Monday, 12 October 2009

(Large) quote of the day: On the causes of the financial crisis and the dangers of increased regulation

Hat tip to Thrutch for spotting this article the Financial Post on the causes of the financial crisis and the dangers of increased regulation – and “how regulation forces homogeneity and therefore susceptibility to the same risks”:

    “IT IS A FUNDAMENTAL misunderstanding that the market is rational and at some sort of equilibrium, where all information and wisdom are incorporated in decisions. Neoclassical economic models filled with unrealistic assumptions about humans and the economy should always have warning stickers attached to them. The market is nothing other than all the millions of decisions that we all take as we produce, act and invest -- and the tiniest bit of introspection is enough to realize that we do not behave like the textbook models. Since finding lots of information before acting takes time and costs money, we often go with our gut, following rules of thumb and copying what others have already done. That is why the market has a herd instinct. When others seem to be successful at something and get rich on it, you follow suit. After a while, the hollowness of the enthusiasm becomes apparent, and then it often changes into overblown fear that soon ushers in recession.
    “A key lesson to be drawn from such events, however, is that borrowers, lenders, bankers and brokers are not the only ones to be affected. Politicians, bureaucrats and central bankers are at least as likely to succumb to the herd instinct -- and they have special power. If you act in a different way from what they have approved, they may take your money or even send you off to jail. This gives them the ability to head the march of the lemmings and set its pace.”



  1. A group of econo-physicsts lead by Physicst Didier Sornette developed a non-equilibrium market model which involves herding effect, that was claimed to have some limited success in predicting market movements, such as the chinese stock market.

    - Econophysicist Predicts Date of Chinese Stock Market Collapse - Part 1

    - Econophysicist Predicts Date of Chinese Stock Market Collapse - Part 2

    Prof. Sornette et al, had submitted their paper to Elsevier for publication. A rough early cut-down version of the paper has already been made freely available from Cornell University's online e-priint services for download:

    The Chinese Equity Bubble: Ready to Burst

    Is this sort of prediction just a coincidence? May be, and perhaps it is too early to tell, but it is interesting that Sornette's paper mentioned 2 other independent R&D groups that reached the same conclusions as his group on using similar (but not exactly the same) models. Sornette & colleagues' paper describes only the general method and not the detail, this indicates that they must be working with some commercial vendors or their funders must want to license the technology to someone (or specific vendor) for commercial use. Dang! If the algorithm are published in it's detailed form, then I would have implemented it myself but it is only a general description (and no doubt including other thousands of software developers like myself out there who are interested in financial market numerical modelling).

    There is no doubt that physicists/scientists at the successful/profitable algo-trading hedge fund as Renaissance Technology (including similar agencies) have figured out the detail of the bits and pieces that are missing from the Sornette's paper and improved it themselves for software implementation (ie, modifying Sornette's model into a more robust version and just keep it to themselves and why not).

    The nature of these predictive algorithms/models are that once they're being made available to the public, ie via peer publication, their usefulness drops to almost zero, since everyone uses it.

    Researches in non-equilibrium economics is still in its infancy and I am sure that theoretical work being done in econo-physics and econo-biology (behavioral) will extend and advance neoclassical economics understanding into more realistic perspective of how the market is supposed to work (ie, power-law or fat-tail).

  2. I know that some readers here had studied engineering (LGM, AndrewB, etc,...), the meaning of the some terms used in econophysics are the same ones you're already familiar with (thermodynamics), such as Critical Point , Phase Transition and Invariance, etc...

    Bubble, Crash is similar to different phases of the market, ie, it transitions from one to the other or back the other way, etc,... At each phase, there is a critical point where this transition takes place, exactly as solid to liquid or liquid to gas, etc,... These transition is similar to herding effect. But Prof. Sornette which I mentioned in my first message, had criticized other econo-physicists in the past for not including some elements of behavioral effect to their models, because humans have behavior and emotions about the market while atoms and particles in a thermodynamic ensemble don't have feelings. An excellent paper on economic scaling-law and power-law, etc, is covered in the following:

    We present an overview of recent research applying ideas of statistical physics to try to better understand puzzles
    regarding economic fluctuations. One of these puzzles is how to describe outliers, phenomena that lie outside of patterns of
    statistical regularity. We review evidence consistent with the possibility that such outliers may not exist. This possibility is
    supported by recent analysis of a database containing the bid, ask, and sale price of each trade of every stock. Further, the data
    support the picture of economic fluctuations, due to Plerou et al., in which a financial market alternates between being in an
    “equilibrium phase” where market behavior is split roughly equally between buying and selling, and an “out-of-equilibrium
    phase” where the market is mainly either buying or selling.

    Download : Economic Fluctuations and Statistical Physics: The Puzzle of Large Fluctuations

    It is interesting to note that recent work by econophysicsts have proposed that the market is truly scale-invariant (a.k.a scaling law) and the data that has being analyzed so far supported this. It is universal, whichever market (international or otherwise), they look at, this universality of scale-invariant appears.It is synonymous to a universal law in physics, where Newtonian Mechanics (NM) work here on earth, it works on the moon , even it works underneath the sea in a submarine. We know that NM is not universal since it has been superseded by relativity, but the idea of universality in economics or social science in general is something unheard of.

    A good paper on this evidence came from the econophysicists at the Center for Polymer Studies at Boston University, which appeared in the Physics Review Journal (2009).

    Reply to "Comment on `Tests of Scaling and Universality of the Distributions of Trade Size and Share Volume: Evidence from Three Distinct Markets


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