How to harness physics envy in economics and finance
By: Open Risk
Tags: Economics, Risk Management, Physics

Artistic depiction of inflationary universes (Credit MoonRunner Design)

Physicists have always marveled at what seems to be our uncanny ability to explain natural phenomena using mathematical methods. E. Wigner captured this sentiment in his 1960 article “The Unreasonable Effectiveness of Mathematics in the Natural Sciences” that closes with these words:

The miracle of the appropriateness of the language of mathematics for the formulation of the laws of physics is a wonderful gift which we neither understand nor deserve

Yet not understanding a powerful tool has never been an obstacle to Homo Sapiens to try to apply it to all conceivable situations and see what happens. It was thus inevitable that we will attempt to understand social phenomena (which are after all also natural phenomena) using the language and tricks of mathematical physics. The term “Physics Envy” has thus come to denote the drive to replicate the mathematical physics approach in the social sciences.

While there have been concrete partial successes of this longstanding program, e.g in describing to a first approximation the evolution of prices in financial markets, historically it has fallen way short of expectations. Even after (or maybe because of) adopting dramatic simplifying assumptions that manifestly do not hold (e.g. perfect information, rational agents etc) mathematical economics (and in particular macro-economics) generates over-complex models that offer little intrinsic understanding of vital aspects of our economic systems.

There are several and deep reasons for this failure (the Hayek lecture cited above highlights some important ones, such as intrinsic complexity and missing measurements of key aspects).

Yet all is not lost! One of the important cognitive strategies employed by the physics tribe since its earliest days is the development of qualitative narratives, metaphors, analogies, thought experiments and visual tools as precursors to establishing the “hard mathematics”.

While establishing governing equations and the eventual empirical confirmation of their validity is the essence of progress in physical sciences, “soft” tools are very important in communicating and internalizing the mental structures that need to be eventually captured through the power of mathematics.

Such qualitative strategies may be useful to emulate in fields such as economics where system complexity is very high. How would such a “Physics Envy Lite” approach look like? This is a difficult question which can only be answered seriously by economists embracing and inventing fruitful qualitative methods. In this post it might suffice to sketch a (tongue-in-cheek) analogy:

One of the speculative theories trying to explain why our Universe has the particular physical parameters it has posits that our Universe is simply in one of the many inflationary bubbles in existence. The analogy and image used is one of a bubbling substratum (a loose reference to the more conventional physical system of soap bubbles that is more amenable to depiction than the Universe itself) which gives rise to a large number of slightly different bubble-universes.

The “obvious” analogy in economics is the formation of financial bubbles where an initial speculative seed expands, absorbing attention and resources in a self-reinforcing manner, ultimately creating its own version of “reality”. Within a bubble economy the “physical constants” take their own peculiar values which may have no relation with prior instances.

#econophysics

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