Opinions #1: Is there such a thing as “Econophysics”?

I thought it a good idea to start the “opinions” category on this blogsite with an entry concerning my own approach to what I do: Econophysics. Is there really such a thing and, if yes, is it a good thing? I will argue there is such a thing, that it is a good thing but that it is different from what most people think it is.

The trouble with Econophysics

Econophysics was a name that was coined in the late 1990’s for a field that was emerging within Physics, in particular from the statistical physics community, where physics-inspired methods were applied to mainly finance problems. At least this was the way the field had come to view itself. However, let me start nagging right there: it is only physics-inspired if the people working on it would have been anything but physicists. Say, if we would have been talking about economists who had taken inspiration from physics then “physics-inspired” would perhaps have been appropriate. However, that kind of physics-inspiration has been rife in Economics since the very early days of the discipline. It was not something that set Econophysics apart.

The reality however was that Econophysics was entirely the field of physicists. Physics had not been the source of inspiration, merely the source of the people who were engaging with it. The true inspiration for Econophysics had started to emerge a few years before. As a young academic in the 1990’s I had seen, already during my PhD-years 1992-1995, that very many fresh MSc- or PhD-graduates were swept off into the increasingly well-paying finance and financial services industry. When I had my first post as an assistant-professor I do recall many a conversation at the coffee table that covered the question: what is it that we are teaching them that makes them so desirable to finance companies? It couldn’t be the economics or social sciences because we weren’t teaching them any of that. It had to be their technical and quantitative competences.

That was of course true! And as in the late 1990’s the flow of graduates into finance, or IT related finance, exploded some researchers started looking at the kind of modelling work these graduates were doing in those finance firms and recognised interesting research questions. The name and the programme of Econophysics really started to sink in after 2000 and the publication of Stanley & Mantega’s Econophysics textbook. Two years later a far more modest and, in my view, more thoughtful textbook appeared by Bertrand Roehner. Where the former book portrayed Econophysics as essentially an applied statistics exercise with relatively little regard for economics or econometrics, the latter attempted a far more careful approach considering the fundamental nature of complexity as a core feature of Econophysics and making a case for a strong but critically empirical focus.

Teaching Econophysics

My own interest into the subject arose slowly in the early 2000’s. I thoroughly admired the patient and thoughtful text by Roehner but I also recognised the ‘sexy appeal’ of the fast and furious approach of Mantega and Stanley. In 1998 I had become involved in Utrecht University’s attempt to found, from the ground up, a residential Liberal Arts & Science college. Collaborating with Economics colleagues on the shape of the mathematics curriculum to benefit both their discipline as well as mine (physics) was eye-opening. Evidently there was a possible and legitimate source for Econophysics in the overlapping use of certain mathematical tools. To me it was equally evident that economists tended to underestimate the mathematical capability of their students and hence fell short of challenging to the same degree as happened with physics students.

As I was developing an Econophysics course for our Liberal Arts & Sciences college with an eye towards bringing the two groups of students together in the same class I chose to use both previously mentioned books. But I also became increasingly worried about what I considered to be a lack of knowledge about economics and social sciences amongst the physics students in the regular physics degrees. From my personal experience there were significant warning lights flashing brightly red about this ever increasing flow of highly-skilled and trained mathematical modellers from Physics (and Applied Mathematics and Computer Science) into the world of Finance where they were constructing elaborate models but in many way with a total disregard of the human-factor in these economic processes. Also in the published literature as early as 2008 the first very critical discussions from within the Econophysics community emerged. Of course then the 2008 crash happened.

An answer to a Queen’s question

Famously Queen Elisabeth II asked at an LSE event why Economics had not foreseen the 2008 crash or prevented it. Let me try an original even if perhaps somewhat radical answer: every reasonable economist had foreseen it and they couldn’t prevent it because they weren’t the ones causing it. Now, 11 years after the crash, it is still very much en vogue among ‘critical thinkers’ to debate at length how the mathematical models of mainstream economics were supposed to have caused all this. However the reality is that the mathematical models that drove early 21st century finance over the cliff-edge weren’t mainstream economics models. If they had been, the outcome might have been different.

The response of the Econophysics community at large seems to have been to very swiftly blame the crash on the supposed deficiencies of Economics as a discipline and instead now present Econophysics as a way of addressing those problems. In many ways such attempts at blame deflection have been largely successful. In a way it is surprising how few economists raise this point while econophysicists are mostly very silent about it.

A new Econophysics

I moved from my career in Physics to Economics in 2010, not Finance or financial modelling or FinTech, but Economics. I found Economics questions incredibly interesting, sharing many of the aspects that I had come across in my physics-research while at the same time being thought-provokingly different. All the economists I talked to (in the case they accepted to talk to an econophysicist) asked me way more interesting questions that made me think, then comparable chats with physicists. Going into a teaching position allowed me to quietly pursue my own research-agenda that neither seeks to make a ton of money from dodgy models nor seeks to overthrow any economic paradigms.

Let me try some bold generalising (and thus inherently prone to error) statements. To me it seems to economy is full of relatively short-lived correlations. When a market-party can identify such a correlation before others do that provides them with a window or arbitrage that can be exploited. That window then ultimately collapses essentially for two reasons:

  • too many parties get in on the game and suck the life out of the arbitrage opportunity;
  • the correlation reaches the end of its lifetime and dissipates;

The first is pretty much entirely in line with main-stream economic theory. The second is a consequence of many different effects ranging from policy volatility in economies, agents adjusting their economic beliefs and down to exogenous shocks and influence.

Old Econophysics was geared towards identifying these arbitrage-windows opening up. Poor regulation in finance allowed sufficiently large agents to dump the losses caused by engagement in this game, and failing to recognize the window was closing or had already closed, onto society at large. Old Econophysics is still alive and kicking and never asks itself why it works the way it does. It beliefs better models, more data, better data will help overcome the catastrophic outcomes.

A new kind or Econophysics should start to rethink itself from the ground-up. There is a lot of interesting Economics out there that probably can be rephrased in terms of many of the physical ideas and methods that physicists have been trained in. But that comes at a cost, or so I have at least experienced. Because these economic systems have properties that differ fundamentally from the properties of analogous physical systems. These differences however do not mean that the physico-mathematical tools cannot be deployed. Instead what they mean is that these tools have to be re-interpreted. As a physicist I find this a wonderful endeavour to undertake. Coyly I sometimes say to my Physics colleagues: I have never learned as much Physics as since I started digging into Economics.

Let me illustrate that by perhaps a slightly superficial example. If you use equilibrium statistical mechanics methods to study a small volume of gas, then you are dealing within typically 10^24 particles that are all identical and indistinguishable. If you are studying the world economy however you are dealing with about 10^10 economic agents that are all distinguishable and that come with many different preferences blowing apart the notion of them being identical. As a result the statistical equilibrium mechanics of the global economy looks nothing like that of an ideal gas. But it doesn’t mean there is not any sensible application of those tools to this system … as a physicist you simply need to carefully rethink the way you use them.

I believe there is the intellectual space in between the traditional disciplines of Economics and Physics for a genuine Econophysics. But this has to be a new Econophysics that first re-examines its tools and methods while testing them on economic questions and problems. That is not the kind of research-programme that will win you funding grants of Physics or Economics funding bodies (also I am way to lazy to apply for those). It is also not the kind of Econophysics that will make the eyes of fundmanagers, investment-bankers and hedgfund owners gleam with the delight of large expected returns. But it is a space I love dabbling in.

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