Put economics back in the philosophy department

Economics has been moved to the mathematics department but belongs in philosophy.

In mathematics, equations must be proven – there is a solution, a final answer.

pie symbol math

Pie doesn’t change depending on the circle – it’s a calculation that equals 3.1415 etc, a precise if infinite number. Pythagoras Theorem states a2+b2=c2 for any right angled triangle with c as its long side. The formula is at least 2500 years old and as true today as it was then.

Mathematical equations give definitive answers, it’s the same with physics. The most famous equation is Einstein’s E=mc2 but Newton’s laws of motion will do as well: force equals mass times acceleration is absolute. There is a reason the Laws of Gravity are called Laws.

This isn’t often the case with financial theory and economics. We may use equations and dress the subjects up like mathematics, but there are no definite answers in the study of finance and economics. By using the same language as mathematics and physics, we have a false sense of security and put too much confidence in the model-driven results.

Reinhart and Rogoff is the latest example of such excess of faith. Intuitively what they say makes sense – excess state debt will slow a country’s growth rate – but too much reliance was placed on the exact 90% debt to GDP figure initially. And now that has been proven to be in error, the whole of the study is almost disregarded. But my point is that the initial trust in the modelling was too great. This is not an exact science. Economic and financial modelling is an attempt to understand, it does not give precise rules and answers (as any GDP forecast highlights so well).

Value At Risk is a particular bugbear of mine. At its most basic form banks use VAR to give a dollar value of potential losses in a given situation. For example, if a stock market falls 3% in a day (perhaps a two standard deviation move), then the model says the bank will lose $100mn. However what is exceedingly well documented is that financial market returns are not normally distributed and supposedly exceedingly unlikely events – eg market crashes – occur much more frequently than mathematical models predict. In financial jargon, tail risk is under-priced. So banks have developed much more complex models for VAR, which is not necessarily progress. In the case of the JPMorgan Whale, the reliance on a VAR risk model few understood hid massive proprietary trading positions, resulting in more than $6bn in losses. This is a multi-billion dollar example of an excess of faith placed in a financial model that completely failed to predict what occurred.

So let’s look at some examples to illustrate the non-precise nature of financial equations. The valuation of shares is a very non exact “science” although that has not stopped many trying. The famous but basic Gordon Growth Model, developed by Gordon and Shapiro in 1956, assumes that the value of a company (V) derives from its future dividends.

Gordon growth model formula

No stock ever has consistently been valued on this basis, but that is not the point – it is an attempt to model and understand a key driver of equity valuation. It may look like a definitive maths equation, but it is not. There are equations for currency valuation, interest rate parity, purchasing power parity and even uncovered interest rate parity. They are all simply attempts to understand movements in exchange rates – and they certainly don’t give answers (otherwise there would be much less trading in forex – a sad state for many of you).

The study of economics and particularly finance is still relatively new and academics have advanced comprehension considerably. But avoid too much reliance on models. New research suggests Google searches could provide the Holy Grail of finance – perfect market timing. Searches such as “stocks” and “portfolio” and “economics” are correlated to falls in the stock market as investors’ type in these searches more often when they are fearful. According to the report “a short term trading strategy based on searches for the word “debt” would have returned 326% between 2004 and 2011. But read on to discover that the volume of searches for “colour” and “restaurant” appear to have more predictive value in future market movements than searches for “Dow Jones”. Why would the stock market be correlated to people searching for the word colour? Clearly this is another example of financial relationships and modelling gone too far.

Which nicely brings me to black box or algorithmic fund managers who mine huge amounts of price data to find tiny relationships between asset prices. They then use leverage to maximise the profit from these small and fleeting correlations to make money.  My view? More often than not, they work until they don’t, by which time any past profits created can disappear remarkably rapidly.

As an aside, a friend of mine worked at one such fund and said it had an exceedingly weird and unpleasant working environment. There were a number of teams of mathematical geniuses who worked on different parts of the black box model and were not allowed to talk to each other. Only the two founders of the fund knew how the different parts came together and as that was the secret to their multi-billion fund. They kept teams totally separate and the secret safe.

The exception to all this distrust is bond mathematics, where valuation equations do truly predict prices. The genius is in knowing what rates to input.

Mathematics and science deal with facts, truths and universal laws. On the other hand philosophy is the rational investigation of principles, a system of thought based on study and investigation. Remembering that economics and finance belong to the latter category and not the former will avoid costly mistakes. The illusion of supposed mathematical safety is dangerous.

17 Comments

  1. It’s not the models, but the people that use them. Most that use them simply don’t understand the underlying math and their limitations.

  2. tis is some serious stuff here…….
    tis is one of the tings which takes time to comprehend(fer me tat is…I’m no economist, juz a cook at some hotel ;) )
    gonna wiki me some VAR and economics tingy….
    although I can relate to tat last sentence…..be it economics or just some simple frozen fish & chips inventory maintenance, math is no absolute tingy…..can never tell wat’s gonna happen da next day….
    gonna bookmark tis one……
    great stuff Louise…..thx

  3. But the reason why the best mathematicians often get it totally wrong is becasue , the market is a market of humans not a market of numbers , and economics has essentially nothing to do with “number math” and is rather “human math” .

    which of course you stated, so that’s why in these wily times of equity “Trading” most people like to throw out the math and just see if the Fed will keep the MBS purchases 1. the same 2. increase or 3. Taper.

    it makes life easy when the Federal Reserve Communist style owns a significant part of the GDP .

