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4. Predicting the big one
RON HAVIV/VII
4
> with the ability of ecosystems to adapt and thrive in the face of all sorts of challenges, including everyday processes like the movement of species, but also continental drift and climate change. Many stable food webs have a “disassortative” structure that is very different from what seems to emerge in financial networks (Nature, vol 451, p 893). Species with many links to others tend to be linked to species that have very few: an insect may pollinate many different plants, while each of those plants may be pollinated by only one or a few insects. Food webs also tend to be built up out of a number of poorly connected subnetworks, meaning that disruption in one area does not necessarily spread to other parts. Translating insights from stable ecological networks into policy prescriptions in the very different world of finance will need a great deal of further study, however. For a start, more compartmentalisation might increase a system’s robustness, but it might also slow the free flow of cash – something that could actually increase the fragility of a financial network in a crisis.
Macroeconomic failure has human consequences
Predicting the big one According to classical models of economics, financial crises don’t happen. People, firms and other economic “agents” act rationally, in their own selfinterest and with profound insight. They would never be duped into investing in a market that was enormously inflated and about to crash. The result is a stable, self-correcting equilibrium. Prices too high? People stop investing. Too low? People start buying again. Clearly, then, there is a lot wrong with classical economics. “Most economic analysis still takes place within a totally inadequate set of concepts,” says JeanPhillippe Bouchaud, physicist and co-founder of the hedge fund Capital Fund Management in Paris, France. “Theories of finance can learn a lot by connections to the rest of science.” For instance, studies over several decades have shown that market fluctuations have a lot in common with processes such as earthquakes that originate in systems that are very much out of equilibrium and naturally subject to abrupt upheavals (Physica A, vol 387, p 3967). This means price fluctuations on the stock market do not have a
bell-shaped “normal” distribution, with the bulk in the mid-range and a steady decline towards each extreme. In fact, the distribution has a much fatter tail of large price fluctuations, subverting a crucial assumption that underlies much of economic theory. The implication is that extreme market events, such as a one-day crash capable of wiping out millions of investors, occur naturally in financial markets even in the absence of any extraordinary circumstances. By contrast, most economists and financial analysts regard such events as strange and unpredictable outliers. “This is, at least in part, because basic market theories can’t explain these large fluctuations in any natural way,” says physicist Gene Stanley of Boston University, a leader in such analyses. Just as in statistical earthquake prediction, the most sophisticated science-based analysis won’t lead to perfect prediction of future market problems, Stanley says. But for markets, as for seismic quakes, closer attention to the statistics of the past can give us a better idea of what’s likely in the future.
Recession bites All indicators of economic well-being have taken a hit in developed countries over the past year
National debt
UK
US
12
House prices
UK
US 30
80
Per cent of GDP
Per cent of population
60 8 6 4
50 40 30 20
2
10 0
0 2007
2009 (projected)
38 | NewScientist | 6 June 2009
UK
25
70
10
Per cent change (12 month average)
US
2007
2010 (estimated)
20 15 10 5 0 -5 -10 -15 -20 1995
1997
1999
2001
2003
2005
2007
2009
SOURCE: IMF
Unemployment
4
> with the ability of ecosystems to adapt and thrive in the face of all sorts of challenges, including everyday processes like the movement of species, but also continental drift and climate change. Many stable food webs have a “disassortative” structure that is very different from what seems to emerge in financial networks (Nature, vol 451, p 893). Species with many links to others tend to be linked to species that have very few: an insect may pollinate many different plants, while each of those plants may be pollinated by only one or a few insects. Food webs also tend to be built up out of a number of poorly connected subnetworks, meaning that disruption in one area does not necessarily spread to other parts. Translating insights from stable ecological networks into policy prescriptions in the very different world of finance will need a great deal of further study, however. For a start, more compartmentalisation might increase a system’s robustness, but it might also slow the free flow of cash – something that could actually increase the fragility of a financial network in a crisis.
Macroeconomic failure has human consequences
Predicting the big one According to classical models of economics, financial crises don’t happen. People, firms and other economic “agents” act rationally, in their own selfinterest and with profound insight. They would never be duped into investing in a market that was enormously inflated and about to crash. The result is a stable, self-correcting equilibrium. Prices too high? People stop investing. Too low? People start buying again. Clearly, then, there is a lot wrong with classical economics. “Most economic analysis still takes place within a totally inadequate set of concepts,” says JeanPhillippe Bouchaud, physicist and co-founder of the hedge fund Capital Fund Management in Paris, France. “Theories of finance can learn a lot by connections to the rest of science.” For instance, studies over several decades have shown that market fluctuations have a lot in common with processes such as earthquakes that originate in systems that are very much out of equilibrium and naturally subject to abrupt upheavals (Physica A, vol 387, p 3967). This means price fluctuations on the stock market do not have a
bell-shaped “normal” distribution, with the bulk in the mid-range and a steady decline towards each extreme. In fact, the distribution has a much fatter tail of large price fluctuations, subverting a crucial assumption that underlies much of economic theory. The implication is that extreme market events, such as a one-day crash capable of wiping out millions of investors, occur naturally in financial markets even in the absence of any extraordinary circumstances. By contrast, most economists and financial analysts regard such events as strange and unpredictable outliers. “This is, at least in part, because basic market theories can’t explain these large fluctuations in any natural way,” says physicist Gene Stanley of Boston University, a leader in such analyses. Just as in statistical earthquake prediction, the most sophisticated science-based analysis won’t lead to perfect prediction of future market problems, Stanley says. But for markets, as for seismic quakes, closer attention to the statistics of the past can give us a better idea of what’s likely in the future.
Recession bites All indicators of economic well-being have taken a hit in developed countries over the past year
National debt
UK
US
12
House prices
UK
US 30
80
Per cent of GDP
Per cent of population
60 8 6 4
50 40 30 20
2
10 0
0 2007
2009 (projected)
38 | NewScientist | 6 June 2009
UK
25
70
10
Per cent change (12 month average)
US
2007
2010 (estimated)
20 15 10 5 0 -5 -10 -15 -20 1995
1997
1999
2001
2003
2005
2007
2009
SOURCE: IMF
Unemployment