Tuesday, 6 December 2011

Does finance need a scientific revolution or science need a revolution inspired by finance


Nature, the British version of Science, rarely makes forays into exploring issues in finance. They invited me to talk at a meeting in September 2009 and I get the sense that they would like to do more but are a bit perplexed by the subtleties of finance. The mind is willing but the body is weak.

In October 2008 Nature published a piece, Economics needs a scientific revolution, by the French econo-pysicist Jean-Philippe Bouchaud, which argued that the fault was with the academic discipline of economics: "Classical economics is built on very strong assumptions that quickly become axioms" where as "Physicists, on the other hand, have learned to be suspicious of axioms. If empirical observation is incompatible with a model, the model must be trashed or amended". More recently they have published a broader article, reflecting the diffusion of the financial crisis into society at large, Science's attitudes mustreflect a world in crisis, by the science writer Colin Macilwain.

Physicists are never slow to criticise the short-comings of other disciplines, but the truth is physics, with its never changing laws, is simple. While physicists are paddling in the play pool, economists are hanging on to a rubber ring in the middle of a North Atlantic gale. It is not surprising they don't look like good swimmers. That said, economists are well aware of the limitations of their discipline. From the mathematician Cournot's criticism of the economists' use of mathematics in the 1830s to the contemporary economist's criticism of the wholesale adoption of the ergodic hypothesis by Paul Davidson, economics could do better.

Since the Second World War, economics has transformed itself from a relatively minor discipline to a dominant field. It is ironic that in the 2008 "Research Assessment Exercise", UK economists judged their work to be "excellent", just as the tsunami of the credit crisis was crashing on the shore. This dominance was built, substantially, on "positive" economics, adopting the ideals of the logical positivists that emerged in central European maths and physics in the aftermaths of the First World War. The authority that these scientist had rested on the fact that they had defeated Germany and Japan.

It was not square-jawed commandos that defeated the Axis, but mathematicians and physicists (like  Turing, von Neumann, Kolmogorov, Weiner, Shannon, ... the list is not short) working in Operations Research, the Manhattan Project and code-breaking, that won the war. In particular the code breakers were able to transform streams of random letters into meaningful messages. This analogue seems to have driven economic research through the fifties and sixties: given the right algorithm the randomness of asset prices can be read. Then, just as the idealised economic order of Bretton Woods collapsed under the reality of people and politics, Black-Scholes-Merton and financial mathematics (apparently) emerged to save the world from random chaos.

The financial crisis of 2007-2009 was a demonstration of limitations of the science that emerged out of logical-positivism and in particular the ergodic hypothesis placed at the core of positive economics. It was not a failure of maths and science in general, but a particular type of science that emerged in the 1920s and dominated society between 1940 and the present.

Macilwain is concerned with he fact that many science policy gurus, generally wedded to the tenets of  positivism,  are "clearly more comfortable discussing the planet's ecological crises than the economic ones currently alarming the general population" and that there is "great danger is that scarce funding will consolidate around single-discipline research". More Big Physics like the LHC, or repeating Tony Blair's "betting the house"on genetics - a bet that has not paid out.

Financial markets are manifestations of random, non-ergodic phenomena, as such they can hardly be amenable to deterministic techniques. Specifically, a single approach to understanding them, whether rooted in analogues from the Olympian disciplines of mathematics, physics or biology, will fail. Scientific revolutions have historically been based on the inter-disciplinary interaction, such as between financiers, lawyers (Bacon, Descartes, Fermat, Huygens) and mathematicians. If society stops to think about the current financial turmoil and what it can tell us, we would surely be at the dawn of another scientific revolution.

3 comments:

  1. Tim,

    It is exciting to think about being at the dawn of another scientific revolution! That is a very positive outlook.

    However, I wonder if the current turmoil merely tells us that people are people, and will in turn get too greedy and then too fearful, again and again.

    Tulips anyone? South Sea shares, perhaps?

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  2. David,

    See the next blog post for a response. I think you might like the quote from "The Complete English Tradesman".

    Tim

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  3. I agree that both science and economics, and even mathematics viewed as a contemporary social practice, need reform. But let us not forget that Keynes, as a mathematician (and later an economist) foresaw much of our current problems. He also informed much of the WWII work that you cite, and which subsequently got 'dumbed down'.

    As a mathematician, I think that mathematics supplies the tools that can support any legitimate approach. Yes, reject 'dumbed-down' mathematics, but it seems to me that the mathematics of Whitehead, Keynes, Turing and Good provide the means to enable at least a vital piece of the reforms that we neeed. Counter-revolution rules, KO!

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