8/14/2019 Economics Crisis

http://slidepdf.com/reader/full/economics-crisis 1/2

2 nature physics | VOL 5 | JANUARY 2009 | www.nature.com/naturephysics

commentary

Economics crisisThomas Lux and Frank Westerhoff

Economic theory failed to envisage even the possibility of a nancial crisis like the present one. A new

foundation is needed that takes into account the interplay between heterogeneous agents.

Once viewed as mystic monetary engineer, Alan Greenspan, ormerChairman o the US Federal

Reserve, has been re-cast as irresponsible villain, one who laid the ground or thepresent worldwide nancial catastrophe.Asked whether his ‘ideology’ had pushedhim to make decisions he now regrets,

Greenspan conessed1

that he would havedeemed impossible the ongoing disruptionsto the nancial system and that “his belie in deregulation had been shaken”.

He is not the only one who has beentaken entirely by surprise. Most economistsdid not in any way oresee the depth o the current crisis, or even consider itpossible. Even those who warned2 o over-exuberance in the US housing market didnot have any clue about the impendingmeltdown, which, to the shocked public,looks as i some Dr Strangelove on WallStreet had pushed the button on a nancial

Doomsday Device. Greenspan’s supposedideology certainly coincided widely withthat o mainstream economists who believein the sel-regulating orces o unrestrainednancial markets, the ‘eciency’ o asset-price ormation, and the increasedeciency in risk allocation and sharingthrough the introduction o ever morenancial instruments.

All o this is just the nance versiono that textbook economic paradigm,‘homo economicus’, who has unlimitedinsightulness and capability o deliberation(economists typically speak o ‘rationality’).

Tis admirable person manages hisnancial aairs as a side-aspect o hisutility maximization problem, taking intoaccount all potential uture happeningswith the correct probabilities. As thereis only one way to be perectly rational,this agent is usually the lone actor ineconomic models — a representativeRobinson Crusoe.

O course, this Crusoe has been oenderided as a straw-man illustration o the dominant paradigm, criticized by non-mainstream economists, unbelievingnatural scientists and a similarly unbelieving public. Still, the straw man

is alive, and was well — at least until thecurrent nancial crisis started to unold.Although the principles outlined aboveare still the basis o most contemporary scholarly activity in economics, there areother trends. Tese include innovativework in ‘behavioural economics’ andexperimental work with human subjects —

recognized in the award o the 2002Nobel Prize to Daniel Kahneman andVernon L. Smith — which have revealeda plethora o behavioural patterns thatcontradict the assumption o perectly rational behaviour.

However, these developments still occupy only a marginal position. Te widespreadperception within our proession is thatbehavioural research delivers a curious set o anomalies or exceptions that lack coherence,and whose impact gets washed out in theaggregate. In contrast, the mainstreamparadigm is seen as a more solid andconsistent ramework. Economic policy advice, particularly in nancial economics,will thereore typically be based on a set o axioms and hypotheses derived ultimately rom the Robinson Crusoe scenario. As

the prevailing nancial crisis cannot beexplained using these standard tools,economic theory basically oers policy makers little guidance about what to do inthe current situation.

A major problem is that despite many renements, this is not at all a system basedon and conrmed by empirical research(as the naive believer in ‘positive science’might expect). Te vision (or ideology)encapsulated in the mainstream approachis o a more ‘pre-analytical’ nature and issupported mainly by elegant but idealisticmodels o the economy. Perect rationality and optimizing behaviour are used so

pervasively in economics education thattheir basic tenets are taken or grantedas the principles ruling the real world,despite all o the anomalies and exceptionsdiscovered in empirical research.

