Economics is a subject of great interest and of paramount importance. It seeks to distil every single one of our individual psychologies and decisions into a simplified mathematical value assigned to a resultant effect. By all means, if economists were not called economists, they would undoubtedly be named the great quantifiers of our world. But human beings are almost infinitely complex in our decision making. Rationality is subjective to a far greater degree than any economist would like it to be. Evidence for this can be found in studying the 2008 crash, we see that previous to the crash in 2007, 25 standard-deviation events occurred in the financial markets according to a Goldman Sachs risk model. Events such as these are only calculated to occur once every million million years, yet according to these risk models these were occurring several days in a row.
So what is wrong with these models? Well, the answer lies within the history of economic theory. Economics is a product of maths and sociology and psychology but during the “Great Enlightenment” as Isaac Newton developed the scientific method, it became logical for scientists to be able to explore the direct effects of changing variables in experiments and plotting “x” against “y”. However these experiments occur under controlled conditions where all else remains the same. In economics, because of the complexity of human behaviour this is not possible to do so and the first of the gross generalisations in the field is established: “ceteris paribus,” allowing us to treat supply and demand with as much surety as we would velocity and time. Moreover, this sets a dangerous precedent that risk models based on probability are treated as certainties as with the results of any scientific experiment. Economic predictions themselves are important factors in influencing the effects on a market as is shown when share prices become artificially inflated after predicted price increases.
The fact is that while economics appears to wear a scientific façade, it is in need of updating urgently. Complexity theorists in mathematics are working to develop economic models which better suit real life as our current models imagine the world to be full of rational decision makers. We do not need to create models for “homo economicus” however for the individuals who exist in reality. High and low probabilities are the artifices of models. A French economist described this as the Allais paradox almost sixty years ago. Compounding the probability of model failure and the probability of events occurring according to any model, leads to an almost immediate discrepancy from the certainty which we want models to give us and the reality that our confidence in models which assume rationality is in itself irrational. As Isaac Newton famously said after losing much of his fortune in the 1712 South Sea Bubble: “I can calculate the motions of heavenly bodies, but not the madness of people.” This is the greatest flaw in economic theory.