Thursday, July 11, 2013

Physicists as Economists

They're almost certainly going to be better than regular economists (h/t Ritholtz):
Mark Buchanan in his new book, Forecast: What Physics, Meteorology, and the Natural Sciences Can Teach us About Economics, describes the central plank of the theory as being a belief in the universe’s dynamic tendency toward disequilibrium and instability. It’s a direct challenge to the prevailing economic theory that markets are inherently self-correcting and always reverting to equilibrium.
Take events such as the 1987 stock market crash, the dot.com bubble, and the flash crash of 2011. The econophysicists will tell you that the market at those times displayed patterns akin to the interaction of water molecules before boiling point or like the tectonic plate activity before an earthquake. They see positive feedback loops, where new market participants are repeatedly influenced by the actions of those before them, moving prices within the entire system inexorably toward an eventual breaking point: a financial bubble leading to a bust.
Even outside of the most newsworthy bubble events, markets constantly go through this dynamic process, says Mr. Buchanan. Using a metaphor from the physical world, he describes it as “avalanche” of common behavior that “sweeps through the system and, as it goes on, fosters a large, coherent change. Then, suddenly, that idea falls out of favor, and there is correction in the other direction.”
Markets are based on human sentiment, once in a while tempered by fundamentals.  Of course they are going to be irrational.  Have you ever talked to anybody who is madly in love?  Investors are like lovers.  Everyday is either the greatest in the world or the worst day ever, it seems.  Then you mix in the herd mentality, and you have some serious trouble.  I remember hearing about the efficient market hypothesis and thinking that this is the stupidest thing I've ever heard.  I don't know that you can boil down economics to physical laws, but markets are definitely irrational.

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