One of the speculations I have made from time to time is that the very assumptions underlying neoclassical economic theory are so flawed in comparison with reality that the theory, while elegant, and able to generate wonderfully pretty mathematical graphs, is deeply flawed.

One such problem is that neoclassical economic theory made use of the mathematics of 19th century Newtonian physics. And just as quantum theory and the theory of relativity gave rise to startlingly different results, if one applies 20th century physics to economic theory, the entire notion of equilibrium breaks down, and one sees radically different predicted results.

Now, along comes Professor Avinash D. Persaud and gives a pointed example. Once you import the Heisenberg uncertainty principle into financial risk models, then instead of generating a stable equilibrium, they drive investors over a cliff:

[Some] have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this...but many regulators and central bankers chose to ignore them both.

The technical explanation is that market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them....

In today’s flat world, market participants from Argentina to New Zealand have the same data.... [and] move into the favoured markets and out of the unfavoured.... [U]nder the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. They are transformed into the precise opposite.

When a market participant’s risk model detects a rise in risk in his portfolio, perhaps because of some random rise in volatility, and he tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues of vertical price falls prompting further selling. Liquidity vanishes down a black hole. The degree to which this occurs is less to do with the precise financial instruments, but more with the depth of diversity of investor behaviour. Paradoxically, the observation of areas of safety in risk models, creates risks and the observation of risk, creates safety.

Quantum physicists will note a parallel with Heisenberg’s uncertainty principle.

Policy makers cannot claim to be surprised by all of this. The observation that market-sensitive risk models, increasingly integrated into financial supervision in a prescriptive manner, was going to send the herd off the cliff edge was made soon after the last round of crises. Many policy officials in charge today, responded then that these warnings were too extreme to be considered realistic.

Until neoclassical economic theory is successfully challenged on its basic premises, we will continue to get policy prescriptions which fail to rein in ruinous speculation, and reward the wealthy and powerful at the expense of the average citizen. Recognizing that seemingly small changes in its basic assumptions generate huge differences in results is a necessary start.

UPDATE 4/3/08: Here is another timely example of how the Heisenberg principle should be included in economic models, courtesy of Mike Shedlock, a/k/a Mish today:

While it's true the Fed typically only does what is expected, those expectations become distorted over time by observations of Fed actions.

For example: If market participants are expecting the Fed to cut on weakness and the Fed does, market participants gets into a psychology of expecting more cuts on more weakness. Here is another example: If market participants expect the Fed to cut rates when economic stress occurs, they will takes positions based on those expectations. These expectation cycles can be self reinforcing.

The Observer Affects The Observed

The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg's Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.

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A good example of this is the 1% Fed Funds Rate in 2003-2004. It is highly doubtful the market on its own accord would have reduced interest rates to 1% or held them there for long if it did.

What happened in 2002-2004 was an observer/participant feedback loop that continued even after the recession had ended. The Fed held rates rates too low too long. This spawned the biggest housing bubble in history. The Greenspan Fed compounded the problem by endorsing derivatives and ARMs at the worst possible moment.