WARNING: Physics Envy May Be Hazardous To Your Wealth!

The quantitative aspirations of economists and financial analysts have for many years been based on the belief that it should be possible to build models of economic systems - and financial markets in particular - that are as predictive as those in physics. While this perspective has led to a number of important breakthroughs in economics, "physics envy" has also created a false sense of mathematical precision in some cases. We speculate on the origins of physics envy, and then describe an alternate perspective of economic behavior based on a new taxonomy of uncertainty. We illustrate the relevance of this taxonomy with two concrete examples: the classical harmonic oscillator with some new twists that make physics look more like economics, and a quantitative equity market-neutral strategy. We conclude by offering a new interpretation of tail events, proposing an "uncertainty checklist" with which our taxonomy can be implemented, and considering the role that quants played in the current financial crisis.Comment: v3 adds 2 reference

The Global Financial Crisis and the Shift to Shadow Banking

While most economists agree that the world is facing the worst economic crisis since the Great Depression, there is little agreement as to what caused it. Some have argued that the financial instability we are witnessing is due to irrational exuberance of market participants, fraud, greed, too much regulation, et cetera. However, some Post Keynesian economists following Hyman P. Minsky have argued that this is a systemic problem, a result of internal market processes that allowed fragility to build over time. In this paper we focus on the shift to the 'shadow banking system' and the creation of what Minsky called the money manager phase of capitalism. In this system, rapid growth of leverage and financial layering allowed the financial sector to claim an ever-rising proportion of national income-what is sometimes called 'financialization'-as the financial system evolved from hedge to speculative and, finally, to a Ponzi scheme. The policy response to the financial crisis in the United States and elsewhere has largely been an attempt to rescue money manager capitalism. Moreover, in the case of the United States. the bailout policy has contributed to further concentration of the financial sector, increasing dangers. We believe that the policies directed at saving the system are doomed to fail-and that alternative policies should be adopted. The effective solution should come in the way of downsizing the financial sector by two-thirds or more, and effecting fundamental modifications