FORECAST: WHAT PHYSICS, METEOROLOGY AND THE NATURAL SCIENCES CAN TEACH US ABOUT ECONOMICS by Mark Buchanan, Bloomsbury USA, New York, 2013
Physicist Mark Buchanan does all the heavy intellectual lifting that asset managers and financiers need in order to really understand the worldwide markets they trade in every day. Many economics critics from other disciplines, myself included, and a few beleaguered economists have tried hard over the past 100 years to explain where conventional economic theories from Adam Smith and Léon Walras in the 18th century to Kenneth Arrow and Gerard Debreu in the 1960s went wrong. Economists who tried to expose the fallacies of equilibrium models, efficient markets, rational actors and other flaws in both micro and macroeconomics have usually been ignored, ostracized, denied tenure and some actually were driven to suicide (Henderson, 1981).
Even physicists and chemists suffered similar rejection. Notably in 1915, Nobelist chemist Frederick Soddy (Nobel laureate in 1921) who wrote Cartesian Economics (1921, republished 2012) was ridiculed by the economics establishment. John Maynard Keynes, a mathematician, achieved his exceptional breakthrough using a disequilibrium model in explaining the persistence of stagnation and unemployment. As author Mark Buchanan points out, the stubborn obstinacy of the economics mainstream has not only failed to explain markets and finance and led to the crises of 2007-8, but is still a continual danger to the global economy. Buchanan's urgency in writing Forecast is based on his prediction that future even worse crises are inevitable - unless we overhaul our economics by basing market models on what we know about the behavior of such complex systems from physics, fluid dynamics, engineering, thermodynamics, biology, ecology, behavioral and brain sciences. This is the direction our Principles of Ethical Biomimicry Finance™ take, co-developed with the scientific team led by biologist Janine Benyus at our partner company Biomimicry 3.8.
Economists have absorbed much from the behavioral and brain sciences, game theory and psychology over the past decade from Paul Zak, Amos Tversky and Daniel Kahneman in Thinking Fast and Slow; from mathematicians Benoit Mandelbrot and Nassim Taleb in his The Black Swan and from game theorists Norbert Wiener, Oskar Morgenstern and John Nash. So far, economists have not applied any of this new knowledge to their still equilibrium-based models and metrics.
Even though such scholars from other disciplines have often been claimed as "economists" and been awarded the Bank of Sweden Prize in Memory of Alfred Nobel: Kahneman (2002); political scientist Elinor Ostrom (2009), game theorists John Nash, Reinhard Selten and John Harsanyi (1994), Thomas Schelling and Robert Aumann (2005), Leonid Hurwicz, Eric Maskin and Roger Myerson (2007), their research has not penetrated most academic courses, nor changed market models. Traders' asset allocation buckets are still fossilized, while performance is unchanged, and benchmarks, CAPMs underlay the algorithms of HFT firms and their dominant position in all financial markets today.
Thus, Buchanan in Forecast spends much effort explaining what is wrong with the Arrow-Debreu and other models based on equilibrium and individual actors. He painstakingly shows how markets can be understood if we took lessons from the 2007 quant meltdown in hedge funds, the May 6, 2010, "flash crash" and the many similar smaller crashes occurring regularly. He sees, as I and others do, that HFT's pursuit of "zero latency" is leading to greater instabilities and why their justifications of providing price discovery and liquidity are false and dangerous illusions.
I will not spoil this fascinating read by disclosing the ending. Suffice it to say that Buchanan describes many of the new models that actually can predict the behavior of markets. Those who miss this book can stay stupid - still giving opportunities to other investors like me who have learned to bypass Wall Street where we can!