Wednesday, July 22, 2009

Modern Economic Theory -- where it went wrong and how the crisis is changing it

When I travel there are two things that I never leave home without -- my BOSE headphones and the latest issue of The Economist. Many overseas flights have been more enjoyable and productive because of these two reliable "companions." My next trip, which will not require an airplane, however, will be to Cambridge (Massachusetts) to teach a course in Executive Education at Harvard University. The course is on portfolio optimization, clearly a very timely topic given the financial crisis. My lecture and handouts are prepared and I am ready for an exciting experience. I will be bringing, of course, my latest issue of The Economist (July 18-24, 2009), which is motivating, in part, this posting.

The cover of this issue of The Economist has a brown book with the title, "Modern Economic Theory," that is melting like chocolate in the summer heat. The caption reads: "Where it went wrong -- and how the crisis is changing it." The issue has several articles, which further reinforced the relevance of my my perspective on the material that I will be covering in my course at Harvard.

My view of portfolio optimization is that of a critical building block for general financial models that can capture complex interactions among agents in the economy. Classical portfolio optimization problems also have an elegant network structure that can be exploited both for conceptualization and visualization purposes and also for computation of solutions. Such building blocks can help in the construction of macroeconomic models in which one can then explore all sorts of policies such as taxes, tariffs, price supports, transaction costs, etc., and upon which one can also build international financial network models and even explore financial intermediation. I have been writing a lot on financial networks with intermediation and electronic transactions and have supervised doctoral dissertations on the subject.

Amazingly, in an article, in this issue of The Economist, on page 66, is written "In many macroeconomic models, therefore, insolvencies cannot occur. Financial intermediaries, like banks, often don't exist." Perhaps some of those macroeconomic modelers should read the literature! A great place to start would be the volume: "Innovations in Financial and Economic Networks" that I edited in 2003 and was published by Edward Elgar. Other relevant papers can be found on the Virtual Center for Supernetworks website.

Then, to add further injury, on page 67, and I quote a remark attributed to David Colander, who has been surveying economists: "Instead of solving models 'by hand', using economists' powers of deduction, he proposes simulating economies on the computer." The entire field of Computational Economics is over a decade old and those of use who work in the interfaces of operations research and economics and finance well know the power and the use of not only mathematical models to capture the intricacies of human and economic interactions but also the use of algorithms and computers to predict the results of such interactions, including product and financial flows and prices. We have a Society for Computational Economics, an annual conference (the most recent one just concluded in gorgeous Sydney, Australia), and even a journal!

There is a serious disconnect between the literature and the state-of-the-art and what some economists and policy makers are aware of. It is high time that areas of computational social sciences, including computational economics, get the recognition that they deserve! There is some hope, nevertheless -- on page 69 of the same issue of The Economist, Andrew Lo of MIT is quoted and his novel idea of creating a financial equivalent of the National Transport Safety Board to deal with future financial crises! Coincidentally, and you heard it here first, we will be hosting Professor Lo in our Fall 2009 INFORMS Speaker Series at UMass Amherst (co-sponsored with the Finance series). I can hardly wait!