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Predicting Economic Crises with Econophysics

11 May 2010 ETH Zürich

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.

Socio- and econophysicists point out quite a number of flaws in mainstream economics, which, they criticize, has lost contact with empirical and experimental facts to a large extent. For example, economic theory relies on the so-called "representative agent" approach, which ignores the very existence of real-world diversity in the nature of different business firms and instead supposes that the economy acts as if there were just an "average" firm. They also miss a link between micro- and macroeconomics. It may be difficult to believe, but the models used by the Federal Reserve and other central banks to judge macroeconomic trends are lacking anything like a reliable model of the financial industry. Econophysicists also warn that efforts to design policies for the strict optimization of economic performance -- the typical aim of most economic thinking – can create hidden risks and costs in form of increased instability.

In their letter to George Soros of March 17, 2010, leaders within the econophysics community point out that "The financial crisis has not only created huge financial losses. It has damaged the economic system to an extent that several countries are at the verge of bankruptcy, and social systems have become dangerously vulnerable. The problems we have seen may just be the beginning of a larger crisis. The situation may totally get out of control, endangering social peace and cultural achievements."

Two months later, Europe has now come up with a bailout plan for Greece, and three people have died in social unrests.

European research initiative

Professor Dirk Helbing of Switzerland's ETH Zurich and many of his colleagues world-wide believe that it is now time for a concerted action and for an ambitious multi-disciplinary approach to building a better scientific understanding of economic and financial systems. A huge European research initiative, called FuturIcT, shall bring together scientists from physics, economics, social, computer and engineering sciences to address the grand challenges of the future. With an estimated budget of 100 million EUR per year, over a period of ten years, this project aims to foster unprecedented scientific discoveries and radical innovation by multi-disciplinary research.

George Soros, who has established the Institute of New Economic Thinking (INET) with an endowment of 50 million dollars, has welcomed the initiative and writes: "The team of scientists that Dr. Helbing has gathered together can, I believe, make a significant contribution to the understanding of the evolution and change in societies as they meet the formidable issues of governance, climate change, sustainable economic balance that we are all faced with in the coming decades."

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