Galileo and Economics

Or ‘Why we can’t blame Galileo for the latest financial crisis!’ 🙂

Modern science can be roughly said to begin with Galileo Galilei. One of the commonly used methods in science is sometimes referred to as the Galilean Style. This style refers to, among other things, the idealizations and abstractions that scientists use in modeling the world out there. Scientific models do not aim to accurately describe the world. Rather, the idea is (Galileo’s idea) to try and abstract away ‘superfluous’ aspects, and also to use idealizations where possible. As an example of an idealization, consider the fact that Newton in his law of gravitation supposed that the entire mass of the object is concentrated on its center. Similarly, Galileo used ‘frictionless’ planes for performing thought experiments, etc.

But what does all this have to do with Economics? There are many concepts and theories used by mainstream economists that have been influenced directly by the Galilean style. Consider the rational actor model. Under this model, the actor (economic agent, person, entity) has perfect information about all angles of the market and is perfectly self-interested and always makes the optimal economic decisions. Obviously, this is a gross idealization. Firstly, we can’t have perfect information about the market. There are way too many details and way too many factors. Secondly, people do not have the computational ability to optimize. In all probability, in the words of Herbert Simon, they follow simple, common sense adaptive rules in reaching economic decisions.

A related assumption is of ‘rational expectations’ according to which economic actors have perfect foresight about the future state of the economy. And finally, based on the above is the infamous ‘efficient market hypothesis’: markets know best; they allocate resources in the best way, etc.

All these concepts and models are totally unrealistic. But it could be claimed (often is) that most sane economists already know that*. But then why, people might ask, would they persist in using such unrealistic models?

Well, because this is what Galileo has taught us! This is the scientific way of doing things; this is the Galilean style remember**? Frictionless planes, ideal gases…rational actors, efficient markets! What’s the problem?

If things could be left at that, then no fault could be found with our economist brothers. But unfortunately for them, their models do not work for practical purposes. If despite all the idealizations and abstractions, the models managed to work for the real world, I am sure no one would have a problem. But the system does not work. So here we  may ask, what is it that Galileo got right but our economist friends didn’t?

The short answer is that the Galilean style is not a magic wand. If it is pursued sensibly, it abstracts the crucial operating features. If it is not pursued sensibly, it abstracts features that have little relation to reality.

Frictionless planes made sense because Galileo wanted to discover the effects of gravity without the confounding effects of the force of friction. Rational models do not make sense because there is NO benefit of understanding actions of agents (people) with perfect information because people simply do not have perfect information and are not super-computational beings who can optimize for all situations. Therefore, the actions undertaken by the economists’ rational, omniscient beings, would be wildly different from the actions taken by ordinary, limited human beings. Similarly it makes no conceptual sense for the rational expectations assumption that calls for perfect foresight of the future: ordinary mortals can barely predict what will happen during the next few minutes, (even if they are given perfect information). And lastly, there is no empirical support for the “efficient market” hypothesis.

Imagine a world (not our world obviously) in which friction was directly linked to gravity. If in such a world, Galileo was obstinate enough to stick to his frictionless planes, despite all evidence to the contrary, despite no empirical support, then Galileo too would have suffered the same fate as our present day economists: Boom, bust, CRASH!

What economists end up doing is studying highly abstract systems that have got nothing to do with the real world. So while they follow the Galilean style, they do so insensibly and the results are out there for all to see!

(Endnote: The above naturally does not apply to all of economics but rather to the dominant, widely used, rational models)

*Apparently, only the sane ones. Some end up believing their own voodoo.

**Of course, the harsher judgment would be that what economists do has got nothing to do with Galileo but is rather a very virulent form of ideological fanaticism!

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rrameez

I am interested in understanding the links between science models and engineering models, and whether we can design a "science" for fields that require interdisciplinary research. Specifically, my field is the design of techno-social systems. Such systems are not traditional computing systems and require an inter-disciplinary approach for their design. Generally, I am interested in modeling and simulation, and seek to apply my knowledge of the same in various domains including arts, politics, science and engineering You can reach me at rrameez@gmail.com Rameez Rahman

11 thoughts on “Galileo and Economics”

  1. Hi,

    I stumbled on your blog via your Pig Data post, with which I agree. I have big issues with your Economics thought, though. Mainly – there is no such thing as a “rational actor” in Economics in the sense you put into the term. What you describe as a rational actor has nothing to do with any prevalent or even non-prevalent school of economics thought.

