Author: Gresham College
An exploration of the remarkable consequences of using Boltzmann’s 1870s probability theory and cutting-edge 20th Century mathematics in economic settings. An understanding of risk, market stability and economic inequality emerges.
The lecture presents two problems from economics: the leverage problem “by how much should an investment be leveraged”, and the St Petersburg paradox. Neither can be solved with the concepts of randomness prevalent in economics today. However, owing to 20th-century developments in mathematics these problems have complete formal solutions that agree with our intuition. The theme of risk will feature prominently, presented as a consequence of irreversible time.
Our conceptual understanding of randomness underwent a silent revolution in the late 19th century. Prior to this, formal treatments of randomness consisted of counting favourable instances in a suitable set of possibilities. But the development of statistical mechanics, beginning in the 1850s, forced a refinement of our concepts. Crucially, it was recognised that whether possibilities exist is often irrelevant — only what really materialises matters. This finds expression in a different role of time: different states of the universe can really be sampled over time, and not just as a set of hypothetical possibilities. We are then faced with the ergodicity problem: is an average taken over time in a single system identical to an average over a suitable set of hypothetical possibilities? For systems in equilibrium the answer is generally yes, for non-equilibrium systems no. Economic systems are usually not well described as equilibrium systems, and the novel techniques are appropriate. However, having used probabilistic descriptions since the 1650s economics retains its original concepts of randomness to the present day.
The solution of the leverage problem is well known to professional gamblers, under the name of the Kelly criterion, famously used by Ed Thorp to solve blackjack. The solution can be phrased in many different ways, in gambling typically in the language of information theory. Peters pointed out that this is an application of the ergodicity problem and has to do with our notion of time. This conceptual insight changes the appearance of Kelly’s work, Thorp’s work and that of many others. Their work – fiercely rejected by leading economists in the 1960s and 1970s – is not an oddity of a specific case of an unsolvable problem solved. Instead, it is a reflection of a deeply meaningful conceptual shift that allows the solution of a host of other problems.
The transcript and downloadable versions of the lecture are available from the Gresham College website:
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Video source Vimeo