Economics evolves into evolutionary economics

The July 2009 edition of Scientific American explores new ways of looking at economics in an article by Gary Stix entitled “The Science of Bubbles and Busts.”

The article explores the growing acceptance by professionals that people quite often are not rational when it comes to dealing with their finances.  We are not homo economicus, as touted by many economists, including Milton Friedman.

Our imperfections are many.  For instance, we are supremely overconfident. We overrate our ability to make decisions in the market. We are also prone to “herding,” following the crowd. We are also overwhelmed by our recall of recent events due to the availability bias. We are creatures who are strictly geared to the short-term.

As a result of this mounting evidence establishing that we are not able to rationally deal with the market, new approaches are inexorably working there way into economics.  These new approaches include evolutionary economics:

“Economists suffer from a deep psychological disorder that I call ‘physics envy,’ ” [MIT professor of finance Andrew] Lo says. “We wish that 99 percent of economic behavior could be captured by three simple laws of nature. In fact, economists have 99 laws that capture 3 percent of behavior. Economics is a uniquely human endeavor and, as such, should be understood in the broader context of competition, mutation and natural selection—in other words, evolution.

Having an evolutionary model to consult may let investors adapt as the risk profiles of different investment strategies shift. But the most important benefit of Lo’s simulations may be an ability to detect when the economy is not in a stable equilibrium, a finding that would warn regulators and investors that a bubble is inflating or else about to explode.

An adaptive-market model can incorporate information about how prices in the market are changing—analogous to how people are adapting to a particular ecological niche. It can go on to deduce whether prices on one day are influencing prices on the next, an indication that investors are engaged in “herding,” as described by behavioral economists, a sign that a bubble may be imminent. As a result of this type of modeling, regulations could also “adapt” as markets shift and thus counter the type of “systemic” risks for which conventional risk models leave the markets unprotected.

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Erich Vieth

Erich Vieth is an attorney focusing on civil rights (including First Amendment), consumer law litigation and appellate practice. At this website often writes about censorship, corporate news media corruption and cognitive science. He is also a working musician, artist and a writer, having founded Dangerous Intersection in 2006. Erich lives in St. Louis, Missouri with his two daughters.

This Post Has 3 Comments

  1. Avatar of Ben
    Ben June 29, 2009 Reply

    Well, I have been watching the market for a while. I was about to hop in last year, but luckily for me the market crashed before I bought anything. As of now my entire portfolio is up about 22 percent, my only big loser is GM. My amazon, sprint, chipotle, solar, and netflix stocks have doubled in value. I just wish I had bought PALM and SIRIUS at their lows, both up over 500 percent recently.

  2. Avatar of Erich Vieth
    Erich Vieth September 3, 2009 Reply

    Paul Krugman writes that economists have been mistaking mathematical beauty for truth:

    And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,” and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.” In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse” of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten.

    What happened to the economics profession? And where does it go from here?

    As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.

    —

    What's the solution, according to Krugman?

    So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

    Many economists will find these changes deeply disturbing.

    http://www.nytimes.com/2009/09/06/magazine/06Econ…

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