Economics

Playing the market casino

October 17, 2013
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How satisfying it must have been to be a scientist in the 18th century, secure in the knowledge that the mathematical predictability revealed by Isaac Newton in the motions of the heavens was sure soon to be extended into every realm of human experience. Thinkers from Kant to Condorcet felt sure that regularities in social behaviour would soon emerge with all the precision and certainty of Newton’s laws of motion, and Adam Smith and his colleague Adam Ferguson encouraged the view that economics had its own gravitational laws too. As Ralph Waldo Emerson later put it, “The level of the sea is not more surely kept, than is the equilibrium of value in society by the demand and supply… the sublime laws play indifferently through atoms and galaxies.”

But times change. Newton’s clockwork universe was always an illusion – he even realised himself that the predictability of his laws dissolved when more than two of them influenced one another, a presentiment of today’s understanding that even the solar system is chaotic over the long term. But such determinacy was truly killed off by the discovery in the early 20th century that nature at the smallest scales follows the laws of quantum physics instead, in which we can know only the chances of different outcomes but not which will prevail: God does play dice.

As for economics, the relinquishment of simplistic determinacy has been slower – indeed, much policy-making has yet to make that step. Emerson’s conclusions about the rigid ‘laws of trade’ will still serve pretty well as a statement of belief for some economic advisers: “wealth brings with it its own checks and balances. The basis of political economy is non-interference. The only safe rule is found in the self-adjusting meter of demand and supply. Do not legislate. Meddle, and you snap the sinews with your sumptuary laws.”

This belief in a “self-adjusting meter” and the dangers of regulation has to have something of the religious in it to have survived the financial crisis, so that even now we hear government advisers suggesting that education would function best as a free market.

It’s perhaps optimistic to imagine that the award of this year’s Nobel prize in economics to Robert Shiller, Eugene Fama and Lars Peter Hansen will do much to dent such thinking, but at least it is good to be reminded of Shiller’s warning that irrational “animal spirits” and inefficiencies pervade the market, and of Fama’s demonstration of the unpredictability of prices – in other words, of the mythical status of the Emersonian market.

True, this issue of predictability here is a complex one. Fama’s demonstration in the 1960s that stock prices quickly return to randomness after some perturbing event looked in fact like a validation of market efficiency: there are no long-term trends that enable you to beat the market casino, because new information about prices is so quickly assimilated and diffused. But Fama in fact showed that those fluctuations, while unpredictable, are not like white noise – there’s something else going on. That inconvenience was ignored in the notoriously unreliable Black-Scholes equation for pricing derivatives, which was itself deemed worthy of a Nobel back in the days when derivatives trading was regarded as a shining example of market innovation rather than a weapon of mass destruction.

The Nobel committee is cagey about assigning interpretations to these important findings. As a result, their blithe statement that “understanding when and why financial markets do not efficiently reflect available information is one of the most important tasks for future research” is a staggering understatement. I’d suggest an alternative phrasing: “understanding how to move beyond the flawed models that underpinned the dominant economic ideology of the past several decades and which exposed catastrophic flaws in the financial system is one of the most important tasks for future research.”

Shiller himself has optimistically claimed that “finance is analogous to engineering”. The grand irony is that we are now closer to controlling what looked like the fundamental indeterminacy of quantum physics than to engineering the market. Traditionally, quantum theory has presented the view that, while we can know the probabilities of the outcomes of a particular experiment on a quantum system, we can’t influence the actual outcome – that’s where God’s dice come in. In particular, random noise in the surroundings tends to scramble the way a quantum system evolves into a well defined ‘classical’ one (a process called collapse of the wavefunction), making it impossible to predict what the final state will be. This effect, called decoherence, is held responsible for producing everyday Newtonian behaviour of large objects from underlying quantum rules.

But researchers at the University of California at Berkeley report in Nature that if you can monitor the random disturbances from the environment, you can supply compensating nudges to a quantum system to steer it along a particular path, in effect collapsing the wavefunction in a carefully controlled manner that is perhaps better described as unfolding but as origami-like folding. It’s a little like measuring the tumbling of God’s dice and applying little pushes to guide them onto particular faces. In some cases the researchers found they could even partially collapse the wavefunction and then ‘un-collapse’ it again to restore the initial state. Such experiments could be useful for quantum computing, where it is necessary to fend off decoherence while the calculations are carried out, but they could also probe what wavefunction collapse – one of the most profound mysteries at the heart of quantum theory – is all about.