    A pretty good citation from Wikipedia should explain what I mean:

    Homo economicus is seen as “rational” in the sense that well-being as defined by the utility function is optimized given perceived opportunities. That is, the individual seeks to attain very specific and predetermined goals to the greatest extent with the least possible cost. Note that this kind of “rationality” does not say that the individual’s actual goals are “rational” in some larger ethical, social, or human sense, only that he tries to attain them at minimal cost. Only naïve applications of the homo economicus model assume that this hypothetical individual knows what is best for his long-term physical and mental health and can be relied upon to always make the right decision for himself. See rational choice theory and rational expectations for further discussion; the article on rationality widens the discussion.

    Some knowedgebale people on Quora also did a nice job: http://www.quora.com/Rational-Actor/What-is-a-rational-actor

    If you want a good firm grasp on economics with the least amount of effort I would suggest “Economics in One Lesson” by Henry Hezlitt. It can be downloaded for free from Mises.org.

    1. Hello Geo,
      Thanks for your nice and informative comment. Indeed I do realize that the model in its technical form does not at all imply larger social or ethical considerations. You can optimize for X and that X may be either altruism or selfishness or whatever. I agree with you. However, in practice, and as espoused by many proponents, it quickly goes down only one route. Just as a small example, and not to single him out or anything, in his introductory text on Game Theory, Ken Binmore makes the same points as you above. However, some pages down the road, it turns to: “For example, when waiting at an airport carousel for our bags, we would all be better off if we all stood well back so that we could see our bags coming. The same applies when people stand up at a football match or when they conduct their business in slow motion after reaching the head of a long line.When large numbers of anonymous folk play such social dilemmas, Kant and your mother are right to predict that things will work out badly if everybody behaves antisocially. But urging people to behave better in such situations is seldom very effective. Why should you lose out by paying heed to your mother when everybody else is ignoring theirs?”

      I don’t think the above is uncommon. Secondly, and more importantly, you are free to disagree with my critique, but surely you realize that its (the critique) not original or unique by any means. Perhaps the most famous example comes from an economist himself, Nobel Prize winner, Amartya Sen. I am sure you have read it, but if you haven’t, I would recommend that you read his essay “Rational Fools”.

      Finally, I accept that not all problems in economics are due to idealization. Some are technical in nature. 50 years ago the outstanding mathematician Benoit Mandelbrot argued out that neoclassical economics is using the wrong distributions, which vastly underestimate risk. It’s now belatedly recognized that he was probably right.

      Thanks again for your comment!

  2. I would completely agree with you in that any economics theory that proposes that people should change, e.g. in the airport carousel example, is simply wrong. A theory is just a model of reality and thus having such unrealistic assumptions renders is useless.

    A theory of a rational actor in the economic sense should (and most sensible ones do) include be centered around the fact that humans are utilitarian machines in their very core. Cost/benefit analysis is what we do every single minute of our lives (and cost, as well as benefit are in no way contrained in mere $$$). Avoiding paing and pursuing pleasure is what we are conditioned by. We do this imperfectly and we do this with limited knowledge. Furthermore the function depends on ones time horizon (2 minutes for a toddler, several years or a decade for a middle aged man, less so for an individual at the age of 90).

    Anyone’s theory which doesn’t take into account this simple fact should be put to rest. As you can see this description of a “rational actor” is much different than the one in your post. I have no high esteem for most current economists and the Nobel prize in this area is virtually a statement of how unfit the particular economist’s views are to reality and, on the other side, how good a fit they are with the goals of the gangsters ruling us all.

