In a lecture I heard some years ago, a philosopher asserted that science tries to answer the question ‘how’, while philosophy tries to answer the question ‘why’. In looking at the corpus of work produced by academics and practitioners on finance, it seems to me that most, if not all, are trying to answer the ’how’ question, but almost none attempt to answer the ‘why’ question. I think this is because finance as a discipline sees itself as an extension of economics; and economics, since the nineteenth century work of French economists such as Walras1 and later of Marshall2 , has been seen in essence as a science, and therefore this preoccupation with the ‘how’ question is a result of a spillover of that assumption.
Scientists, of course, would find the idea of a science that relies on the concept of ‘externalities’ and an attempted aggregation of individuals’ often disparate behaviours and mood shifts to explain why the laws postulated by this science do not seem to work dynamically or universally, somewhat baffling. In his book The Origin of Wealth, Eric Beinhocker relates a meeting between economists and scientists in the mid 1990’s in Santa Fe. What the scientists found most fascinating was how economists took a snapshot of science in the late nineteenth century, applied it to their discipline, then evolved this discipline with scant regards to the huge advances made in science thereafter. Economics as a discipline has therefore developed within the confines of how science saw the world at that point in time, while science moved on. Thus, economists still talk of ’equilibrium’ – in 1880 all the rage in physics – while scientists today talk of entropy, for example. Perhaps there is also still a misreading of Adam Smith where many students of economics read The Wealth of Nations, but pay less attention to his The Theory of Moral Sentiments which contextualises it, and so fail to place Smith within the context of the moral philosophy of the eighteenth century that believed in the rationality of humans.
The object of this article is not to enter this debate. In the interest of common sense, and because how we perceive economics has a direct bearing on how we perceive financial theory, I would point out that we are all perfectly comfortable in boarding a metal tube with wings to fly because we are confident that outside the context of quantum mechanics, the laws of Newtonian physics, will always apply in the same way and are never affected by ’externalities’. However, I would venture that no one would do the same if the laws affecting flight were as ill-fitting, and with the constantly-shifting outcomes, as the laws of economics. Common sense, therefore, tells us the laws of physics are constant, observable and universal, and observation tells us the ’laws’ of economics are not. To my mind this argues that we should stop treating economics, and indeed financial theory, as a science and go back to treating it as part of political philosophy. Perhaps by re-examining the ideas of the nineteenth century economist Bastiat’s notion of the ’full picture’3 , we begin to make sense of the failures seen in the financial markets in the context of what we can observe today.