Econophysics, the financial crisis, and the need for greater transparency

November 23rd, 2010

Whether or not the economy mirrors seismic activity, we still need financial transparency, explains Karly Curcio

SystemF2/Task Force*

Policy makers and economists around the world are being challenged with the question “what needs to be done to ensure the soundness of the global financial system?” Scholars are introducing non-traditional methods for attacking the question. Some economists say that traditional economic theory holds, and that the best approach is to allow for free markets with minimal regulatory distortions. Others argue that we must be open to an alternate paradigm. In a letter to George Soros, financier and founder of the Institute for New Economic Thinking, a group of economists expressed “dissatisfaction with the state of economic theory, and it is obvious that new approaches are needed to address the fundamental and practical challenges of our financial, economic and social system.”

One proposed approach is to compare financial systems with natural ecosystems. A burgeoning field of econophysics is studying and developing this idea. These econophysicists observe that “extreme events can be the result of systemic instabilities.” That is to say that, like earth quakes, large shocks to the economy can occur and be the result of friction between unstable components of its foundation.

One of the first studies linking natural science and financial markets was published in 2003 in a letter to the scientific journal, Nature, by a Boston University team of physicists and an MIT Economist. One contribution of their study was that trades made by large funds beget more trades, and that most trades respond in the market with the same action as that of the initial large fund trade. Better understanding and possibly predicting the dynamic relationship between actors in financial markets requires a paradigm shift.

Econophysicists argue that financial crises are difficult to predict because markets are neither self-regulating nor self-correcting as traditional free market theory would dictate. “The periodic upheavals are the result of a cascade of events and feedback loops, much like the tectonic rumblings beneath the Earth’s surface.”

E. Eugene Stanley, an author of the above mentioned study on financial markets explains, “If you analyze [financial shocks], this earthquake law is obeyed perfectly. […] A big shock causes smaller aftershocks, and then ones smaller and even smaller.”

So what do we know? …Financial crises mimic patterns in natural sciences, particularly seismic activity. No individual can predict exactly when and how a financial crisis will occur. However, a “black swan”—as Nassim Nicholas Taleb labels it—will occur again. Taleb argues that we must “robustify” our society against black swans—or unforeseeable economic shocks with large-scale financial effects.

We also know that the more durable our financial foundation is, the less vulnerable the system will be to large shocks to the economy. After the 1929 crash, the Glass-Steagall Act became law and separated Wall Street from Main Street, or investment banks from depository banks. Directly following the 2008 financial crisis, the Dodd-Frank bill passed by congress was intended to be a total overhaul of the U.S. financial structure that would ensure consumer protections and safety as well as the soundness of the banking system.

These laws will help with strengthening our financial foundations, but there is only one way to best protect domestic and global financial systems from future crises: demand greater financial transparency and reporting by major actors in the system. The opacity of the financial system now allots for way too much instability and uncertainty, solely for the benefit of the corporate and political elite.

Offering an alternate paradigm to economic theory is important for working towards solid answers to the pressing question, “what needs to be done to ensure the soundness of the global financial system.”  Irrefutable, though, is the fact that greater financial transparency is a necessary part of the answer.

*Image source: AttributionNoncommercialShare Alike Some rights reserved by SystemF92; Graphic adaptations: Task Force on Financial Integrity & Economic Development

Written by Karly Curcio

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