Wednesday, May 18, 2011

The Physics of Finance

In the spring of 2009, in the wake of the recent financial crisis, economists gathered at a conference in Dahlem, Germany for five days of discussion on the economic modeling of financial markets. After the meeting, the group issued a joint statement on the economic profession's failure to either see the financial crisis coming or to judge its ultimate severity. The lack of understanding, they suggested in the conference report, is due

“... to a mis-allocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public.”

The full report makes good reading. Most importantly, it singles out the lack of realistic market dynamics as the primary failing of the standard models used by economists. These models assume that markets tend to a state of balance or equilibrium, and pay no attention to potential positive feed backs -- among asset prices, investors views, new regulations and so on -- which might drive markets far away from a state of balance. Realistic models would seek to capture such processes from the outset.

This aim of this blog is to cover and comment upon a wide range of new research -- much of it in physics, but some elsewhere - which is beginning to fill this gap. The idea is to accept that markets like most other natural systems have rich and complex internal dynamics. As with the weather, terrific storms can brew up out of blue skies through quite ordinary natural processes. If the equilibrium fixation of traditional economics has pushed the study of crises to one side - as the study of those exceptional events that occur when markets fail - the new perspective aims to understand how crises of many kinds emerge quite naturally from market processes. As any glance at history shows, they surely do, and quite routinely.

This work has been developing and growing more sophisticated since early evolutionary models of financial markets first developed in the mid 1990s at the Santa Fe Institute in New Mexico. It has come a long way since then, particularly in the past five years, and a growing number of economists and policy makers are beginning to take it very seriously. As just one example, Nature recently published a paper reviewing research on the stability of banking "ecosystems" - looking at problems that can arise in networks of banks -- which was co-authored by a mathematical ecologist, Robert May, along with an employee of the Bank of England, Andrew Haldane.

Old crude ideas about efficient markets and market equilibrium are rapidly being buried, good riddance, to be replaced by more realistic and useful ideas emerging from the physics of finance.

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