If correct these theories could reshape our understanding of economics 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.
Ole Peters is lead researcher of the London Mathematical Laboratory’s economics program and his theory has also won over two noted thinkers in the world of finance in Nassim Nicholas Taleb and Michael Mauboussin.
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.
Peters says the way we think of “ergodicity” is that 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. In those instances, his solution is to borrow math commonly used in thermodynamics to model outcomes using the correct average.
“The problem is that much of academic economics has gone off the rails,” said Peters.
“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 has developed a wide and devoted online following since his paper “The Ergodicity Problem in Economics” was published late last year. Peters takes aim at expected utility theory. 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 that expected utility is calculated as an average of all possible outcomes for a given event. In other words, what you might expect on average has little resemblance to what most people experience.
Consider a simple coin-flip game:
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. If you flip 100 times you expect to get 50 heads and 50 tales. 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.
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.
“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 just a handful of players.
“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. 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, lambasts Peters for misunderstanding the economic theory behind decision making.
“Peters’ thesis is that he has discovered a hidden assumption of economic theory that undermines its validity, but it’s not there,” he wrote. 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.”
His paper, which ultimately found a place in the prestigious Nature Physics journal, quickly became one of its most popular.
“The notion of utility may exist, but not in the way the psychologists and economists have modeled it,” Taleb said. “The results are monstrous.”