What is the Nobel Prize for economics?

Rational markets can be efficiently designed, most economists will concur. And by using complex algorithms and models, efficient markets can become ever more rational.

That was essentially the premise behind awarding this year’s Nobel Prize in Economics – the Sveriges Riksbank Prize – to two American luminaries of game theory, Alvin Roth and Lloyd Shapley. Designing systems to efficiently match students with schools, organs with recipients and husbands with wives, among other things, Roth and Shapley have independently advanced the science of cooperative game theory to improve markets and keep pushing out the ‘efficient frontier’.

Both recipients are undoubtedly well-deserving, having laboured for decades, publishing scores of papers between them and turning literally hundreds of students into avid game theory researchers themselves. Yet at a time of global economic turmoil, almost unprecedented in living memory, the choice is a curious one. Academic economics – a pinnacle of which is stochastic game theory – after all, can be as much to blame as any other cause of the GFC, whether that be global trade imbalances, income inequality, the failure of ratings agencies or mere regulatory incompetence. And, after awarding no less than eight previous Nobel Prizes to other game theorists before Roth and Shapley, surely Sweden’s Riksbank could have by now worked this out?

Alas however, within the cloistered halls of academic and central bank economics, it seems not. Economics here is seen as a science, something that can be accurately measured and rationally explained through mathematical models and theorems. Unlike the humanities, which use a different lens of understanding, economics as science is as predictable as the limits of probability allow.

But by treating economics in this way we face a prisoner’s dilemma. Not the prisoner’s dilemma of Cold War nuclear planning of course – a theoretical game interrogated by the RAND Corporation in the 1950s, where Shapley himself once worked – but the prisoner’s dilemma of Plato’s Allegory of the Caves, something you’d rarely see in a modern economics syllabus. Tied to the wall of a cave, the Greek philosopher postulated, and having only seen the world refracted into shadows, was the representation of a jar or an urn cast against the wall merely a symbolic vessel, or to these prisoners was it the real thing? Having seen no ‘real’ example, wouldn’t the shadow become the reality?

Expanded upon millennia later by French philosopher Jean Baudrillard, Plato’s cave wall shadows would to postmodern thinkers become ‘simulacra and simulation’, the title of Baudrillard’s 1985 text on the subject. And in a world of symbols and simulacra the representational would become the real. Indeed, to any reader of an online article on this subject, how could that not be so?

Yet returning to economics, herein lies the dilemma: how can a science that only deals in models and representations, that may or may not be true, be properly interrogated? How do we know – as Baudrillard asked, paraphrasing Argentine author Jorge Luis Borges – where the landscape of the map ends and the desert of the real begins?

If this all sounds a bit Matrix, it is – the film’s scriptwriters were big fans of Baudrillard – but it’s not mere fantasy. It’s indeed a question being asked by hedge fund manager Christopher Cole of Artemis Capital Management, who says that financial markets have become “a game of impossible objects.” And making a lot of money from trading volatility, Cole should know:

In a world where global central banks manipulate the cost of risk, the mechanics of price discovery have disengaged from reality,” Cole wrote in a recent letter to clients, “resulting in paradoxical expressions of value that should not exist according to efficient market theory.

He continues:

Fear and safety are now interchangeable in a speculative and high stakes game of perception. The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.

And the result of this, Cole says, is at the heart of our present crisis:

In the postmodern economy market expectations are more important to fundamental growth than the reality of supply and demand the market was designed to mimic. Our fiscal wellbeing is now prisoner to financial and monetary engineering of our own design. Central banking strategy does not hide this fact with the goal of creating the optional illusion of economic prosperity through artificially higher asset prices to stimulate the real economy. In doing so they are exposing us all to hyperreality or what Baudrillard called ‘the desert of real’.

To traders, not to mention economists who have puzzled over the increasing volatility of equity, debt and commodity markets in recent years, this much is obvious. Billionaire investor George Soros’s theory of financial reflexivity – essentially, that you make more money by predicting what other people will predict – has transmogrified into a Nyarlathotep of abstracted and semiotic markets.

It’s where the value of derivatives exceeds tenfold the value of real money and where bad economic news leads to good days on the share market, all in the vain hope that Ben Bernanke, or Mario Draghi, will print more money and save the day. It’s where, like Schrodinger’s cat, the Aussie dollar can be both a risk asset and a safe haven all at the same time. It’s where the Riksbank prize committee, in all their wisdom, can award money to the grand theorists of such a perverted system, and believe that they’re doing humanity a service.

But as we’ve written before in this column, the sacred idols of economics – infinite growth, logical actors, efficient markets, rational price discovery – are daily getting smashed on the rock of financial reality and by retreating into hermetic Gnosticism, academic practitioners of the dismal science are merely making themselves increasingly arcane, even irrelevant.

When we think of the world’s economic problems, what we need is not more efficient tools to game the broken model, but a new model, or preferably no model. When we consider the challenges humanity faces in the 21st century, when the first world pain of the GFC is long forgotten, what we need is a better philosophy and better institutions to underpin it, where the resources we have at our disposal can be distributed or put to work, in a fairer, more equitable and more humane manner than either socialism or capitalism can currently come up with.

