Friday, July 17, 2009

The Evolution of Economics

One economist leading the effort to define that new paradigm is Andrew Lo, of the Massachusetts Institute of Technology, who sees merit in both the rational and behavioural views. He has tried to reconcile them in the “adaptive markets hypothesis”, which supposes that humans are neither fully rational nor psychologically unhinged. Instead, they work by making best guesses and by trial and error. If one investment strategy fails, they try another. If it works, they stick with it. Mr Lo borrows heavily from evolutionary science. He does not see markets as efficient in Mr Fama’s sense, but thinks they are fiercely competitive. Because the “ecology” changes over time, people make mistakes when adapting. Old strategies become obsolete and new ones are called for.

That is from an article in the Economist describing how the rational expectations school of economics has been discredited. Behavioral economics has been successful at exposing the fallacies of rational expectations, but it has not succeeded in creating a new framework. A new approach adopts elements of both schools, and places them in a dynamic evolutionary framework.