Week 1: Why Do We Care?

Hi guys!
I hope everyone had a lovely time at Disneyland; if you didn't go, consider yourselves at least a little bit lucky, because I guarantee you got more sleep than I did.

So I'd like to start out by explaining why my project is even relevant in the first place.  Why study Econophysics?  How is it different from or applicable to "normal" economic theory?

When I first started this project way back in October, I found basically an overwhelming number of resources on the Internet that related to this field of study.  One of the things I found was a news editorial by Vincent Fernando about Econophysics, which can be found at
http://www.businessinsider.com/failed-economists-concoct-new-econophysics-2010-8
(I spent about a half hour trying different variations of Google searches before I thought to look in my browser history.  D'oh.)

For those too lazy to read the whole thing, the most important sentence is probably,
"[Econophysics is flawed] because economics is a social phenomenon, like politics, or social development.  It's not physics, and it's not chemistry."

The idea being that we cannot predict the behavior of humans (and thus the markets) using laws derived to predict the behavior of particles and other physical phenomenon like earthquakes.  This is by virtue of the fact that, unlike electrons, humans make decisions that are emotion-based, occasionally illogical, and that depend on limited information.

(Let's forget for just a moment that most modern macroeconomic theory is based on rational choice, which states that people make decisions that are the most prudent, logical, and likely to provide them with the greatest benefit in their own self-interest.  How much more particle-like and/or oversimplified can we get here?)

(If you can't tell, I'm not the biggest fan of rational choice theory, mostly because the only place I've ever seen people act 100% in their own self-interest is in the BASIS parking lot.)

Mr. Fernando's claim, however, completely misunderstands the nature and purpose of Econophysics.

Let's look at a definition by Dr. Roy Frieden, my onsite-advisor, who has analyzed this topic with regard to optical statistics:

"[The basic premise of econophysics] is that the same mathematical and phenomenological insights that are used to provide unification for complex physical systems can now apply to problems of economics and finance."  (Frieden and Gatenby, 2007, p. 43).

Dr. Frieden is not claiming that people are atoms, or that we should expect them to behave rationally and logically all the time.  He is claiming that the overall behavior of markets and economic systems can be compared with behaviors in the natural sciences.  He is claiming that the same tools (e.g. statistical models, physical models and theories, etc.) can be applied to understand markets better.

It is important to make the distinction, as Mark Buchannon does quite well, that "The most important lesson of modern physics is that it is often not the properties of the parts that matter most, but their organization, their pattern and their form."  (Buchannon, 2007, p. 10).  He goes on to say that "no study of soil or stones could perfectly explain [the circular patterns that form due to weather and earth movements] just as no study of air molecules on their own could help anyone understand a hurricane." (p. 12)

In much the same way, while humans as individuals are very complex and ruled by emotion and unpredictability, that doesn't mean that their actions as a whole can't be predicted or at least understood.  Current Macroeconomic theory aims to do exactly that, after all--  there is no reason that physics, a field dedicated to unifying and modeling smaller parts of a whole, cannot at least attempt it.

Perhaps the one thing that Mr. Fernando got completely correct in his article was that current macroeconomic theory, bluntly put, isn't working very well.  As the economic consultancy London Economics, led by John Kay, points out, "It is a conventional joke that there are as many different opinions about the future of the economy as there are economists.  The truth is quite the opposite.  Economic forecasters... all say more or less the same thing at the same time... The differences between forecasts are trivial compared to the differences between forecasts and what actually happens... what they say is almost always wrong... the consensus forecast failed to predict any of the most important developments in the economy over the past seven years."

What I hope to evaluate with this project is not only the usefulness of these comparisons to physics but also the extent to which they can be applied.  So far, it seems to me that a further study into econophysics can, at worst, only broaden our knowledge of current economic workings, and at best, can be used to permanently change our view of the markets, especially given the current misunderstandings going on in economics.

(Note: Mr. Fernando is also incorrect in his assumption that the field of econophysics is somehow "new."  While the term was coined fairly recently-- in 1995, still roughly fifteen years before his editorial was published-- the field has been around for much longer than that, and has influenced modern economic theory in several important ways.  I will hopefully cover those in the near future.)

Sorry this is a bit long...
Have a great week everyone!  Please feel free to comment!