Wednesday, August 04, 2010

Phenomenology

"One of the embarrassing dirty little secrets of economics is that there is no such thing as economic theory properly so-called. There is simply no set of foundational bedrock principles on which one can base calculations that illuminate situations in the real world." -- Brad DeLong

My title does not refer to an approach in continental philosophy associated with Husserl and Heidegger. Rather, I refer to a term used in physics and engineering by practitioners who know they are not trying to develop models derived from fundamental laws, but only modeling the phenomena.

I find it of interest that Brad DeLong has recently described economics as phenomenology. A noted "rocket scientist" on Wall Street came to the same conclusion:
"The techniques of physics hardly ever produce more than the most approximate truth in finance because 'true' financial value is itself a suspect notion. In physics, a model is right when it correctly predicts the future trajectories of planets or the existence and properties of new particles, such as Gell-Mann's Omega Minus. In finance, you cannot easily prove a model right by such observation. Data are scarce and, more importantly, markets are arenas of action and reaction, dialectics of thesis, antithesis, and synthesis. People learn from past mistakes and go on to make new ones. What's right in one regime is wrong in the next.

As a result, physicists turned quants don't expect too much from their theories, though many economists naively do. Perhaps this is because physicists, raised on theories capable of superb divination, know the difference between a fundamental theory and a phenomenological toy, useful though the latter may be. Trained economists have never seen a really first-class model. It's not that physics is 'better', but rather that finance is harder. In physics you're playing against God, and He doesn't change his laws very often. When you've checkmated Him, He'll concede. In finance, you're playing against God's creatures, agents who value assets based on their ephemeral opinions. They don't know when they've lost, so they keep trying." -- Emanuel Derman (2004) My Life as a Quant: Reflections on Physics and Finance, John Wiley & Sons.
I think one can read intimations of Soros' reflexitivity or Joan Robinson's historical time in the above quote. Derman is even more direct about a Post Keynesian concept elsewhere:
"Slowly it began to dawn on me that what we faced was not so much risk as uncertainty. Risk is what you bear when you own, for example, 100 shares of Microsoft - you know exactly what those shares are worth because you can sell them in a second at something very close to the last traded price. There is no uncertainty about their current value, only the risk that their value will change in the next instant. But when you own an exotic illiquid option, uncertainty precedes its risk - you don't even know exactly what the option is currently worth because you don't know whether the model you are using is right or wrong. Or, more accurately, you know that the model you are using is both naive and wrong - the only question is how naive and how wrong." -- Emanuel Derman (2004)

5 comments:

Magpie said...

That's a thought provoking article.

However, I would advice caution in relation to some of the ideas expressed by Derman:

"In physics, a model is right when it correctly predicts the future trajectories of planets or the existence and properties of new particles, such as Gell-Mann's Omega Minus. In finance, you cannot easily prove a model right by such observation."

The first idea (that models are useful when they correctly predict empirical phenomena) is a great part of what Friedman advocated in his notorious 1953 "Methodology of positive economics". And this hasn't worked too well for mainstream economists, I'm afraid.

In mainstream economics this notion has been used to justify absurd assumptions, on the basis that the presumed predictive power of the model would somewhat compensate for this failure. To make things worse, attempts to empirically test these supposedly powerful models have always been neglected.

This leads me to the second idea: that you cannot easily prove a model is right.

Although Derman may be right in pointing this as a problem, in contrast to Derman, I find that the greatest economic problem is that one cannot easily disprove a model, on the basis of its failure to predict empirical phenomena.

In practice, the use of metaphysical assumptions, like "utility", "representative agent" and such, allow for an unlimited reformulation of failed hypothesis.

I trust you'll find the following quote from Von Mises' Human Action (page 868) quite illustrative. In it you'll find the same neglectful disdain for empirical proof we find in neoclassical economics, and the notion of "representative agent" distilled to its ultimate consequence: what makes sense in economics, is what the economist thinks makes sense. In other words: if reality disproves the theory, then reality is wrong.

"Economics, like logic and mathematics, is a display of abstract reasoning. Economics can never be experimental and empirical. The economist does not need an expensive apparatus for the conduct of his studies. What he needs is the power to think clearly and to discern in the wilderness of events what is essential from what is merely accidental."

You'll notice that to a great extent, these notions are related to what is known as methodological individualism.

I could go on outlining the failings in Von Mises' thought ("ecnomics, like logic and mathematics", for instance). But I believe I have made my point.

I would like to know what DeLong thinks of this, as methodological individualism is indeed a shared cornerstone of much of mainstream economics, whether "fresh" or "saltwater".

sergei2b471 said...

”Perhaps this is because physicists, raised on theories capable of superb divination, know the difference between a fundamental theory and a phenomenological toy, useful though the latter may be“

I think this is a bit wrong. There aren't any fundamental theories in physics, just theories that are very good at explaining the empirical evidence. No one knows how to correctly interpret quantum dynamics, (the Copenhagen interpretation and the many worlds interpretation are mathematically equivalent), and are therefore just "phenomenological toys" as much as economic theories.

Physics and economics are obviously extremely different fields of study, but the difference doesn't come from physics being somehow more "fundamental".

Robert Vienneau said...

I want to say that a difference exists between using Kepler's laws of planetary motion to summarize empirical observations and further deriving them from Newton's laws. Given relativity and quantum mechanics, Newtonian mechanics cannot be ultimately fundamental.

Magpie said...

I certainly agree that summarizing an empirical phenomenon is one thing; explaining it through fundamentals is another, probably more valuable, thing.

However, at the moment, I doubt we know enough about individual human behaviour (or, indeed, even aggregate human behaviour) to attempt a similar feat in economics (or in the other social sciences).

Think about Copernicus, Kepler and Newton: we are trying to be like Newton, while we aren't yet sure we had a Copernicus, let alone a Kepler.

Just my two cents.

Robert Vienneau said...

Kepler had data from Tycho Brahe, if I remember correctly. We have quite of bit of recent (since WWII) economic data. Kepler could find laws independent of changes in human institutions. I'm not sure economists will ever be able to construct such laws.