For instance, it would be hardto nd supporting evidence or thermly held belie that more derivative

instruments — which should allow agentsto insure themselves better against thestochastic wheels o ortune — lead to abetter allocation o resources and thusan increase in market eciency. Tisassertion is based entirely on the benetso contingent claims in the textbook general-equilibrium model. Derived inthe abstract, the eciency gain throughderivatives is only a hypothesis, yet this isnot how economists are used to thinkingo such theorems: it is the mathematicalproo within the model economy that isconsidered its validation, rather than any 

empirical evidence.A glance at real-lie operations inderivative markets easily shows why thetheory ails: instead o hedging away risk,many market participants use derivativesin an ‘anomalous’ way, to build upspeculative positions so as to prot romhigher returns, as long as the downsiderisk does not materialize. Te near disasterbrought about in the late 1990s by thecollapse o notorious hedge und Long-erm Capital Management (intellectually based on modern derivative theory) shouldhave raised some doubts. I that was not

compelling enough, the present crisisshould constitute its ultimate rejection.Te dominance o the rational-agent

paradigm is intimately intertwined withan even more cumbersome ‘conceptualreductionism’. As there can only be oneway to act ully rationally, everyoneshould display exactly the same behaviour.Tereore, a representative agent would besucient. aking both aspects together,the typical ormat o current economicmodels is that o a single household or rmmaximizing its utility or prot over a niteor innite liespan. echnically, this is adynamic programming problem.

To the shocked public, it looks

as if some Dr Strangelove

on Wall Street had pushed

the button on a nancial

Doomsday Device.

© 2009 Macmillan Publishers Limited. All rights reserved

8/14/2019 Economics Crisis

http://slidepdf.com/reader/full/economics-crisis 2/2

nature physics | VOL 5 | JANUARY 2009 | www.nature.com/naturephysics 3

commentary

Tis methodological preerence excludesthe study o interaction among economicagents. However, most o what is relevantand interesting in economic lie has to dowith the interplay and connection betweendiverse economic actors. Te current crisisis a perect example o the importance o 

interactions at various levels. It was theinteraction between highly connectedinternational nancial markets that hasgenerated the spillover rom the USsubprime-mortgage problem to other layerso the nancial system.

Securitization o credit risks enabledlenders to sell various parts o theirmortgage portolios to other nancialinstitutions thus creating new links withthese buyers as well as, indirectly, amongthem. Other new asset classes, such ascredit deault swaps, added additionalnew links between ormerly unconnected

entities. Tis gives us a glimpse o hownancial innovations have increasedthe degree o connectivity within thenancial system. It is well known thathighly connected systems might be ‘robustyet ragile’3, but such important aspectshave been out o reach o the mainstreamapproach to economics.

In act, the ubiquitous notion o ‘systemic risk’ signals that current eventsconcern the nancial system at an aggregatelevel. For natural scientists, the distinctionbetween micro-level phenomena and thoseoriginating on a macro-, system-wide scale

rom the interaction o microscopic unitsis clear. Te overall systemic eatures o the crisis would be seen as an emergentphenomenon o the dispersed micro-activity. o reduce these macro events tothe outcome o the decision process o asingle agent seems to be missing the point.

As with systemic risk, the notion o coordination ailure (a term oen usedto characterize the endogenous natureo economic slumps and recessions)in itsel encapsulates a perspective o the ‘more is dierent’ paradigm4, aninvoluntary negative collective outcomeo a system o dispersed activity. Ratherthan looking or the explanation in aparticularly odd case o a microscopicdynamic programming problem, it wouldseem much more plausible to investigatethe ‘logic o collective activity’ on themacroscopic scale. However, due to theconceptual reductionist philosophy,

macroeconomics has been entirely reducedto microeconomic theory in the past ewdecades by insisting on representativerational agents. Tat the overall systemis dierent rom its parts is plainly incomprehensible rom the viewpoint o the ruling school o thought.

Economics has thus, by its methodology,tied its own hands and prevented theanalysis o vital aspects o economicsystems. For example, despite the recentsurge o research in network theory, thenow apparent linkages between banks havereceived scant attention. In the ew papersthat have been published, the analyses areo a static nature based on equilibriumconcepts and do not easily lend themselvesto empirical applications. Te even smallernumber o studies using empirical data orrealistic models come rom authors witha background in physics5. Unortunately,

the study o anything at a systemic levelhas been dened away rom economics by the insistence on micro-oundations thatsimply set the macro sphere equal to themicroscopic base unit.

