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Even a Caveman Can Understand Why Economics Fails

When it comes to understanding the financial world, I usually don't know what the hell is going on. And there's a good chance neither do you.

It's not for lack of trying, or (excessively) low IQ. Nor is it that we always get it wrong. But trying to decode the morning WSJ or the ceaseless babble on CNBC recalls the opening of the film "2001: A Space Odyssey."

That's the scene where humankind's distant ancestors, waking from a peaceful night's sleep on the African plain, are suddenly confronted with a mysterious black obelisk. Their response, accompanied by a lot of frantic shrieking and hopping around, is familiar: What the hell is going on?

As a species, it seems, homo economicus is almost as primitive as homo sapiens. Which is why it's no surprise that every financial crisis is followed by much frantic shrieking and hopping around by businesspeople, economists, journalists and consumers. Old theories are torn down, older ones resurrected. We prod our once trusty quantitative models for signs of life. When new facts challenge our cherished beliefs -- home prices always rise, markets are efficient -- we bare our fangs.

Since the latest meltdown, much of the blame for this sorry state of affairs has correctly fallen on the "dismal science." Thomas Carlyle's description of economics turns out to be only half true, because there's nothing especially scientific about it.

Most of its practitioners value broadly descriptive, "elegant" ideas more than empirical observation. Once adopted, theories turn hard as bone, which economists from rival clans use to club each other with. Worse, the profession apes the scientific method by emphasizing arcane financial math and half-baked experiments, often not to check underlying assumptions but rather to reinforce them. Intellectual bubbles inevitably yield financial bubbles, as "fat tails" whip around to smack us in the face.

Is there a way out of the desert? Just possibly, and it comes in the form of the physical sciences. So-called econophysicists are devising new ways of understanding economic phenomena that rely on observation and testing. And they're discovering that disasters in the financial world and in the physical world often look alike:

Scientists have found that earthquakes, natural and financial, share similar patterns. Small, subtle market gyrations are such regular occurrences that they are barely noticed; extreme market shocks -- the proverbial "Big One"-- are very rare. So too with earthquakes, which also adhere to a statistical relationship known as a power law.

Economic earthquakes also trigger dangerous aftershocks. Just as 19th-century Japanese geophysicists discovered that aftershocks continue to reverberate well after a first major tremor hits, modern-day stock market seismologists have identified a similar pattern with financial crashes.

That seems to describe how the housing crash in the U.S. rippled into a banking and sovereign debt crisis in Europe. Econophysics also points to runaway executive compensation in the financial industry as a sign that the free market has broken down, as one Purdue University researcher recently concluded.

The approach might even let banks -- and regulators -- test a new financial product in the lab before it is loosed on the global economy. Writes econophysicist Jean-Philippe Bouchaud, head of research at investment firm Capital Fund Management:

Innovations in financial products should be scrutinized, crash tested against extreme scenarios and approved by independent agencies, just as we have done with other potentially lethal industries (chemical, pharmaceutical, aerospace, nuclear energy, etc.).
Interestingly, the emergence of econophysics since the mid-1990s represents a return to roots for economics. Giants of the field, like Alfred Marshall in the late-19th century, were heavily influenced by earlier ways of studying physics. And the ideas have moved in both directions, with economists also shaping physics in more recent years.

Of course, if the markets are prone to random walks, so are the sciences. The history of scientific discovery is anything but linear, full of false starts and dead ends. Econophysicists themselves argue about whether their methods are sufficiently rigorous and their findings too broad to be precise. It's too early to tell.

The more obvious problem is that economic disasters are more complex than natural ones. That's because they're man-made. Seismographs are pretty good at picking up tremors in the earth's crust, but we have yet to develop a sure-fire device for reading flutters in the economy, otherwise known as us.

The tectonic plates here consist of countless social, political and economic dynamics, all grinding against each other in ways that defy easy interpretation, let alone precise measurement. Complexity, as one economist said, breeds perplexity.

I'm all for letting physicists and other eggheads take a crack at deciphering the hidden patterns of finance. If there's a general theory of economic relativity waiting to be uncovered, let's get to it (anything is better than having to watch "Mad Money"). But I won't be surprised if they're soon gibbering at the obelisk like the rest of us.