Second excerpt...
The Physics of Finance 2013-06-07
A second excerpt of my forthcoming book Forecast is now online at Bloomberg. It's a greatly condensed text assembled from various parts of the book. One interesting exchange in the comments from yesterday's excerpt:
to which one Jack Harllee replied...Food For Thought commented....Before concluding that economic theory does not include analysis of unstable equilibria check out the vast published findings on unstable equilibria in the field of International Economics. Once again we have someone touching on one tiny part of economic theory and drawing overreaching conclusions.I would expect a scientist would seek out more evidence before jumping to conclusions.
This response fairly well captures my own position. I argue in the book that the economics profession has been fixated far too strongly on equilibrium models, and much of the time simply assumes the stability of such equilibria without any justification. I certainly don't claim that economists have never considered unstable equilibria (or examined models with multiple equilibria). But any examination of the stability of an equilibrium demands some analysis of dynamics of the system away from equilibrium, and this has not (to say the least) been a strong focus of economic theory.Sure, economists have studied unstable equilibria. But that's not where the profession's heart is. Krugman summarized rather nicely in 1996, and the situation hasn't changed much since then: "Personally, I consider myself a proud neoclassicist. By this I clearly don't mean that I believe in perfect competition all the way. What I mean is that I prefer, when I can, to make sense of the world using models in which individuals maximize and the interaction of these individuals can be summarized by some concept of equilibrium. The reason I like that kind of model is not that I believe it to be literally true, but that I am intensely aware of the power of maximization-and-equilibrium to organize one's thinking - and I have seen the propensity of those who try to do economics without those organizing devices to produce sheer nonsense when they imagine they are freeing themselves from some confining orthodoxy. ...That said, there are indeed economists who regard maximization and equilibrium as more than useful fictions. They regard them either as literal truths - which I find a bit hard to understand given the reality of daily experience - or as principles so central to economics that one dare not bend them even a little, no matter how useful it might seem to do so."