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Dynamics of Markets - The New Financial Economics

Joseph L. McCauley

posted on 17 August 2010

reviewed by Enrico Scalas

Back in 2004, I wrote a review on the first edition of this book (see it on Amazon). Now, a second edition has been published by Cambrige University Press and it contains enough new material for another short review.

The author himself writes that: "The present book includes our discoveries since 2004. In particular, we've understood the limitations of scaling and one-point densities [...]. Our focus in this edition is therefore on the pair correlations and transition densities for stochastic processes, representing the minimum level of knowledge required to identify (rule out) a class of stochastic processes."

This claim is substantiated in chapter 3, where a light introduction to stochastic processes is presented suitable for physicists who normally are not exposed to conditional expectation and martingales.

As in the first edition, McCauley rejects marginalism in Economics and, since Chapter 2, he replaces "equilibrium" prices with an equation of the form dp/dt = D(p,t) - S(p,t) where p(t)  is the price of an asset, D(p,t) and S(p,t) are, respectively, demand and supply as a function of price and time. This assumption is later used in Chapter 4 to debunk Adam Smith's invisible hand and in Chapter 10 to criticaly discuss rational expectations. Incidentally, McCauley's simple assumption provides an answer to Smolin's puzzle on how to include time within Walrasian marginalism. The Perimeter Institute physicist succeeded in writing a piece on marginalism and in systematically ignoring most of the developments of econophysics, not to mention early criticisms of marginalism put forward by Sraffa in the 1920s [1]! (see also a discussion on Smolin's paper).

Well, to be honest, Sraffa is not included in the references of McCauley as well as Hyman Minsky [2]. But it is interesting to see how McCauley reaches similar conclusions as Sraffa and Minsky by using different tools and methods in Chapters 4, 9 and 10.  Take, for instance, the instability of the economy. This is discussed in  Mccauley's Chapter 9, using the history of FX market with focus on the USA.

McCauley's call for an empirically-based macroeconomics was at least partially fulfilled by some non-orthodox schools of thought in economics. Among empirically-oriented macroeconomists I like to quote Paolo Sylos Labini [3] whose work is well known in Italy.

I enjoyed this new edition very much. It is food for the mind! Moreover, as indicated above, it is written in a way that should be readily understandable to most applied scientists. And, oh yes, please, do follow the author's advice. If you just wish to learn how to make ad hoc models to be sold to well-heeled buyers, just put his book away and look elsewhere.

References

[1] Two relevant works by Piero Sraffa are:

P. Sraffa (1926), The Laws of Returns under Competitive Conditions, Economic Journal, 36, pp. 535-50.

P. Sraffa (1960), Production of Commodities by Means of Commodities: Prelude to a Critique of Economic Theory. Cambridge University Press.

[2] H. Minsky (1986), Stabilizing an Unstable Economy, Yale University Press.

[3] Papers and books by Sylos Labini can be found from the site of Fondo Sylos Labini.