    I view the work of Amartya Sen as particularly misguided. Her notion of “commitment” is intended to show that a person can act against his *percieved* best interest. This can not happen. She fails to distinguish short-term gains from long-term gains. She calls short-term gains “rational action” and calls long-term gains “commitments” (cause that’s what they are). This is completely unnecessary and confusing.

    A rational actor tries to maximise his cost/benefit equation with regards to a given timeframe. Saying that one would waive short-term gains for long-term benefits is nothing new in economics or any other field of human study. This is the essence of our survival, this is the essence of capital (postponed consumption). If the person already has an idea of the long-term benefits of an action, whether you’d call it a commitment or not is irrelevant. If the benefits (adjusted with accord to his time-preference) are preferable to him compared to the immediate gain of pursuing another path, he would act in a way in which he believes he can achieve the long-term gain, scrificing his short-term ones.

    As for Mandelbrot’s work: I got superficially familiar with it and it seems to me that it is a custom case of the “heavy tails” issue which brought down some quite clever trading giants in the past. Not being a fan on neoclassical economics (at all!) this does not really bother me. To make the full circle: doesn’t Mandelbrot’s work concern exactly the application of “pig data” in economics or do I have it wrong?

    1. Yes, I think you are right (on Mandelbrot and pig data). There can be two contrasting positions on that. First is favorable to economists which is: The reason economics doesn’t do well or is not as productive as the natural sciences is because natural sciences explore their theories through carefully modeled experiments and not in the cluttered “world out there”. So for physics it doesn’t matter if the law of falling bodies doesn’t hold if i do an experiment outside my building with wind and all sorts of other factors playing a part. Physicists are simply not interested in that. They do their own carefully modeled experiments. Whereas on the other hand, economics is only productive insofar as its theories/models make sense in the cluttered “world out there”. And that’s simply not going to happen, just like the law of falling bodies won’t give me accurate results, if i tried to make sense of it by dropping a ball outside my window.

      The second position is this (not so favorable): It’s true that some areas of physics can do experiments (others, like cosmology, can’t) and that economics can’t. But that doesn’t account for the radical failure of assumptions like the Efficient Market Hypothesis and Rational Expectations Theory. Those are principles that have little if any empirical support or conceptual justification. And theorems that depend on assumptions about perfect information (even into the indefinite future) are so wildly unrealistic that it’s not surprising that the constantly fail.

      1. Thank you for your input on that.

        As far as “Efficient Market Hypothesis” goes, I think there is an important fact about how it is derived that you may not be aware of. It is derived based on a simple empirical observation – “Human action is an attempt to substitute a more satisfactory state of affairs for a less satisfactory one.” (L.V.Mises). Human action is what ecomics is about (all types of organizations are just a “sum” of such actions).

        Then *deductively* the whole theory of economics is built on top of that. Thus, no additional empirical observation are needed to support or reject the theory (even though evidence *does* is in fact aligned with it, just look at the recent regulatory-induced crisis). It can only be rejected if logical fallacies are found in different aspects of it, or if at some point in time humans stop acting in an attempt to improve their well-being, in which case in just a few months or years there will be no need for economics at all.

        At least this much is true for the Austrian school to which the book I recommended earlier is the most approachable introduction. Other schools are trying to ignore this and some attempt to use pig data, as you describe it, to come up with other satisfactory theories. What can be seen around us is partially an effect of this line of economic enquiry.

          1. I appreciate the video in terms of artistic value and yes, I do disagree with it’s tenants. It’s a straw man. It prortrais a rational egoist as uncooperative, heartless, not caring for other etc., capitalism as promoting hatred amongst humans and lacking compassion. In fact it’s completely the opposite – it’s the only tool that provides basis for productive cooperation in any area, it promotes caring for others, reciprocating, etc.

            The video should be targeted at the socialists who endorse and in fact subsidise lack of cooperation, lack of interest, rudeness, etc. towards others by making people think they can somehow bend reality through an imaginary entity called “the state”. All those “social” programs, you know, that’s what they really insentivise…

              1. Yes, this space is not appropriate for deeper discussions on such topics, but I remain open for other means of having a proper debate on these issues, if you might be interested in one (you have my e-mail). Thank you for your replies 🙂

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