• 042-35941921, UAN: 03-111-999-101
  • info@kipscss.net

Economics

  • Brandon Kochkodin
  • Jan, 2021
  • 201
  • Everything We’ve Learned About Modern Economic Theory Is Wrong

Ole Peters, a theoretical physicist in the U.K., claims to have the solution. All it would do is upend three centuries of economic thought

The proposition is about as outlandish as it sounds: Everything we know about modern economics is wrong.

And the man who says he can prove it doesn’t have a degree in economics.

But Ole Peters is no ordinary crank. A physicist by training, his theory draws on research done in close collaboration with the late Nobel laureate Murray Gell-Mann, father of the quark. He’s also won over two noted thinkers in the world of finance - Nassim Nicholas Taleb and Michael Mauboussin - not to mention a groundswell of enthusiastic supporters in the Twittersphere.

His beef is that all too often, economic models assume something called “ergodicity.” That is, the average of all possible outcomes of a given situation informs how any one person might experience it. But that’s often not the case, which Peters says renders much of the field’s predictions irrelevant in real life. In those instances, his solution is to borrow math commonly used in thermodynamics to model outcomes using the correct average.

If Peters is right - and it’s a pretty ginormous if - the consequences are hard to overstate. Simply put, his “fix” would upend three centuries of economic thought, and reshape our understanding of the field as well as everything it touches, from risk management to income inequality to how central banks set interest rates and even the use of behavioral economics to fight Covid-19.

“The problem is that much of academic economics has gone off the rails,” Peters, lead researcher of the London Mathematical Laboratory’s economics program, wrote in an email. “We can trace back the reasons for this to the 17th century, but it’s important, first of all, to state clearly that something is not the way it should be, and that any statements coming from economics must be evaluated carefully because they may be based on flawed reasoning.”

Peters is far from the first to play the part of the outsider coming to bravely save economics from itself. There’s even a joke among economists that every few years, a physicist stumbles into the field, looks at the math and declares that none of it makes sense (and then tries in vain to fix it). He concedes his ideas haven’t gotten very far with actual economists. Many have either rejected them outright or dismissed them as nothing more than a willful misunderstanding of the facts. (More on that later.)

Yet despite what dyed-in-the-wool economists might think, he’s developed a wide and devoted online following since his paper “The Ergodicity Problem in Economics” was published late last year. Next month, his institute will hold a virtual conference on all things related to Peters’ work, from explainers to implications for fields as varied as finance and medicine. It has already attracted over 500 attendees from around the world, even a few economists.

Peters takes aim at expected utility theory, the bedrock that modern economics is built on. It explains that when we make decisions, we conduct a cost-benefit analysis and try to choose the option that maximizes our wealth.

The problem, Peters says, is the model fails to predict how humans actually behave because the math is flawed. Expected utility is calculated as an average of all possible outcomes for a given event. What this misses is how a single outlier can, in effect, skew perceptions. Or put another way, what you might expect on average has little resemblance to what most people experience.

Consider a simple coin-flip game, which Peters uses to illustrate his point.

Starting with $100, your bankroll increases 50% every time you flip heads. But if the coin lands on tails, you lose 40% of your total. Since you’re just as likely to flip heads as tails, it would appear that you should, on average, come out ahead if you played enough times because your potential payoff each time is greater than your potential loss. In economics jargon, the expected utility is positive, so one might assume that taking the bet is a no-brainer.

Yet in real life, people routinely decline the bet. Paradoxes like these are often used to highlight irrationality or human bias in decision making. But to Peters, it’s simply because people understand it’s a bad deal.

FLIP A COIN?

Even with increased payouts for winning flips, and a 50-50 chance of landing on heads each time, the game is a loser fig.1

Here’s why. Suppose in the same game, heads came up half the time. Instead of getting fatter, your $100 bankroll would actually be down to $59 after 10 coin flips. It doesn’t matter whether you land on heads the first five times, the last five times or an...

Share on facebook or twitter

Email to a friend