Saturday, March 3, 2012

Quote of the Week from Emanuel Derman’s insightful book, Models.Behaving.Badly. (2011):

”Physicists, brought up on a diet of astounding theories and successful models, have the ability to distinguish a theory from a model and a good model from a bad one. Economists for the most part have never seen a genuine theory, and so discrimination is harder. The simple models they work with fail to reflect the complex reality of the world around them. That lack of success is not the fault of economists, for people have proved difficult to theorize about, and we still await an understanding of Spinoza’s adequate causes for their behavior. But it is the economists’ fault that they take their simple models so seriously. Finding the truth about nature takes cunning and intuition. The invisible worm of financial economics is its dark secret love of mathematical elegance regardless of its efficacy, and its belief that rigor can replace fact and intuition.”
A former theoretical physicist and Wall Street Quant, Derman offers a unique perspective on the difference between physics and economics through a distinction between theories and models. Stemming from the Great Recession, countless articles have been written about the state of economics today and potential directions for the future. As Derman wisely points out, the incorporation of human action significantly hinders the ability of economics to create genuine theories, those that prove true for all instances across time.

This view is not to suggest that mathematical elegance should be disregarded, but rather that its limitations in predicting human behavior be understood and acknowledged. Advances within physics, such as chaos theory and quantum electrodynamics (QED), are currently being employed by economists (ie. Steve Keen) to formulate new models of the economy. However, it remains unlikely that these advances will ever fully predict the future actions of individuals and therefore some level of uncertainty will always remain present within economical models.

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