Steve Hsu (hap tip Efrain)

... is another physics type who is interested in markets, though it seems that he is actually a physicist still, so I don't know how much solidarity he'd muster for us dropouts. At any rate, he also has a blog that mashes up all sorts of intellectual endeavour. Today's missive is about Keynes' brand of economics:

As someone with a mathematical bent I was not initially drawn to Keynes' brand of economics -- my interests were in areas of modern finance like option pricing theory, volatility, stochastic models. But like Keynes I have seen a bubble up close -- first in Silicon Valley, and now, from a greater distance, the current credit crisis. What seemed to be reasonable rough approximations: efficient markets, no arbitrage conditions, stochastic processes, etc., are now revealed as terribly naive and dangerous. And so over time my views have come to resemble those described below. (See my talk on the financial crisis, and this Venn diagram.)

The views described below are a piece that is floating around the intertubes this morning from the NYT magazine -- Keynes biographer basically says that Keynes came up with the idea of the black swan and not that self-aggrandizing Taleb bozo.

Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes.

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

This is all great and I am in complete agreement. Markets are traded by monkeys. The future is hard to predict. In the absence of information (and even sometimes in its presence) we look to our neighbor to figure out what to do. The possibility of feedback under such circumstance is obvious.

But what is new in all this? Anybody who has worked in markets for any length of time already knew that the emperor had no clothes. Disrobing Alan Greenspan and his flawed ideology is not an intellectual challenge. These guys were like the flat earth club -- fine if your in the mood to argue a bit and get into the philosophical details of what the word "proof" might mean, but a boring distraction when it comes to shipping cheap plastic shit from Long Doc to Long Beach.

What is challenging is figuring out if there are patterns to the "irrationality" of markets, and if these patterns are stable enough to be studied and related to other systems we can study in the same way that classical economics is related to physical systems that tend toward equilibrium. The sad things is that I'm sure there are economists out there studying this stuff. Only physicists (not Hsu of course) think that physics is the only science just because it happens to be the simplest one (excepting perhaps mathematics). Why don't these guys get a voice? Why is orthodoxy such a stunningly powerful force in academia?

I guess I think that the really disturbing thing is not that the emperor has no clothes, but the fact that so many people are surprised by this.