This article is a follow-up of a short essay that appeared in Nature 455, 1181 (2008) [arXiv:0810.5306]. It has become increasingly clear that the erratic dynamics of markets is mostly endogenous and not due to the rational processing of exogenous news. I elaborate on the idea that spin-glass type of problems, where the combination of competition and heterogeneities generically leads to long epochs of statis interrupted by crises and hyper-sensitivity to small changes of the environment, could be metaphors for the complexity of economic systems. I argue that the most valuable contribution of physics to economics might end up being of methodological nature, and that simple models from physics and agent based numerical simulations, although highly stylized, are more realistic than the traditional models of economics that assume rational agents with infinite foresight and infinite computing abilities.
Deep Dive into The (unfortunate) complexity of the economy.
This article is a follow-up of a short essay that appeared in Nature 455, 1181 (2008) [arXiv:0810.5306]. It has become increasingly clear that the erratic dynamics of markets is mostly endogenous and not due to the rational processing of exogenous news. I elaborate on the idea that spin-glass type of problems, where the combination of competition and heterogeneities generically leads to long epochs of statis interrupted by crises and hyper-sensitivity to small changes of the environment, could be metaphors for the complexity of economic systems. I argue that the most valuable contribution of physics to economics might end up being of methodological nature, and that simple models from physics and agent based numerical simulations, although highly stylized, are more realistic than the traditional models of economics that assume rational agents with infinite foresight and infinite computing abilities.
The current direful crisis puts classical economics thinking under huge pressure. In theory, deregulated markets should be efficient, rational agents quickly correct any mispricing or forecasting error. Price faithfully reflect the underlying reality and ensure optimal allocation of resources. These "equilibrated" markets should be stable: crises can only be triggered by acute exogeneous disturbances, such as hurricanes, earthquakes or political upheavals, but certainly not precipitated by the market itself. This is in stark contrast with most financial crashes, including the latest one. The theory of economic equilibrium and rational expectations, as formalized since the 50's and 60's, has deeply influenced scores of decision-makers high up in government agencies and financial institutions. Some of them are now "in a state of shocked disbelief", as Alan Greenspan himself declared when he recently admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending. Economic theories turn out to have significant impact on our every-day life. The last twenty years of deregulation have been prompted by the argument that constraints of all kinds prevent the markets from reaching their supposedly perfect equilibrium, efficient state. The theory of Rational Expectations has now permeated into International Political Economics, Sociology, Law, etc. 1Unfortunately, nothing is more dangerous than dogmas donned with scientific feathers. The present crisis might offer an excellent occasion for a paradigm change, already called for in the past by yawing economists such as John Maynard Keynes, Alan Kirman or Steve Keen. They have forcefully highlighted the shortcomings and contradictions of classical economics, but progress has been slow. Of course, it is all easier said than done, and the task looks so formidable that some economists argue that it is better to stick with the implausible but well corseted theory of perfectly rational agents rather than to venture into modelling the infinite number of ways agents can be irrational. So where should one start? What should be taught to students in order to foster, on the long run, a better grasp of the complexity of economic systems? Can physics really contribute to the much awaited paradigm shift? After twenty years or so of "econophysics"2 and around 1000 papers in the arXiv, it is perhaps useful to give a personal birds eye view of what has been achieved in that direction.
Econophysics is in fact, at this moment in time, a misnomer since most of its scope concerns financial markets. To some economists, finance is of relatively minor importance and any contribution, even significant, can only have a limited impact on economics at large. I personally strongly disagree with this viewpoint: the recent events confirm that financial markets hiccups can cripple the entire economy. From a more conceptual point of view, financial markets represent an ideal laboratory for testing several fundamental concepts of economics, for example: Is the price really such that supply matches demand? Or: Are price moves primarily due to news? The terabytes of data spitted out everyday by financial markets allows one (in fact compels one) to compare in detail theories with observations and the answers to both questions above seem to be clear no’s. 3 This proliferation of data should soon concern other spheres of economics and social science: credit cards and e-commerce will allow one to monitor consumption in real time and to test theories of consumer behaviour in great detail. 4 So we must get prepared to deal with huge amounts of data, and to learn to scrutinize them with as little prejudice as possible, still asking relevant questions, starting from the most obvious ones -those that need nearly no statistical test at all because the answers are clear to the naked eye -and only then delving into more sophisticated ones. The very choice of the relevant questions is often sheer serendipity: more of an art than a science. That intuition, it seems to me, is well nurtured by an education in natural sciences, where the emphasis is put on mechanisms and analogies, rather than on axioms and theorem proving.
Faced with a mess of facts to explain, Feynman advocated that one should choose one of them and try one’s best to understand it in depth, with the hope that the emerging theory is powerful enough to explain many more observations. In the case of financial markets, physicists have been immediately intrigued by a number of phenomena described by power-laws. For example, the distribution of price changes, of company sizes, of individual wealth all have a power-law tail, to a large extent universal. The activity and volatility of markets have a power-law correlation in time, reflecting their intermittent nature, obvious to the naked eye: quiescent periods are intertwined with bursts of activity, on al
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