Negative pigs

They say no-one except Vince Cable saw the global financial crisis coming. They couldn’t be more wrong.

Latest World Finance column on Frederick Soddy’s contribution to economics.

Higgs boson

Latest rumor on Higgs boson front is that CERN is arranging a press conference on July 4 to (possibly) announce the official discovery of the Higgs boson.

I was originally a skeptic on the Higgs, though I’ll admit I did warm to the Standard Model while writing my book Truth or Beauty. In my mind it has come to resemble an iconic piece of architecture from the 1960s, which I hope will be lovingly refurbished rather than dynamited by planners.

Anyway, the discovery is very exciting if it turns out to be true – though as I mentioned back in 2008, it would be even more exciting if the particle turns out to be at least slightly different from expected …

Climate Change and its Impact on Preservation Management of Archaeological Sites, Athens

Talk at roundtable on climate change and cultural heritage in Athens, April 2012.  Watch video

Breakthrough economics

This is an article based on my talk at the Breakthrough Capitalism Forum in London, May 29, 2012. Versions available in Polish and Spanish.

Economics can be viewed as a mathematical model of the world. Such models are interesting because they encode a kind of story about reality. The models – and especially the assumptions on which they are based – therefore reveal much about the way we see the world and we see ourselves.

An early example was the Greek model of the cosmos. This model incorporated two main assumptions. The first was that the celestial bodies moved in circles, which were considered the most perfect and symmetrical of forms. The other assumption was that the circles were centered on the Earth. In Aristotle’s scheme, the planets and stars were thought to be encased in crystalline spheres which rotated around us at different speeds.

Of course, as we now know, both of these assumptions were wrong. But that didn’t seem to matter, for the model persisted for well over a thousand years – it was adopted by the Church, and was not finally overturned until the Renaissance. How did it manage to last for such a long time?

The main reason for the success of the Greek model of the cosmos was that it could make accurate predictions of important events such as eclipses. In a time when human affairs were believed to be influenced by the movements of the celestial bodies, this was an impressive demonstration of the power of mathematics, and gave a sense of order and stability to the universe (our desire to predict the future is coupled with a yearning for a comprehensible world).

Another reason, though, is related to aesthetics and the fact that, as Aristotle put it, man is a political animal. There was a strong parallel between the perceived order of the cosmos and the order of society. As with the model of the cosmos, Greek society was structured as a series of concentric rings, with slaves at the base, followed in ascending order by ex-slaves, foreigners, artisans, and finally the land-owning, non-working upper class. These men alone could be citizens, and oversaw everything from above, like the stars in the firmament (women did not take part in political life and took their social class from their male partner).

A model of the universe which suggested that everything has its natural place in a beautiful, geometrically-governed cosmic scheme therefore supported the status quo. For this reason it would certainly have appealed to the male leisure class that ruled ancient Athens, and later to the Catholic Church.

The first cracks in the model appeared in 1543, when Copernicus proposed that the Earth might go around the Sun, rather than vice versa. In 1577, the Danish astronomer Tycho Brahe observed a comet which passed between the planets, so if Aristotle’s crystalline spheres had actually existed, it would have broken through them. Finally, in 1687, Isaac Newton combined Kepler’s theory of planetary motion, with Galileo’s study of the motion of falling objects, to derive his three laws of motion and the law of gravity. The static circles of classical geometry were replaced with dynamical equations, which had a different but equally powerful aesthetic appeal.

Newton’s work laid out a template which scientists have continued to follow until the present day. To understand and predict a system, you break it down into its constituent parts, find the mathematical equations that govern their behaviour, and solve.

This mechanistic approach has been very successful in areas such as chemistry and physics. Newton was less confident that it would apply to other fields. After losing most of his fortune in the collapse of the South Sea bubble, he warned that ‘I can calculate the motions of heavenly bodies, but not the madness of people’. In the nineteenth century, though, economists decided to forge ahead anyway. The result, known as neoclassical economics, was directly inspired by Newton’s ‘rational mechanics’. As a mathematical model, it may have had as great an effect on society as the Greek model did in centuries past.

Efficient markets

In order to mathematicise the economy, economists of course had to make many simplifying assumptions, which imposed a kind of symmetry on the system. No one thinks these assumptions are completely true, but they have certainly been extraordinarily influential, and have shaped the way we see the economy – and therefore the economy itself.

The theory assumed that individuals and firms, who were the atoms of the economy, acted independently, rationally, and with similar power to maximize their own utility. This led to the famous caricature of rational economic man, or homo economicus. The ‘invisible hand’ (usually attributed to Adam Smith, though the idea predates him) then drives the economy to a stable equilibrium. The result of all this was supposed to be societal happiness, or what economist Francis Edgeworth called in 1881 ‘the maximum energy of pleasure, the Divine love of the universe’. As with the Aristolian scheme, everything is driven towards its correct place in the natural order.

