In “Models Behaving Badly” (reviewed in the Wall Street Journal by Burton G Malkiel) trained physicist and former head of quantitative analysis at Goldman Sachs, Emanuel Derman, explains that financial models trying to quantify human behavior in the same manner as physical models try to explain nature is “like trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper. It doesn’t fit without cutting off some essential parts.”
Physical models explaining the nature of the universe are like Cinderella’s pretty glass slipper? One wonders which of the physical models explaining the nature of the universe are as pretty as Cinderella’s glass slipper–Quantum Theory that provides a robust model for explaining what happens at the particulate level of nature, but can’t account for gravity? Or Relativity Theory, that seems to explain the gravitational force holding together the stars and planets, but requires for its explanations to work that fully 96% of the universe be comprised of undetectable “dark” mass and energy, and that light be the fastest entity in the universe, and that collapses in a heap at the quantum level? If these are his “pretty slippers”, it would be hard to imagine what an ugly slipper might look like.
The social sciences, primarily economics and finance, but sociology a bit too, have seemed envious of physics and its apparent ability to apply abstract mathematics to create models that explain the nature of the universe. Physics has been very successful at explaining, in a humanly-useful manner, particularly at the quantum level, the behavior of matter and energy using mathematical models. All of the information technology upon which the developed world now so depends owes its myriad applications to the investigations and discoveries of particle physics and the mathematical models used to explain them. Without understanding the proton, neutron and particularly, electron, et al, and the forces animating them, nothing of cell phones, computers, radios, televisions, microwaves, etc., would be possible. But understanding these bits of matter and energy, and the phenomena associated with them, is of little use in explaining, for example, how planets stay in orbit, or the emergent qualities of life. The behavior of the parts can not be used to fashion viable theories about the nature of the whole. The domain for which the “laws” of physics is explicated by Quantum Theory is quite limited.
Similarly, the domain for which Relativity Theory is relevant and useful is limited to only the very large or very fast, neither of which hold much relevance to the human condition.
Fitting nature into the pretty glass slipper of either theory requires quite a bit of nature to be left out. Why economists and financial quants would be envious of these models, and wish to emulate them in devising models that might explain human behavior is something of a mystery, perhaps explained by the apparent, though illusory, determinism provided by the models. Though the position of an electron can never be certain until it is measured (which would thereby prevent measurement of its velocity), physicists have nonetheless been able to devise accurate probability models for where it should be that have proved quite robust and useful. Though the visible and detectable universe exists in an apparent miasma of dark energy and matter, Mercury’s precession in its orbit around the sun due to the bending of space-time is accurately predicted by Relativity Theory. The economists and quants suffer an envy-induced myopia, seeing the abstract mathematics that have provided physical models with some limited predictive usefulness, while ignoring their irreconcilability even within the inanimate world in which they exist, and the mountains of nature that the models must ignore for their predictive capabilities to be of any usefulness, failing to see that no model of human behavior that must necessarily be so limited in its domain has really any predictive usefulness.
Just as Quantum Theory can’t predict planetary orbits, microeconomics–theories of the individual economic actor–provides few clues as to how economic systems and markets might behave in aggregate. The foundational premise of microeconomics–that humans, or organizations of humans, behave rationally to maximize welfare–seems inapplicable to macroeconomic entities like markets and economic systems. What appears rational at the individual level–buying a momentum stock or a subprime mortgage CDO–yields apparently irrational results, as momentum stocks climb regardless of fundamental values, and housing prices appear (for a time) capable of growing to the sky. The rational activity of millions of individual economic actors becomes apparently irrational when considered in the aggregate.
Had economists and financial quants been paying attention to the lessons from physics, they might have realized the difficulty in creating models that scale from the individual to the aggregate. Instead of having physics envy, they might have developed from physics a humble wisdom: If even the inanimate universe can’t be successfully modeled, how then is it remotely possible that the vastly more complex and unpredictable nature of living creatures could be modeled in a manner to yield useful predictions over the vast panoply of potential experience? About the best can be hoped in the animate world is to develop generalized rules that are useful only in context, such as is provided by evolution theory, such as that man is a living creature, and like all living creatures, must have as his foremost concern his own survival and propagation, a corollary of foundational premise of microeconomics. It is an infallible observation, applicable in all realms, but it only offers predictive usefulness subjectively, through the prism of each individual’s perception, which does investment analysts, macroeconomists, et al, little practical good.
Freud proposed that female children, upon discovering they lack a penis, feel envy for not having one, because at some point, they realize they need a penis if they are to make love to their mothers (I am not making this up). But which is more powerful, the penis or the womb? Which of the parents in a young child’s life is generally the most powerful and influential? Indeed, the mother. A female child might notice a penis and be confounded by her lack of what appears might be such a useful appendage, but if she is paying close enough attention to notice a penis, then surely, she would also notice from interactions with her mother that whatever other benefits might accrue to the owner of a penis (standing to pee?), they can’t hold a candle to the mysterious power over the world that accrues to people without them, like her mother, and herself. Besides, as the old joke goes, with what she’s got, the little girl will surely learn soon enough that she can get as many as she might desire of what the little boys have.
The world of economics, finance and sociology can’t pee standing up–there is no way their fields will ever be reducible to a few elegant equations (however overrated are the elegance and explicatory powers of physics equations) . The irreducible complexity of life that compels mathematical envy in the social science academy is also what makes its study so interesting. It is why the life sciences (of which economics, finance and sociology are but a part) are the hard sciences. Plugging values into an equation and turning the crank is easy. Thinking deeply to account for all the possible variables and their potential impacts, including thinking through one’s own perceptual biases that might have impacted the observations, is something no computer will ever do; no abstract mathematics could ever capture. Practitioners of the social sciences require more than elegantly-organized information to fashion a useful understanding of humanity. They need an abundance of humility and objectivity over a virtually limitless domain of experience. In short, they need wisdom, which is, like a womb to a penis, a far more powerful thing than math.