Just as the first theorist of shadow games, Plato, was very much interested in good governance – he is perhaps best remembered today for his Republic – so too were the economists of the eighteenth and nineteenth centuries: Adam Smith, Jeremy Bentham, John Stuart Mill, Karl Marx and David Ricardo. And while it is not Nobel practice to posthumously award prizes to the centuries-long dead, perhaps future choices ought to be more focussed on those finding solutions for the common good, not the common denominator.

The nature of men and women who work in garrets, coming up with radical new philosophies, is that they’re generally unknown or unappreciated by their contemporaries – I can think of one Australian economics professor who fits this mould. But just as the Nobel Prize has experimented with radical selection in the Peace Prize – the European Union this year was a bold but enlightened choice – perhaps the economics division could seek such people out, leaving game theory to the Field Prize in mathematics.

It’ll stir up controversy for sure, but the alternative is just more of what we already have: shadow banking, shadow prices and shadow games. All representational and, ultimately, chimerical.

Michael Feller is an investment strategist at Macro Investor. If you take the red pill, Macro Investor is offering a free 21-day trial to new subscribers. If you take the blue pill, then you’ll awake in your bed, remember nothing, and believe whatever you want to believe.

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Comments

  1. Good article.

    Any successful or credible economic theory must include human behavior as an integral part of it. Either through chaos theory of Feigenbaum or perhaps through advanced neurons network or AI. Anything less is doomed to fail.

    BTW, your analogy of AUD to Schrodinger’s cat is not quite parallel. We can *observe* that AUD is “both a risk asset and a safe haven all at the same time”. We can only *observe* a cat that is either alive or dead.

  2. Goood discussion. Apropos this prize for game theory the originator, Nash, said later that his view of people at the time he created it was malicious and overly rational. In other words, it’s assumptions were wrong, though not as an intellectual exercise.

    Secondly, economics still depends on assumptions from the likes of Bentham et al and that is absurd. Bentham’s ideas are so weak, so easily knocked over, that a so-called sciene that uses assumptions directly from his ideas is in herehntly falwed. In fact it is not science, it is a cult.

    • Interesting information from your link,TP : “Remember when the options-pricing pioneer Robert Merton won the award in 1997 a year before his hedge fund Long Term Capital Management imploded and almost took down the world financial system?

      • That line really made me wince. The Black-Scholes-Merton model was quite extraordinary; it provided a pricing system that is now ubiquitous. There was nothing wrong with his academic work, LTCM was just way, way too leveraged. He was a most deserving recipient, and the collapse of LTCM in no diminished the mathematics he helped develop. Poor fund management, yes. Bad financial mathematician, certainly not.

        • thomickersMEMBER

          Good take on the LTCM incident.

          Strangely… I wonder if they were just a little bit less smarter and were unable to discover a model to pricing options, would they have lost a lot of money?

  3. Macroeconomics itself is the core of the problem. It lends itself to the notion of there being levers, tools, procedures that when pulled and manipulated by great brains and great computers will result in human happiness.

    Interest rates are the current fish of the day but tomorrow there will be new lever of choice.

    Plenty of need for regulation and enforcement but trying to ‘stimulate’ and otherwise manipulate the level of economic activity is the problem – or a good part of it.

    Less fiddling by the overconfident.

  4. An appreciating risk asset is the best safe haven. Attack is the best defence. Thats why economics is not science.

  5. gibber_blotMEMBER

    The Nobel Prize for Economics is a prize for mathematicians. And pretty weak maths, at that. Most of the models bare no resemblance to any market that I have ever seen.

      • In science and medicine yeah.

        Peace, maybe not so much – Barack Obama & the EU??

        Who’s next in line for that one…Bono???

        • Ok, I had physics in mind in particular.

          I mean, sometimes they made mistakes. After all, they awarded a Nobel prize for medicine for discovering cure for cancer in 1930s!

  6. The economics Nobel isn’t actually a nobel prize. Alfred Nobel specified physics, chemistry, medicine, literature and fraternity as the prize categories. The Swedish Bank originated the economics prize in 1969.

    Fittingly, it is economists creating the illusion of scientific merit by awarding themsleves prizes using a co-opted brand.

    I’m thinking of starting the “Award for telekinesis in memory of Alfred Nobel”.

  7. Yes it is a disgrace to the real Nobel laureates.

    They are not Nobel prize winners but Sveriges Riksbank Prize winners.

    Piggy-backing on the credibility of real science.

    Economics. The abysmal science. QED by GFC.

    Economists should do their homework and come back when they are finished. And show results.

    Until then no more self-aggrandising fake Nobel prizes.

  8. Economics is the only field in which two people can share a Nobel Prize for saying opposing things – Alazar

    Q: How many Chicago School economists does it take to change a light bulb?
    A: None. If the light bulb needed changing the market would have already done it.