In the same way that geocentric models of the cosmos were used for forecasting the positions of the celestial bodies, the aim of economic models was to make accurate predictions. However in this case the models did not seem to work so well. Predictions of quantities such as oil prices or gross domestic product are famously unreliable, and even today are not much better than random guessing.

The problem was apparently solved in the 1960s when the ‘efficient market hypothesis’ was floated as an explanation for the inaccuracy of forecasts. This was a physics-inspired theory which assumed that markets magically attain a stable and optimal equilibrium, and any changes are random perturbations that inherently cannot be predicted. However it should be possible to calculate risk based on statistical methods such as the normal distribution (bell curve), or variants thererof. The normal distribution is mathematically similar to a square (the word ‘normal’ is from the Latin for square) or circle in that its properties can be specified by a single number. The risk of an asset could be measured by the standard deviation of its past fluctuations, just as the size of a circle is given by the diameter.

This elegant theory, with its emphasis on stability, symmetry, and rationality, was the backbone of what Alan Greenspan described to the US Congress as ‘the whole intellectual edifice’ forged by Nobel laureate economists that ‘collapsed’ during the recent financial crisis – and indeed helped cause it by creating a feeling of false confidence. So why is it that economic storms still come as a surprise? Perhaps it is because concepts such as the self-centered homo economicus have even less relationship to the movements of money, than Earth-centered circles do to the movements of planets.

Not normal

The theory assumes that the ‘invisible hand’ drives the economy to a stable equilibrium. But the price of an asset – say gold – is often very unstable. The reason is that we buy gold because we hope it will go up in value, and if the value is going up we get excited and buy more. This positive feedback drives the price up further. The same thing happens in reverse on the way down, resulting in an unpredictable series of booms followed by busts. The same effect is seen for other assets such as oil, housing, currencies, and so on.

Now, this kind of unpredictability is superficially consistent with the efficienct market hypothesis, and is often wheeled out as support for the theory. However unpredictability does not imply efficiency – snowstorms are unpredictable, but no one calls them efficient. The theory also assumes that price variations are random, independent, and therefore normally distributed. But as we know markets are susceptible to sudden changes including catastrophic crashes. Their statistics are not ‘normal’, as predicted, but are similar to those of earthquakes in that they follow a highly asymmetric ‘power-law’ distribution – most price movements are small, just as the Earth is constantly experiencing small tremors, but there is the ever-present possibility of extreme events. Orthodox theory sees the economy as fundamentally stable, but perturbed by random pieces of news, while in fact the economy is a lively and dynamic system, dominated by nonlinear feedback loops and prone to sudden changes.

The model assumes that people act independently and make rational decisions to optimize their own utility (the proof of market equilibrium actually assumed infinite computational capacity, and the ability to plan into the future). But as behavioural economists or for that matter advertisers know, emotions such as trust and fear play a vital role in markets. So does communication between market players, as shown by the rapid financial contagion that often follows a seemingly contained local crisis.

The original idea of neoclassical theory was to optimise happiness. But while the economy has grown enormously in recent decades, reported happiness levels have remained static or even declined slightly. Perhaps one reason is that we have internalised these values of rationality, independence, and utility optimisation; while happiness apparently has more to do with connectivity, communication with other people, and a sense of community. The model, it seems, does not correctly predict what makes people happy – and could in fact be making us unhappy.

New model

To summarise: our orthodox theory, which has long dominated economics, is based on ideas of stability, symmetry, rationality, and mathematical elegance which go back to the ancient Greeks. We have modeled people as if they were rational and can look into the future. We model the economy as if it obeyed the harmony of the spheres. Like the Greeks, we have imposed our ideas of order and logic onto the universe. But there is one important difference, which is that the Greek model could make useful forecasts of events like eclipses – they could predict when the lights were going to go out. Our models don’t have that degree of empirical validity. The financial crisis which began in 2007, and came close to shutting down the global financial system, went unpredicted by every major forecasting institution including the IMF, the OECD, and the US Federal Reserve.

Motivated in part by the crisis, we are now seeing the development of a viable alternative to mainstream economics, that exploits new tools from applied mathematics (e.g. complexity theory, network theory, nonlinear dynamics), as well as from other fields (e.g. psychology, ecology, ethics), and tempers them with a healthy dose of humility (models are incomplete patches that are only useful in certain domains and contexts). As argued in my book Truth or Beauty, this development is part of a larger shift in science from seeing the world as a Newtonian machine to seeing it as a living system.

Given that its drawbacks have been known for some time – so-called heterodox economists have been criticizing it for decades – how did the neoclassical model manage to persist for so long? In this case the answer has nothing to do with prediction. That leaves aesthetics and the status quo. As with the Greek model of the cosmos, the idea that the system is the stable, rational, efficient, and optimal outcome of a mathematically-governed process is clearly one that is favored by the small elite – that layer of distant stars in the financial firmament – which derives the most benefit from the current arrangement.

Once again, we need a new model of the world – and one that is based on the messy realities of people and the environment, rather than elegant circles. Could the financial crisis be the comet that shatters the crystalline spheres?