Darwin Day 2011

Today is Darwin Day — the 202 anniversary of Darwin’s birth on February 12, 1809. Theodosius Dobzhansky (try saying that three times), a Ukrainian American biologist, is credited with saying that “nothing in biology makes sense except in the light of evolution.”  I think it’s fair to extend that well past biology – natural selection applies to a great many different systems including of course, economics.

Eric Beinhocker chose to entitle his groundbreaking book “The Origin of Wealth,” a clear echo of Darwin’s masterpiece “The Origin of Species.”  Actually, Beinhocker’s full title is “The Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics.”   Not everything he writes about is directly related to evolution, but evolution plays a central role in the explanation of how the economy works.  Daniel Dennett – one of the greatest philosophers of our time – has described evolution as a method for “creating design without a designer.”  That sums up why evolution is so important: it shapes the participants into ‘better’ and ‘better’ designs as the environment around them changes.

When I started this blog and I created my reading list I included Beinhocker’s book and added “Everyone in the world should read this book.”  I really do mean that.  It’s not just that his book is well written and a joy to read.  It’s also that the contents are just that important.

Here’s an example of the importance of the topics he covers – the causes of volatility.  Many people and firms use volatility – or a multiple of it – as their primary measure of portfolio market risk [parametric models of Value-at-Risk are little more than a multiple of the portfolio’s volatility].  Well, what causes volatility?  Traditional economists have long held that volatility is the result of inefficiencies in the markets – that if information flowed faster and without distortion, then volatility would be lower because the information would be incorporated into securities’ prices faster, leading to smaller swings in the price.  Sounds good.  Only problem is that it isn’t true.  Markets today – with instantaneous and ubiquitous electronic communications (how many of you are reading this on a mobile device?) are just as volatile, if not more so, than markets in the early 1900’s. Volatility has been more or less stable, with some notable crashes excepted, throughout that entire period.  Beinhocker’s book shows that most of the volatility of the stock markets can be atributed to what I call “edge effects” – the sequence in which individual buy and sell orders are allowed to be processed by the exchange.  In other words, the rules of the exchanges – the process by which it matches those who want to buy with those who want to sell – is what seems to drive volatility.  Hardly consistent with traditional economics.

Beinhocker covers a remarkably large number of economic topics ranging from the misapplication of physics-inspired mathematics to complexity simulations.  His explanations of agent-based modeling and the role of natural selection in understanding the economy and markets are in depth and quite thorough.  He explores the “myth of sustainable competitive advantage,” how trading strategies win and lose in different environments according to the rules of evolution, and does a very good job of explaining how feedback loops can drive the behaviors we see in real markets.  All of this is not only consistent with Darwinian evolution – it depends on it.

Dr. Andrew Lo is another heavy hitter enamored with Darwin.  He’s the MIT Sloan School Harris & Harris Professor of Economics.  Dr. Lo’s firm and my firm have a business partnership, and I’ve had the pleasure of hearing him speak several times.  Dr. Lo talks about what he calls ‘Physics Envy,’ a deep psychological disorder afflicting Economists.  He explains “we wish that 99% of economic behavior could be captured by three simple laws of nature.  In fact, economists have 99 laws that capture 3% of behavior.  Economics is a uniquely human endeavor and, as such, should be understood in the broader context of competition, mutation, and natural selection – in other words, evolution.”  As a market risk manager, Darwinian, and (former) physicist, I love that quote.

I celebrate Darwin Day not only because of its powerful explanatory power over economics, markets and risk, but also for what it has done for humanity.  His remarkable idea has allowed biology and medicine to advance in ways that Darwin himself could not have dreamed of.  Said differently, if it weren’t for Darwin’s work, modern medicine simply would not exist.  Millions of people would continue to die from diseases that instead we cure and treat routinely.  And if that isn’t worth celebrating, I don’t know what is.

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