Why Economists Hate Physicists

Published in Investing on 8 February 2010

Why are economists so bad at making forecasts?

Thomas Carlyle called economics "the dismal science" but economists do have a noble goal (and yes, I do mean noble not "Nobel" although the latter does spur them on!). 

The holy grail of economics is the creation of a model which enables the accurate prediction of all aspects of the economy. Such a model would greatly improve living standards by making the allocation of resources as efficient as possible. Who could be against that?

An investor who possessed this model would be in possession of a veritable philosopher's stone because of its power to predict the future. The trouble is that human nature is too complex to be predicted this accurately; such a model will only ever exist if humanity is reduced to the level of automata. 

But people are interested in prophecies, even if it is just predicting the weather or the winner of this year's Cheltenham Gold Cup (one of the best predictions for tomorrow's weather is that it will be just like today's weather and my money's on Denman!).

In Homer's epic The Iliad, Cassandra really could see the future, including the destruction of Troy, but Apollo had cursed her so that no-one would believe her predictions. Today many economic forecasters are Cassandra's opposite; many people believe their detailed prophecies which are cursed to be wrong! 

To quote the economists J.K. Galbraith and Ezra Solomon, "the only function of economic forecasting is to make astrology look respectable."

Physics 10, Economics 0

Unfortunately too many economists, as well as academics in the more descriptive disciplines, suffer from "physics envy." Physicists use complex mathematics to produce extremely accurate predictions of a system's future behaviour but unfortunately many people, especially economists, have incorrectly assumed that if they too use complex mathematics this will automatically improve the accuracy of their predictions. 

Today, the economists' preference for complex mathematics means that Adam Smith's seminal book, The Wealth of Nations, would today be rejected by most major journals because it contains very little mathematics.

One of the best examples of physics envy is seen in "efficient market theory" (EMT) which in its original form made the reasonable observation that the market price of traded assets is usually fairly accurate. But once the mathematical economists got their mitts on EMT they decided that "usually" was insufficient; for them market prices are always 100% correct and they had pages and pages of equations to prove that they were right. They had created "strong EMT" and we're still paying the price.

These economists assume that the economy is a highly predictable system, where the market participants (people, firms and governments) will always behave rationally so the behaviour of an economy can be precisely modelled by some complex equations which contain a lot of Greek symbols. 

But it's blindingly obvious that people, firms and governments will sometimes act in a highly irrational manner (just ask any psychiatrist or political commentator).

The Three Laws of Physics

Andrew Lo, a professor at the MIT Sloan School of Management, sums up the situation in one sentence; "In physics, it takes three laws to explain 99% of the data; in finance, it takes more than 99 laws to explain about 3%."

The problem with economic models is that the behaviour of a modern economy is far too complex to predict with any great accuracy. 

In recent years, events such as the Russian financial crisis and the credit crunch have dealt a fairly hefty blow to strong EMT but because so many people's careers and livelihoods depend upon it the theory will not die. Strong EMT is just like Arnold Schwarzenegger's Terminator towards the end of the first film; it's been hit really, really hard but it absolutely will not stop.

However, the cat is out of the proverbial bag with the emergence of the field of behavioural economics, where ideas from psychology which are combined with those of economics, which is working its way into the Universities and will thus emerge into the markets in the years to come. 

The award of the Nobel Prize in 2002 to Daniel Kahneman, one of the founders of behavioural economics, may be viewed by future economic historians as the date when the stake was driven through the heart of strong EMT (though it will probably take decades to die).

A Physics Postscript

Just in case you're wondering about the three laws that Lo mentioned, they are Newton's Laws of Motion and they really do describe most of what happens in the physical world (but it's a bit less than 99%).

The main exception encountered in everyday life is electricity (more properly "electromagnetism") which follows Maxwell's Laws of Electromagnetism. When you combine Maxwell's and Newton's Laws you get Einstein's Theory of Special Relativity ("E equals m c squared" and that it is impossible to travel faster than the speed of light). 

The other exception is Quantum Mechanics, the study of atomic particles, a subject so strange that Niels Bohr, its founding father, said that "those who are not shocked when they first come across quantum theory cannot possibly have understood it."

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Comments

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Fool1357922608 08 Feb 2010 , 11:18am

There are some similarities however: if you ask 3 physicists or 3 economists to explain the fundamental theories of their subject you still get 5 opinions.

BarrenFluffit 08 Feb 2010 , 12:20pm

As you say EMH is not a wholly accurate characterisation of how markets work. But its central characterisation of markets as places where information is priced is the foundation of other approaches.

RJJohnson2010 08 Feb 2010 , 2:19pm

I think the reverse is also true: physicists hate economists. The argument goes that far too much scientific talent is being hoovered up by hedge funds and investment banks. PhDs who would have continued scientific research in the old days are now being paid big money to blind investors with partial differential equations etc.

tux222 08 Feb 2010 , 6:50pm

On the physics front, you've missed out gravity. Newton's law of universal gravitation allows one to calculate its effects extremely well, but physicists are still quite baffled as to how it fits in with the other fundamental forces.

And there's still the problem that we can only see 4% of the universe. Another 20% must be "dark matter" which is detectable, so far, only by its gravitational effects on galaxies and larger structures. Which leaves 76% "dark energy", an even less-understood something, which appears to be going to blow up the entire cosmos in the (hopefully) far future. The "big rip", or hyperinflation on a cosmic scale....

Not so very different from economics after all?

maddogmcguinness 09 Feb 2010 , 3:20pm

And they all hate GEEKs, because those are the only people making any real money these days.

PedroKTFC 09 Feb 2010 , 4:27pm

As a physics PhD, I think the reason economists have poor theories is obvious - they don't test them against the real world. In physics, a theory only survives until it fails against the real world. Economists are driven by politics, for example for free markets or against. So they construct theories and look for evidence to prove their theories, rather than looking to disprove them. If a theory's predictions fail, then the theory needs amending, period!

PatInvest 09 Feb 2010 , 9:57pm

A rather contrived article, but I do note physicists understand that observing how a system works affects the outcome of the system - just read about Schroedinger's cat if you want to know more. Likewise, if economists all worked out how to predict future economic events, they would affect the outcome and the predictions would no longer hold true.

JRAY100 10 Feb 2010 , 10:49am

Ever heard of chaos theory?!

anobserver 10 Feb 2010 , 5:58pm

The article is written as though exact predictions are attempted with advanced theory. In fact a lot of the complex theory attempts to deal with uncertainty in markets. See for example share Portfolio Theory, Black-Scholes equation to price options and David Li`s Gaussian cupola. The latter was a major contributor to recent problems with securitised debt because of statistical problems and insufficient back-testing on real data.

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