Can Science Help Solve the Economic Crisis? (Edge Essay)

CAN SCIENCE HELP SOLVE THE ECONOMIC CRISIS?

By Mike Brown, Stuart Kauffman, Zoe-Vonna Palmrose and Lee Smolin

The economic crisis has to be stabilized immediately. This has to be carried out pragmatically, without undue ideology, and without reliance on the failed ideas and assumptions which led to the crisis. Complexity science can help here. For example, it is wrong to speak of "restoring the markets to equilibrium", because the markets have never been in equilibrium. We are already way ahead if we speak of "restoring the markets to a stable, self-organized critical state."

In the near-term, Eric Weinstein has spoken about an "economic Manhattan project". This means getting a group of good scientists together, some who know a lot about economics and finance, and others, who have proved themselves in other areas of science but bring fresh minds and perspectives to the challenge, to focus on developing a scientific conceptualization of economic theory and modeling that is reliable enough to be called a science.

As the person who originated the proposal of an "economic Manhattan project" mentioned in the Brown, Kauffman, Palmrose, & Smolin essay, I should probably explain why I am not a co-author. What is happening in this discussion is that the proposal is, as I feared, being treated as a kind of economic Rorschach test in which people imagine for themselves what an "economic Manhattan project" might mean. Does it mean a soviet style planned economy? A priestly cabal of researchers taking sabbaticals, far away from their core competencies, to play 'mad scientist' with the economy? A secret group searching for a simple unified field equation that can be proven to predict security price movement?

Happily the answer is "no" several times over, so let me clarify and remove some of the confusion.

The idea for a Manhattan project was born in the wake of a number of email exchanges and conversations with some of the people I most respect in the financial world, in which I tried to find out if the people who showed by their research, public speaking and trading that they anticipated crisis, were now being called in to help. Prominent among the people I thought should be called in to help were in fact, Emanuel Derman and Nassim Taleb.

Typical of these investigations was a call to a mathematical colleague and co-author Adil Abdulali who had prominently lectured and published on the danger and fraud inherent in the valuation of mortgage backed securities. He told me that he too had not been contacted by anyone and claimed that that corporate types within the banks were finding an eager media audience for the theory that 'rocket scientists' and PhDs had caused the financial world to collapse because their models had supposedly treated human beings like protons (or some other such nonsense).

In short, a system of selective pressures was, to my way of thinking, being installed to short circuit the natural reordering of the universe of 'experts' by this disaster.

At least to my knowledge, not one of the constructive scientifically minded people who had earned our attention and trust by speaking up before the upheaval, were being called in on these secret meetings where the fate of the world was being decided. It was in this light that I began mentioning to people the idea of an economic Manhattan project, away from the corridors of power, staffed by credible people who as scientists were comfortable with their own ignorance and unintimidatated by those with titles or authoritative baritones.

To be clear, the world's markets are going to be analyzed, modeled, and regulated by panels of "experts". That is not at issue. What is at issue is whether the scientific community has the moral luxury, as some commenters here heartily recommend, to sit this one out and complain from the sidelines when most of the skills needed to debunk seemingly sophisticated failed market theory are scientific in origin. But to believe in one's own ability to improve a theory and make contributions across disciplines require taking serious risk and I well understand that some may find such risk frightening. I would be happy enough for those who feel sure they have nothing to contribute to avoid such an undertaking.

But there are plenty of constructive and imaginative risk takers who know just how flawed this system really was. The original Manhattan project was never a sure thing. It was born of a recognition that we needed to risk succeeding at the price of possible failure. Yet, had it failed it is not clear that we would have been much worse off than had we never dared to try. By any definition of 'scientific community', those who study systems and demonstrate some measure of predictive or explanatory power have to be considered scientists. To our way of thinking, the biologist traveling to the Amazon to meet with a tribal medicine man may be seen as one scientist visiting the pharmacological laboratory of another. Therefore Taleb's argument that markets should be left to practioners is based on a misunderstanding, as the practioners with predictive power are arguably the most important scientists of this system.

We have had a massive failure of a dominant model. We are trying to find the right people to deal with this failure. And, at least some of those people are likely to be unfamiliar voices. It is as simple as that.

Here is the basic idea to first approximation which will be spelled out in detail elsewhere. First there needs to be a great debunking of bad models as well as an elevation of those models which are either already mature or readily salvageable. This could turn out to be a bit more subtle than some scientists appreciate, for while many of the holes in economic and financial theory are wallpapered over with obvious error, not all of the defects are irreparable.

Some salvageable models have been kept on life support by adding epicycle after epicycle to deal with their obvious incompatibilities with markets and observed human behavior (e.g. the inexplicable neoclassical insistence on fixed preferences) while common risk measures like Value-at-Risk are probably flawed beyond hope. And yet, insights from fields as diverse as gauge theory, and evolutionary psychology may have a positive role to play in healing what ails the cartoonish homo economicus model to create a more realistic scientific theory of market agency. But the best way to do this is too subject the models to a marketplace of ideas somewhat more vigorous than modern day economics.

Next we need to get financial economists to become more comfortable with their new found ignorance in the wake of this failure. This likely entails a profound move away from 'risk management' towards the "management of uncertainty". Uncertainty is effectively a second order effect, which deals with the risk that the risk assessment is wrong. It should now be clear to all that it is high time to bring this long neglected 1920's theory of economist Frank Knight back from the periphery and treat it with the respect it has just earned and the modern mathematics it requires. Additionally there needs to be a reckoning with the ignorance and incentive incompatibility, exposed by the debunking.

To put it simply, there is something of a conservation equation: the smaller our knowledge of markets, the greater our financial reserves need to be to withstand the uncertainty in the system. What we have learned is that our communal financial ignorance is far greater than many of our financial elders would have lead us to believe.

If we had embraced uncertainty management rather than risk management and done even a rudimentary job of estimating the uncertainty in the system, the mathematics would not have been nearly as courteous to the preposterous positions taken in the markets, which doomed our last financial system. This is to say nothing of the myriad principal-agent problems with incentives rampant throughout the system.

To sum up, most all of the criticisms of the financial Manhattan project mentioned have been valid critiques but appear addressed to utopian projects that are not under discussion so far as I am aware. There was however a valid criticism about ideology which should be addressed.

We in favor of an EMP are possessed of an ideology as Larry Sanger correctly points out, if a somewhat minimal one given the extraordinary circumstances. Let's spell it out. Many of us who work in finance are even more horrified by what we see than the lay public appears to be. Some of us spoke publically for years about the dangers posed. Others published papers or books to spread the word. Curiously, however, our country's laws would not even permit average families to voluntarily invest in those hedge funds that profited from this crisis by, for example, shorting subprime mortgages.

Accordingly, we don't believe that citizenship in the United States should now hurriedly be converted into forced participation in an unaccountable secretive national hedge fund which buys lousy assets at inflated prices from banks mismanaged for personal profit by multi-millionaires, and makes non-consensual capital calls on uninformed, captive, financially unsophisticated families.

Oddly, that's not hyperbole. That's a description of what has taken place. It's the reality that's objectively outrageous.

We think that just like high net worth individuals are represented by 'family offices', those average families deserve now to be represented at the table by financially and scientifically sophisticated individuals with the character necessary to question cronyism and the scientific background to debunk financial mischief dressed in Greek letters and accessorized with stochastic differential equations.

Sometimes, it takes a good physicist to keep another honest. Or an economist. Or trader.

- Eric Weinstein on Edge.org on Dec 10, 2008