Market Belief System

Finance needs its own Dirac or Where to for Economics after the Global Financial Crisis...

There's been a lot of discussion on what went wrong in financial markets that lead to the Global Financial Crisis (GFC) of 2007.

Some of the views around have blamed the Quants, others fraud, whilst others point to greed and naive belief in markets. Former US president George W Bush captured it with a great one liner "Wall Street got drunk".

The common thread of most reviews and opinions on the GFC is that the complexity of the instruments was the major problem.

Complexity is not unique to Wall Street or that Wall Street is much more complex than other areas of technological and professional endeavour.

We only have to think about the Space Program, Medical Science, Planning Wars etc.

Complexity in and of itself is not the problem but something we must live with because it is part and parcel of the human condition.

Whilst complexity alone may not be responsible, it is fascinating how weak theory finds its way in financial practice that would not in other fields.

It's all the more fascinating because if you walk into a trading room and talk to seasoned traders, you very quickly conclude that they are at best condescending of theory, especially the so called Efficient Market Hypothesis (EMH) - yet they use models!!

A similar trip to Risk Department is disturbing because you will find people espousing market efficiency, dynamic hedging etc.

In fact modern financial risk management infrastructure is built around EMH and its corollaries, due to its adoption into regulatory frameworks and business schools.

We must seriously evaluate any theory that leads to this kind of confused practice. If a theory had a large body of empirical evidence behind it we may tread a little more carefully, but EMH is full of caveats on why it can't be observed ... due to market imperfections.

EMH does lead to mathematical formulations but Economics is not Physics and it should not be so enamored by the success of Physics and assume that if it adopts its major tool - Mathematics - it too will be just as successful in predicting the world.
Economics needs its own style that utilises math where appropriate but should not fall into a reductionist trap, which will only harm it.

Moreover and as far as I know a case has not been made why math suits economics so well.

Even though physics is suited to math, physicists tried to understand the effectiveness of mathematics to explaining nature (see Eugene Wigner's famous article).

If a lesson must be sought in the success of physics, the early 20th century physics revolution is a good place to start.

It's a good place, because it started by two seemingly small things, namely Blackbody Radiation and Maxwell's Electrodynamics not quite fitting in with the known physics.

This is not to say that physics did not have work-arounds to explain away the anomalies, but revolutionary steps were taken that overthrew the accepted orthodoxy.

The old order of Classical Mechanics did not completely disappear but came back when Dirac astonishingly realised that much of it could be reinterpreted.

Physics had to abandon long held views of the universe and learned a new vocabulary that pretty much guaranteed that it could no longer have a "picture" of nature.

It's clear that economics needs to undergo a revolution, since a central principle (ie EMH), so embedded in policy and theory, has failed so comprehensively in the GFC.

Economics is trying other ideas from psychology, behavioural science and many other areas, but as since these have been around for a while and not really made the kind of impact that is needed, given the importance of the subject in everyday life, the chances are that the revolution will probably come out of nowhere like in physics ... and perhaps find its own Dirac too.

PS - Economics is much harder than physics, because anything useful gets political  Maybe this aspect of economics may hold back progress and perhaps the attempt at mathematising the subject was made to remove the subjective element.  They don't call it the "dismal science" for nothing.