May 162010

Do physicists have better tools than economists or financial experts for predicting economic crises? Mainstream economists largely failed to forecast the sub-prime mortgage bubble, the ensuing financial crisis, and its global impact on world economy, which has now even challenged Europe’s economic, political and social systems. A handful of physicists working on economic problems — in the small but rapidly growing field of “econophysics” — have done better.

Already in 2005 Didier Sornette, a physicist, earthquake scientist, and financial expert at ETH Zurich, predicted bubbles in the US real estate markets. His prediction turned out to be completely right, despite the arguments of many economists that such bubbles could not exist, and even if they could, their bursting would be unpredictable. Since then Sornette has successfully predicted the bursting of many other bubbles, for example, in the oil and Asian financial markets.

Importance of feedback loops

In spring 2008, long before Lehmann Brothers defaulted, socio-physicist Dirk Helbing with colleagues James Breiding and Markus Christen were pointing out that the financial system had undergone changes that made it inherently unstable. Using the theory of complex systems, they argued that most analyses of the financial and economic system were too simple-minded, as they underestimate the importance of feedback loops and cascading effects. Things played out much as they predicted. A few months later, the financial system would have collapsed, had the European central bank and the Federal Reserve in the US not taken bold measures to provide exceptional amounts of liquidity.

The financial and economic crisis embarrasses not only people and politicians all over the world, but also winners of Nobel prizes in economics such as Joseph Stiglitz and Paul Krugman. In a column of the New York Times, Krugman asked “How did economics get it so wrong?” Behavioral economists such as George Akerlof and Robert Shiller see the problem in the assumption that humans would decide rationally. Instead, they believe one needs to consider human psychology — inclinations to irrational decision-making, risk aversion, and herding behavior.

Financial markets and earthquakes

Econophysicists agree, but also think that this is just aesthetic surgery. They claim that the pillars on which economic theory is built are fundamentally flawed. In a recent letter to George Soros, they point out that, in contrast to what mainstream economics says, markets are not stable, efficient, and self-regulating by nature, but would tend to stray far from equilibrium (as bubbles and crashes illustrate). Their models — inspired by years of success in understanding the rich dynamics of many physical systems — explain extreme events such as financial crises as emerging naturally through interactions and feedbacks among market participants. Upheavals in financial markets, these models suggest, should be almost as difficult to respond to as earthquakes, unless the structure of today’s market interactions is changed.

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