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So I got pulled into economics in 2007 because of the 2008 economic crisis. Mike Brown who
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had been the first CFO of Microsoft, Chief Financial Officer of Microsoft and treasurer
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of Microsoft, he came to Toronto in 2007 and took my wife and I out to dinner and said
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he was trying to put together a research group to work on economics and he would like me
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to be involved. And I said, "I don't know anything about economics." And he said, "That's
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okay because nobody does and the whole system is about to collapse." He said, "The balance
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sheets of all the big investment banks -- it's like they have cancer. They're full of holes."
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And I remember being very struck by this because this was before anybody was talking about
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this.
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And so I started to meet with a group of people that he was pulling together to understand
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what was gonna happen and to understand if there was any way to save the situation. It
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was a very ambitious thing and, of course, we failed. But along the way I was motivated
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as a kind of public service to get interested in economics.
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And what I found . . . economics, in a way, is very easy for a physicist to understand
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because it's very mathematical. And the mathematical models that they use are very clean. They're
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based on assumptions and hypotheses, and you can study them. And as I studied it I began
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to understand, some for myself and more from just reading around because the faults with
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the standard economic models, with the standard models of finance, are well known. They have
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been in the literature for decades and decades. So let me give some examples.
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The standard model of economics is called the neoclassical model and it assumes that
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markets or systems where trading happens between consumers and firms and there's certain simple
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models of how that goes on. And the ideas that these come to equilibrium. Equilibrium
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not in the physical sense but in special economic sense in which you reach a point at which
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the prices are fixed such that market forces fix the prices such that you maximize the
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happiness of the consumers and maximize the profits of the firms. And in so called equilibrium
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nobody can become happier or more profitable without somebody else becoming less happy
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or less profitable. And the ideology behind this -- not behind the mathematics because
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mathematics doesn't have an ideology -- but behind the arguments that were made and still
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are made from this model is that markets don't need regulation because they have these natural
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equilibria where everybody benefits to the maximum possible. And if you're in equilibrium
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you can't do better.
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Now there's a fault with this and it's an obvious fault and it's been known since the
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1970s from some theorems proved by some economists including some of the founders of this field
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of mathematical economics, which is that there's not one equilibrium, there are many equilibria.
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In fact, there's a vast number of equilibria. And so which equilibria, even assuming that
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this is a decent model of the economy which is not clear, but even assuming it's a good
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model, which equilibria you're in depends on the past history, it depends on regulation,
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it depends on politics, it depends on taste, it depends on changing taste, changing preferences.
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And so history matters and what's called path dependence matters.
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This takes us outside the neoclassical model of economics but it doesn't take us outside
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of economics because some wiser economist, for example, Brian Arthur had for years been
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developing models and theories of path dependent economy where the history does matter. People
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from the area of complex systems like Stu Kauffman, Prubac in developing models of markets
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where the history matters, where there's not a single equilibrium, where there are many
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equilibria. And where change is paramount.
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Another symptom of this is the idea that arbitrage isn't, I mean, in these neoclassical models
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when you go to equilibrium, arbitrage is impossible. Arbitrage is making a profit from trading
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around a circle of goods or a circle of currencies without actually producing anything. And in
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equilibrium that's supposed to be impossible but lots of firms and investment banks made
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fortunes off of currency trading, so why is that? It turns out because you're never really
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at equilibrium.
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So why is the notion of equilibrium so powerful? I think part of the answer is this idea of
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physics envy, that economists thought that what they're doing was more scientific, hence
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more correct, if it looked like physics. And physics had this timeless picture in which
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what really mattered, as we were saying before, is the whole history of the system. And in
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physics there's also a big notion of coming to equilibrium which is, although however,
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it's important to say, a different notion of equilibrium. And somehow people in economics
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got seduced into this model which again works in the small -- if you have a small little
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corner of the economy, a small market -- it may work for a while to characterize approximately
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what's going on. Arbitrage is not always there. It's not always, I mean, arbitrage, arbitrage
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does get eaten up. There are market forces which do push you towards equilibria. There's
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some truth in it.
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But the whole thing is a disaster if I can say that as an outsider. And it led indirectly
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-- it wasn't the only reason why regulations were lifted on markets and trading through
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the decades, but when people were making arguments to Congress, to the President's office that
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the economy would be better off without regulation, this was the "scientific rationale for it"
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and led to the very unstable situation of the last economic crisis.
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And indeed there's still a very dangerous and unstable situation in the world economy
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because -- well, I'm not an economist. I'm not gonna pontificate about the problems in
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the economy, but one could see how the idea of timelessness gave false comfort to an unsuccessful
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scientific theory in the realm of economics.