Risk Latte - Economics and the Theory of Finance – It Ain’t Physics!

Economics and the Theory of Finance – It Ain’t Physics!

Rahul Bhattacharya
December 23, 2008

Recently, some economists, a few very well known amongst them, got very upset when they read our recent post on our site: Quantity Theory of Money – the Fisher-Friedman Illusion! .They wrote to us with lengthy explanation of Irving Fisher’s thesis on the equation of exchange and defending the name and the turf of the celebrated economist.

To all those people we have only one answer: It ain’t physics!

Of all the crises confronting us today, none is greater or more devastating than the crisis that is shaking the foundations of the Economic Theory and the Theory of Finance. As the titans of the banking and investment banking lie humbled and as thirty years of a secular bull market comes to an end, the winter of 2008 is finally drawing the curtains on one hundred and fifty years of economic thinking, which was predicated on the notions of equilibrium and linear dynamics.

The world, as economists are realizing, does not come wrapped in differential calculus.

Hundred fifty years of obsession with equilibrium and linear dynamics (CAPM, linear optimization, asset allocation models, Black-Scholes option pricing models) has resulted in a lot of Nobels, but pretty much nothing else

“Causality” and “correlation” are different concepts and whereas you can have “reverse causality” in financial markets and economies the notion of “reverse correlation” is not possible. How many economists understand this? Theory of probability is totally counter-intuitive and whereas one can apply probability theory and stochastic processes to quantum mechanical world in physics, it makes no sense to build models of a larger, real world of men and things based on these. If economists and financial theorists know that Economics is not physics, especially quantum mechanics, then why do they keep on applying probability theory and stochastic processes to economic systems?

In fact, economics should be studied more like electrical engineering or systems engineering. I believe Economics is an extremely complex subject, one that should borrow heavily from history, sociology, molecular biology and systems / electrical engineering.

As long as economists, and their closest cousins, the financial theorists, compete with the physicists in their usage of differential calculus, as long as economists delude themselves into thinking that they are scientists we will keep moving from crisis to crisis.

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