Nature 455, 1181 (2008).

[5] Robert M. May, Simon A. Levin and George Sugihara, Complex systems: Ecology for bankers, Nature 451, 893-895 (2008).

[6] J. Doyne Farmer and John Geanakoplos, The virtues and vices of equilibrium and the future of financial economics, Complexity (2009), 14:11-38.

[7] Andrew G. Haldane and Robert M. May, Systemic risk in banking ecosystems, Nature 469, 351-355 (2011).

[8] Paul Krugman, How Did Economists Get It So Wrong?, The Times Magazine (September 2, 2009).

[9] Thomas Lux and Frank Westerhoff, Economics crisis, Nature Physics 5, 2-3 (2009).

[10] Jean-Philippe Bouchaud, The (unfortunate) complexity of the economy, Physics World, April 2009.

[11] Neil Johnson and Thomas Lux,
Financial systems: Ecology and economics, Nature 469,
302-303 (2011).

[12] Cars Hommes, The heterogeneous expectations hypothesis: Some evidence from the lab, Journal of Economic Dynamics and Control
Volume 35, Issue 1, January 2011, Pages 1-24.

[13] Mauro Gallegati and Matteo G. Richiardi, Agent Based Models in Economics and Complexity, Complex Systems in Finance and Econometrics 2011.

[14] Speech of Jean-Claude Trichet, President of the European Central Bank, on November 18, 2010

"When the crisis came, the serious limitation of existing economic and financial models immediately became apparent. Arbitrage broke down ... markets froze ... market participants were gripped by panic. Macro models failed to predict the crisis and ... [to explain] what was happening ..."

"[In] the face of crisis, we felt abandoned by conventional tools. ... The key lesson ... is the danger of relying on a single tool, methodology or paradigm. The atomistic, optimising agents underlying exiting models do not capture behavior during a crisis period.
Agent-based modelling ... allows for more complex interactions between agents. ... we need to better integrate the crucial role played by the financial system into our macroscopic models."

"I would very much welcome inspiration from other disciplines: physics, engineering, psychology, biology. Bringing experts from these fields together with economists and central bankers is potentially very ... valuable."

"A large number of aspects of the observed behaviour of financial markets is hard to reconcile with the efficient market hypothesis... But a determinedly empirical approach -- which places a premium on inductive reasoning based on the data, rather than deductive reasoning grounded in abstract premises or assumptions -- lies at the heart of these methods ... simulations will play a helpful role."

Jean-Philippe Bouchaud comments on this speech as follows:

"Those not steeped in economic theory may not realize how revolutionary Mr. Trichet’s challenge is. Economics has traditionally been closely focused on developing a core set of ideas that are very different from those that Mr. Trichet champions above. It is truly remarkable for the president of the ECB to suggest such a radical departure from the traditional canon of economics, and it is a reflection of the seriousness of the crisis and the magnitude of the loss of confidence in existing tools. And it is not just Mr. Trichet who is asking these questions -- senior policymakers in finance and economic ministries, central banks, and regulatory agencies across the EU, as well as in the US and other countries are asking similar questions. For more than a decade, the principal investigators of this proposal have been advocating and leading the development of new approaches along the lines these policymakers are seeking."

For example, in September 2010, Ben Bernanke said in Princeton:

"The crisis should motivate economists to think further about their
modeling of human behavior. Most economic researchers continue to
work within the classical paradigm that assumes rational, self-interested
behavior and the maximization of expected utility,[...]

Another issue brought to the fore by the crisis is the need to better understand the determinants of liquidity in financial markets. The notion that financial assets can always be sold at prices close to their
fundamental values is built into most economic analysis..."

Discussion

why all economic theories are reduced to financial ones, where is real economy, where are production, distribution and consumption of real goods, economy is not finance isn't it ?

I agree with Pertev Dural that it is important and interesting to look beyond financial economics. But there are also some examples of this sort of work, like Viaggiu et al. "Statistical ensembles for money and debt" (http://arxiv.org/abs/1109.0891) and Ikeda et al. "Coupled Oscillator Model of the Business Cycle with Fluctuating Goods Markets" (http://arxiv.org/abs/1110.6679). Given the dominance of financial economics in econophysics it would be nice to have a venue (e-journal? special issue? discussion area on the econophysics forum?) devoted to non-financial econophysics.

- the paradigm of the homo economicus, assuming perfectly optimizing egoists with rational expectations, is an idealization, which does not match empirical observations AT ALL.

I have spoken about the Dollar crisis in 4/2007 before it occurred, wrote a paper about it in 1/2008, and have described the crisis in ch. 9 of my 2009 Dynamics of Markets. I find it remarkable that that entire work ha been ignored by the econophysics and economics community.

Pertev, I think you will find what you are looking for here:

 

http://www3.unifr.ch/econophysics/?q=content/simplified-exposition-axiomatic-economics

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