<![CDATA[Everything We’ve Learned About Modern Economic Theory Is Wrong]]>

But Ole Peters is no ordinary crank. A physicist by training, his theory draws on research done in close collaboration with the late Nobel laureate Murray Gell-Mann, father of the quark. He’s also won over two noted thinkers in the world of finance — Nassim Nicholas Taleb and Michael Mauboussin — not to mention a groundswell of enthusiastic supporters in the Twittersphere.

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.

If Peters is right — and it’s a pretty ginormous if — the consequences are hard to overstate. Simply put, his “fix” would upend three centuries of economic thought, and reshape our understanding of the field as well as everything it touches, from risk management to income inequality to how central banks set interest rates and even the use of behavioral economics to fight Covid-19.

“The problem is that much of academic economics has gone off the rails,” Peters, lead researcher of the London Mathematical Laboratory’s economics program, wrote in an email. “We can trace back the reasons for this to the 17th century, but it’s important, first of all, to state clearly that something is not the way it should be, and that any statements coming from economics must be evaluated carefully because they may be based on flawed reasoning.”

Peters is far from the first to play the part of the outsider coming to bravely save economics from itself. There’s even a joke among economists that every few years, a physicist stumbles into the field, looks at the math and declares that none of it makes sense (and then tries in vain to fix it). He concedes his ideas haven’t gotten very far with actual economists. Many have either rejected them outright or dismissed them as nothing more than a willful misunderstanding of the facts. (More on that later.)

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.

Starting with $100, your bankroll increases 50% every time you flip heads. But if the coin lands on tails, you lose 40% of your total. Since you’re just as likely to flip heads as tails, it would appear that you should, on average, come out ahead if you played enough times because your potential payoff each time is greater than your potential loss. In economics jargon, the expected utility is positive, so one might assume that taking the bet is a no-brainer.

Yet in real life, people routinely decline the bet. Paradoxes like these are often used to highlight irrationality or human bias in decision making. But to Peters, it’s simply because people understand it’s a bad deal.

Here’s why. Suppose in the same game, heads came up half the time. Instead of getting fatter, your $100 bankroll would actually be down to $59 after 10 coin flips. It doesn’t matter whether you land on heads the first five times, the last five times or any other combination in between.

The “likeliest” outcome of the 50-50 proposition would still leave you with $41 less in your pocket.

Source: Bloomberg

Note: Each player starts with $100. Landing on heads results in a 50% increase in wealth. Tails results in 40% loss. The game assumes players will land on heads half the time and tails half the time given a large enough sample.

Now, say 10,000 people played 100 times each, without assuming all players land on heads exactly 50% of the time. (This mimics what happens in real life, where outcomes often diverge dramatically from the mean.)

Well, in that case, one lucky gambler would end up with $117 million and accrue more than 70% of the group’s wealth, according to a natural simulation run by Jason Collins, the former head of behavioral economics for PwC in Australia who has written extensively about Peters’ research. The average expected payout, pulled up by a lucky few, would still be a hefty $16,000.

“For most people, the series of bets is a disaster,” Collins wrote. “It looks good only on average, propped up by the extreme good luck” of a just a handful of players.

While Peters employs plenty of high-level math to make his case, an experiment by a group of neuroscientists in Copenhagen also put his theory to the test. And in the lab, people changed their willingness to take risks when the circumstances changed, in ways his equations anticipated, even when classical economic theory suggested that doing so would be considered irrational.

“There’s a sense that ergodicity economics can’t possibly be right because it’s too simple,” said Oliver Hulme, one of the experiment’s designers. However, it “made a very bold, falsifiable prediction” that stood up, he said.

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.

And according to Peters, one of those “fudges” just happens to be the entire field of behavioral economics, which has won widespread acclaim — not to mention a couple of Nobel Prizes — over the past decade for explaining all the mind-bending ways people don’t act rationally. Instead, he says the field might be better explained as a symptom of economics’ lack of formal rigor.

It’s no surprise that economists haven’t quite embraced Peters’ point of view. Numerous economics journals have rejected his paper on the basis that it simply wouldn’t be of interest to their readers.

Benjamin Golub, an economics professor at Harvard University, is less charitable. He lambasts Peters for misunderstanding the economic theory behind decision making and says Peters’ work ultimately amounts to little more than a straw-man argument that solves a narrow set of problems that already had well-known solutions.

“Peters’ thesis is that he has discovered a hidden assumption of economic theory that undermines its validity, but it’s not there,” he wrote in an email. Even if Peters wasn’t “confused” about the content, Golub says “he would still be off the mark understanding what its remaining open problems are. That is part of the reason no expert takes him seriously.”

Nevertheless, Peters’ theory has earned plenty of praise from heavyweights outside of economics. Taleb, of “Black Swan” fame, has promoted Peters’ work on Twitter and in his own scientific papers, and has called his findings “100% correct.”

Mauboussin, the former head of global financial strategies at Credit Suisse, Rick Bookstaber, a former risk manager at Bridgewater who helped draft the Volcker Rule while serving at the SEC and U.S. Treasury, and Emanuel Derman, a pioneer of quantitative investing, have also supported Peters’ research on ergodicity economics.

His paper, which ultimately found a place in the prestigious Nature Physics journal, quickly became one of its most popular. (For what it’s worth, his work has even inspired a hardboiled, German-language thriller titled Gier, about a man who was murdered for his incendiary ideas about economics.)

“The notion of utility may exist, but not in the way the psychologists and economists have modeled it,” Taleb said. “The results are monstrous.”

Flip a Coin?

Start with $100, End with $59