Three Longs & Three Shorts

Everything We’ve Learned About Modern Economic Theory Is Wrong

Economists have been under attack as a profession collectively not least for their failures in predicting or explaining some of the economic events or even the divide over what’s now being referred to as Modern Monetary Theory. And often the criticism seems to come from the field of basic sciences, such as physics. One such theoretical physicist, Ole Peters, in a paper published late last year, seems to question the fundamental basis of modern economics – the expected utility theory i.e, the assumption that human beings act rationally for profit maximisation after a cost-benefit analysis. At the core of Peters’ argument is “ergodocity” – a concept that arose in nineteenth century physics, almost two centuries after the foundational concepts of risk and randomness originated in classical economics.
“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.
…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.
…Peters asserts his methods will free economics from thinking in terms of expected values over non-existent parallel universes and focus on how people make decisions in this one. His theory will also eliminate the need for the increasingly elaborate “fudges” economists use to explain away the inconsistencies between their models and reality.”