    Q; How many central bank economists does it take to screw in a lightbulb?
    A: Just one – he holds the lightbulb and the whole earth revolves around him.

    Economists do it with models.

  9. A party of economists was climbing in the Alps . After several hours they became hopelessly lost. One of them studied the map for some time, turning it up and down, sighting on distant landmarks, consulting his compass, and finally the sun.

    Finally he said, ‘ OK see that big mountain over there?’

    ‘Yes’, answered the others eagerly.

    ‘Well, according to the map, we’re standing on top of it.’

  10. Well if you class economics as the study of people and incentives then in terms of science it is comparable to pychology. You can use mathematics to describe certain things within it, but at the end of the day, no two people are the same so you can only really talk about tendancies towards certain things.

    It is impossible to design perfect systems/formulas for the same reason you can’t predict how people are going to react and behave in certain situations. You can only really say what is likely to happen.

    Economics needs to start looking at problems as a pschology researcher looks at pschological theories. EG, people tend towards confirmity, people tend to obey authority figures, people tend to behave this way when certain things within the economy are triggered.

    At the end of the day, there will NEVER be some perfect system where everyone gets a ‘fair’ share (what’s fair anyway?) because humans, like any social animal, are heirarchical and like all animals are selfish in certain ways (but unselfish in others due to our social nature). One persons ‘fair’ can be extremely unfair to another, especially when you get an overriding authority involved.

  11. There are three kinds of economists: those that can count and those that can’t.

    President Harry Truman famously asked to be sent a one-armed economist, having tired of exponents of the dismal science proclaiming “On the one hand, this” and “On the other hand, that”.

  12. Many of the critical comments here seem to have missed Alvin Roth’s very real contributions both to economic analysis and human welfare. His application of matching theory to kidney exchange (for example) has (arguably) saved thousands of lives. He did this by publishing highly theoretical models in economics journals then speaking to doctors about how to apply his ideas in practice. Simply googling “Alvin Roth Kidney Exchange” provides all of the details.

    Many previous Economics ‘Nobel’ recipients could be criticised for the abstract and irrelevant nature of their work, but not this year’s.

    http://www.reuters.com/article/2012/10/15/nobel-prize-roth-kidney-idUSL1E8LFFW320121015

    http://en.wikipedia.org/wiki/Alvin_E._Roth#New_England_Program_for_Kidney_Exchange

  13. A great post Flashman.
    Just a quick philosophical point. I disagree with Plato and Baudrillard. We never have access to Reality even if we wonder out the cave or stop staring at stock prices and wonder down to our local fruit market. Another set of individual and collective illusions simply take over, which is OK- I’m not advocating some transcendental mumbo-jumbo here or suggesting that one illusion isn’t preferable to another.

    I just think that the idea of Global Capitalism (of which shadow banking and finance are a part) has become so large, unrelenting,and bigger that the ‘State’ that it’s worth thinking about the ideological constructs that occupied minds before the past few decades of globalisation and global capitalism.

    Could we see returns to nationalism, faith in science, or something else? If I were to take a punt I’d say class politics will spring up sooner or later as we’re starting to see in the US elections. Slowly but surely.

  14. This is the second post in the last few days wherein the author confused the notional value of a derivative with its market value. I’m surprised, it’s a seriously elementary mistake.

    When someone says the ‘value’ of derivatives exceeds tenfold the value of money, they’re comparing the notional value of outstanding derivatives contracts with M3 or broad money. But as I said on SoN’s latest post, quoting the notional value of a derivative is like quoting the value of a house and saying that that’s what a photo of the house is worth. The accumulated global derivatives market isn’t worth hundreds of trillions, any more than a piles of photos of houses in my city is worth hundreds of millions. Notional value just produces a Big Scary Number which people enjoy bandying around, but it betrays a certain financial illiteracy when they do.

    By far the biggest OTC derivative market is the interest rate swaps market, accounting for around 60% of outstanding contracts. To me, a party in an interest rate swap, the value of the swap is simply the net difference between the present value of the payments I must make and the PV of the payments I receive. The payments are derived from some notional underlying principal, but this principal is not at stake in the swap. All that is at stake is the respective streams of interest rate payments. The principal never changes hands, so the notional value is irrelevant. What matters is the market value of the contract, and obviously it’s tiny compared to the value of the underlying principal, or notional value, of interest rate swaps.

    So whilst the notional value of OTC derivatives was some $650 trillion at the end of last year, the market value of the derivatives market was $27 trillion, less than half global broad money supply, and considerably less than equities markets or conventional FI markets.

    http://www.bis.org/statistics/otcder/dt1920a.pdf (you need to add a little more on for exchange-traded derivatives, but it’s still a fairly negligible proportion of the total).

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  16. John Nash’s nickname for primitive game-theory was “fuck-you buddy”. The Sveriges Riksbank has awarded the fake-Nobel in economics against the expressed wishes of the Nobel family and countless real Nobel winners for decades now. If they want to mock his memory, then they should add a prize for astrology as well.