What could be the way out o thisdilemma? In our view, a change o methodological orientation in economicsis needed, to take into account the ‘moreis dierent’ paradigm. On the one hand,economists need to take seriously the various deviations rom ‘rationality’revealed by behavioural research. On theother hand, however, to avoid getting lost

in a patchwork o behavioural biases andanomalies, a new empirically based type o micro-oundation is necessary — one thatstresses more the links between boundedly rational agents rather than the agents’internal processes. It would, thereore,also not be enough to replace the currentparadigm by a representative ‘non-rational’actor (as has sometimes been done inrecent literature).

Te experience o the naturalsciences in coping with complexsystems would suggest a parsimoniousstochastic approach. Because agents

in large economic systems will display heterogeneity in terms o their dierentmicro motives, degrees o deliberation andinormation-processing capabilities, onemight hope that this variability o humanbehaviour can be quantied in a tractableway using statistical laws. Ongoing work inspired by statistical physics shows thatrelatively simple models with plausiblebehavioural rules have the potential toreplicate key empirical regularities o nancial markets6. In these models, directand indirect local and global interactionsbetween market participants are importantingredients in understanding the dynamics

o nancial markets. Currently, similarly simple stochastic models are beingdeveloped in the study o the distributiono income and wealth7, and someeconomists have even taken this approachto macroeconomic models8.

Te apparent systemic vulnerability o our globalized nancial markets hasbrought to the ore another carelessly neglected acet o economic interactions.Most economic problems are emergentphenomena o complex societies that

require a systemic perspective. A newmicro-oundation based on interactionswould be the missing macro counterpartto the microeconomic regularitiesrevealed in behavioural economics. odevelop a proper perspective on systemicphenomena, economics as a science shouldtake stock o the experience o the naturalsciences in handling complex systems withstrong interactions. A partial reorientationin modelling principles and moremethodological fexibility would enableus to tackle more directly those problemsthat seem to be most vital in our large,

globalized economic systems.❐

Tomas Lux is in the Department o Economics,

University o Kiel, Olshausenstraβe 40, D‑24118

Kiel, Germany, and is a member o the research

 group ‘Risks in the Banking Sector’ o the Kiel 

Institute or the World Economy.

e‑mail: lux@bwl.uni‑kiel.de

Frank Westerhof is in the Department 

o Economics, University o Bamberg,

Feldkirchenstraβe 21, D‑96045 Bamberg, Germany.

e‑mail: rank.westerhof@uni‑bamberg.de

References1. Andrews, E. L. Greenspan concedes error on regulation.  

Te New York imes online 23 October 2008.2. Shiller, R. Irrational Exuberance 2nd edn (Princeton Univ.

Press, 2005).

3. Watts, D. J. Proc. Natl Acad. Sci. USA 99, 5766–5771 (2002).

4. Anderson, P. W. Science 177, 393–396 (1972).

5. Iori, G., Jaarey, S. & Padilla, F. J. Econ. Behav. Organ. 

61, 525–542 (2006).

6. Lux, . in Handbook on Financial Economics (eds Schenk-Hoppé, K.

& Hens, .) (Elsevier, in the press).

7. Chatterjee, A., Yarlagadda, S. & Chakrabarti, B. (eds) Econophysics

o Wealth Distributions (Springer, 2005).

8. Aoki, M. & Yoshikawa, H. Reconstructing Macroeconomics:

 A Perspective rom Statistical Physics and Combinatorial Stochastic

Processes (Cambridge Univ. Press, 2007).

AcknowledgementTe authors are grateul to Mishael Milakovic or inspiring discussions.

Economics should take stockof the experience of the

natural sciences in handling

complex systems with strong

interactions.

Economic theory offers

policy makers little guidance

about what to do in the

current situation.

© 2009 Macmillan Publishers Limited. All rights reserved