Seismic science of finance
(China Daily)
Updated: 2010-08-16 11:29
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It's tempting to pull out the old earthquake metaphor when talking about the latest financial crises. How else to describe the economic devastation - the tremors in the subprime mortgage market, the seismic collapse of Lehman Brothers, and the aftershocks in Europe?
But some academics are taking the metaphor seriously, pursuing a new field they call econophysics. The approach represents a break from traditional economics, by studying financial earthquakes in much the same way geologists study those on terra firma.
"New approaches are needed to address the fundamental and practical challenges of our financial, economic and social system," a group of econophysicists wrote recently in an open letter to George Soros, the billionaire investor and philanthropist.
Macroeconomists construct elegant theories to inform their understanding of crises. Econophysicists view markets as far more messy and complex. Drawing on the tools of the natural sciences, they believe that by sorting through an enormous amount of data, they can work backward to find the underlying dynamics of economic earthquakes and try to prepare for the next one.
Financial crises are difficult to predict, the econophysicists say, because markets are not, as some traditional economists believe, efficient, self-regulating and self-correcting. The periodic upheavals are the result of a cascade of events and feedback loops, much like tectonic rumblings.
Scientists have found that earthquakes, natural and financial, share similar patterns. Small market gyrations are such regular occurrences that they are barely noticed; extreme market shocks are very rare. So too with earthquakes, which also adhere to a statistical relationship known as a power law.
Economic earthquakes also trigger dangerous aftershocks. The currency crisis in Thailand during the late 1990s was followed by similar problems in Indonesia and South Korea. After Lehman Brothers faltered in 2008, Washington Mutual, the Wachovia Corporation and scores of smaller banks toppled over like dominoes.
Some econophysicists, as well as economists and politicians, suggest that the ongoing turmoil in Europe was triggered by the lingering effects of the 2008 panic that started in the United States.
"Great earthquakes shape landscapes," said Didier Sornette, who runs the Financial Crisis Observatory in Zurich. "Great crashes shape regulation, the perception of risk and the psychology of people."
In the wake of the recent crisis, lawmakers have just completed the biggest overhaul of financial rules since the 1930s.
Lessons learned by earthquake scientists are instructive here as well.
After the Great Earthquake of 1906 in San Francisco, architects and engineers greatly revamped the city's building codes so the buildings would be able to withstand an even heftier blow. Likewise, the recently enacted regulatory reforms are intended to act like shock absorbers to buttress the market's wild swings.
"We want to fortify structures so they don't collapse," said Lawrence H. Summers, the president's chief economic adviser.
Other administration officials suggest that the so-called systemic risk council of regulators can be on the lookout for early tremors in financial markets, just as seismologists do.
Still, no panacea for calming the volatile markets is in sight.
"We can have sound financial institutions but still have major financial earthquakes if the policies that governments pursue are fundamentally unbalanced," said Lowell Bryan, a senior partner at McKinsey & Company. "Nobody seems quite interested in going through the pain."