The uncertainty principle

Do financial systems abide by a completely different set of rules?

 
January 11, 2013
David Orrell

Since neoclassical economics was invented in the late 19th century, economics has modelled itself after physics and engineering. Economists have sought mechanistic ‘laws’, which do for money what Newton’s laws did for motion. As Lawrence Summers put it in 1991, while chief economist at the World Bank: “Spread the truth – the laws of economics are like the laws of engineering. One set of laws works everywhere.”

But is it really possible to describe the economy in terms of mathematical laws? It seems instead that economic ‘laws’ hold only loosely and for a certain set of conditions.

Plotting the future
The archetype for an economic law is the law of supply and demand. This is usually illustrated by plotting two intersecting lines, showing how supply and demand change as a function of price for a particular product or service. If price goes up, then demand usually decreases, so a plot of demand versus price slopes down. However, a higher price typically attracts more firms into the market, so a plot of supply versus price slopes up. The two lines intersect at a single point. Neoclassical economists claimed that in a competitive market, prices will be driven to this point, which represents the unique stability of supply and demand in perfect equilibrium.

The idea of a balance between supply and demand seems intuitively reasonable, and captures a basic property of markets. The problem occurs when it is labelled law, and treated as a mathematical truth. In his 1871 Theory of Political Economy, the economist William Stanley Jevons wrote that economics is “as sure and demonstrative as that of kinematics or statics, nay, almost as self-evident as are the elements of Euclid, when the real meaning of the formulae is fully seized”. But the reality is a little more complicated.
For one thing, the idea that supply and demand can be plotted as independent curves isn’t quite right. Economists can only measure the number of transactions, taking place at a certain number of price points. But supply and demand affect one another in complicated ways, meaning prices may never reach equilibrium.

A good example is the price of gold. It is often asked whether the price of gold is in a bubble or not, but it’s not the right question, because gold is basically always in a bubble. The worth of the metal is created mostly by the fact that people think it has worth, now and in the future. It doesn’t make sense to talk about an equilibrium value for gold: instead it is sustained by a bubble of human belief, which is constantly rising and falling. If the price of gold goes up, then rather than reduce demand, its relative costliness may strengthen the perception that gold is holding its value and will continue to climb, fuelling further price rises. Conversely, a dip in prices may make nervous – or over-leveraged – investors dump their holdings. The result is boom or bust behaviour, with no stable, long-term equilibrium in sight.

Just as there is no law for the price of gold, so there is no law for the price of other important items. It is thus hard to predict price fluctuations for anything, from oil to houses. The economy is not a stable mechanical system governed by exact laws. It is better viewed as a complex system, in which prices are emergent properties that cannot be precisely calculated.

Understanding the process
The definition of emergence is itself somewhat fuzzy, but the basic idea is that a system can exhibit properties that cannot be understood by reducing a system to its components. The term was first used to describe properties of living systems by philosophers such as Samuel Alexander, who wrote in 1920: “Physical and chemical processes of a certain complexity have the quality of life. The new quality life emerges with this constellation of such processes, and therefore life is at once a physio-chemical complex and is not merely physical and chemical… The existence of emergent qualities thus described is something to be noted, as some would say, under the compulsion of brute empirical fact.”

Emergent properties are in fact characteristic of complex systems in general, including biological, social, or physical systems. Sometimes emergent properties are so exact that they appear to represent a fundamental law, even though this is not the case. An example is phase changes, such as the freezing of water to ice, which cannot be deduced from a study of individual molecules. Some physicists, such as Robert Laughlin, even believe that Newton’s laws of motions are the emergent result of some finer-scale dynamics.

The emergent properties that characterise systems such as the weather, biology, or the economy are different in that they are general tendencies, which elude precise prediction. There is no precise law for a cloud, and there is no law for a market. All we can do is make some rough estimates. Complex systems, it seems, have their own inbuilt uncertainty, rather like the uncertainty principle in quantum physics, but without the neat mathematical equations.

Of course, this doesn’t necessarily mean that economics should stop incorporating techniques from physics. The methods just need updating, from Newtonian mechanics to the world of complexity, emergence, and uncertainty.

This might seem disappointing to those who want more certainty. But as shown by the minutes from the meetings of the Federal Reserve, one asset that was in remarkably strong supply prior to the crash that began in 2007 was certainty in the strength of the economy.

At one such get-together it was described as “a lot like a tennis racquet with a gigantic sweet spot”. In fact, studies have shown that economic forecasters consistently overestimate the accuracy of their predictions, and tend to be too optimistic. This naturally imbues policy makers with a pleasant but potentially dangerous feeling of false confidence. A little less certainty might actually help make the economy a safer place.