    I find your article very bullish for equities ! as long as next week the Fed increases MBS or pulls a different string with regard to “loosening” .

  4. Like like like like – I cannot like this post enough!

    There is a better way of improving economics, finance, interpretations of value, economic systems (etc etc) than the model-based systems we seem to have at present. There is ALWAYS a better way; a way that has not yet been thought of or put into practice. This new way will not be discovered in any useful way in the mathematics department alone. It will be discovered with, at the very least, a healthy dose of philosophical thinking, where models and absolutes are not required to move forward in understanding. Philosophy leaves room for the unquantifiable, which is an essential realisation when dealing with capital markets because are tiny wee human brains cannot understand everything, cannot identify/measure/manage all risk etc.

    The suggestion in the title is magnificent but an even better suggestion to putting economics back into the philosophy department, is to mimic the methods Craig Venter used to map the human genone. Say what?! Rather than simply move economics to the philosophy department, a better approach would be to put philosophers, mathematicians, economists, and most importantly, TRADERS (because the group of academics is going to need to be kept grounded!) under the same roof, and then force the lot of them to CONTINUALLY communicate and problem solve. Perhaps something like this already exists?! Anyone? Bueller?

    Anyway, loved the post, Louise. My comment is probably off-track a bit but it was fun to write.

    Ps……“There is a tempting and fatal fascination of mathematics that Albert Einstein warned against. He said, “Elegance is for tailors. Don’t believe in something because it’s a beautiful formula.’” (I have no idea if this is an accurate quote of Uncle Albert but it’s thought-provoking nonetheless!)

  5. Hey, great article. I guess it is a ripoff by banks basically. They hire all these graduates with math background so that they can market complicated stuff to their clients. The trend continues I guess. I do agree that these mathematicians are really weird and making money does not equate to formulas. Many great hedge fund managers who have made money consistently, with a decent Sharpe are normally great thinkers (philosophers) and not necessarily mathematicians. Unfortunately in the current times, the adjustment takes much longer but then it really will hurt as you suggested. Another good example would be Relative Value fixed Income trading, besides your High Frequency example.

  6. What a great post. I also needed to consult Wiki to help me understand some of it but I I really learned a lot from it. Thanks ForexLive and Louise. This is really amazing content. My wife even loved it and she does not trade or even really follow markets. ;)

  7. Good post. VAR is a bug bear of mine as well and can/has caused problems at banks.
    The post also made me think of the fiasco at Long-Term Capital Management L.P. (LTCM).

  8. The best post I have read here!!!

  9. its leverage…300:1 and you’re out on a limb x everyone = disaster

  10. Good article, thank you. Few weeks before the R&R revelation hit the wires John Mauldin did a series of articles on the futility of relying upon economists. Very in depth debate. They can be found in his “Thoughts from the Front Line”. I have read John for many years and highly recommend.

    http://www.mauldineconomics.com/

  11. Mathematics is the basis of life and so all derivations including economics. It is no accident that the classical Newtonian laws of motion is known as “The mathematical basis of natural philosophy”
    The issue with econometrics is that it based on infinite functions unlike the traditional maths of finite. Because all the inputs ( variables) are plenty and sometimes hard to know past data is relied upon to interpolate the future. This then means that most input in economic equations are either wrong or inherently unreliable therefore producing wrong outcome. It therefore means that realistic and up to date variables must be associated with econometric functions for realistic and correct outcome based on time tasted mathematical structures. That is the reason they are called behavioral as parameters keep changing by human actions

  12. This article also points to the stupidity of the use of indicators to predict future prices. Always wondered how traders claim to rely on one indicator or the other to make money. Almost an impossibility and this article proves that completely

  13. A very well written post! Please keep them coming.

  14. I’m insane. That being the case, FXlive doesn’t publish me comments. I respect you though cause your ‘thinkin’ is bold. Sometimes bald, sometimes dummer than sh^t. Other times like the latest loaf…Hmmm pretty damn good. I’d eat it.
    I’ll take you seriously though cause you are not stupid (at least not today-:)

  15. Economics belongs in the creative writing department. Virtually all government, central bank, and Wall street economists now are simply in the business of promoting their organization regardless if the purpose is to delude and confuse the public that there is no real inflation or that the purpose of QE ad-nauseum is to help the 99%, or that savers should take more risk and buy equities. Better yet, move economics into the realm of theoretical astrophysics. Then the economists can join in the never-ending search for the God particle to justify their insane monetary theories.

  16. Excellent observation. The markets like the human being is not a rational creature. Philosophy is clever reasoning but mathematics is a better instument for veiwing the market.

  17. Thumbs up ma’am.

    Inclusion of the LTCM blow-up would have been appropriate when talking about the maths. Afterall LTCM were headed by Nobel Lauraete Economists who gave the financial community the Blacks & Scholes option pricing FORMULA which is 3 orders of complexity – just kidding – more than the simple Gordon formula.

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