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8 April 2013

A storm coming: What economics can learn from meteorology

Chasing equilibrium failed in climate science, and it will fail in economics too, writes Mark Buchanan.

By Mark Buchanan

Whether or not a wider economic catastrophe ensues from the recent events in Cyprus, the European Union and the International Monetary Fund certainly handled the situation rather indelicately. An Italian politician has already voiced the alarming idea that the banking system might be made whole through a Cyprus-inspired seizure of bank depositors’ funds on a global scale. Trust is a delicate thing. Who is safe? No one knows.

We’ve become used to the daily rhythm of new financial and economic hazards, and so quickly. In only a few years, we’ve seen a virtual disappearance of economists cheering on globalization, telling us that depressions were a thing of the past and that modern financial engineering had made markets more efficient than ever.

Our leaders are largely now making things up as they go. When former president of the European Central Bank Jean Claude Trechet spoke at a 2010 ECB conference, he noted that standard economic theory was completely useless during the crisis:

The serious limitations of existing economic and financial models immediately became apparent… in the face of the crisis, we felt abandoned by conventional tools.

A major reason for that uselessness lies in economic thinking itself, which has long been based on notions of balance and equilibrium, on the idea that the economy at large and financial markets in particular naturally tend toward a state of balance. Though it is now couched in abstract mathematics, the idea goes back to Adam Smith’s famous notion of the invisible hand.

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Equilibrium thinking is so deeply ingrained for most economists that they find it difficult to think in other terms. Unfortunately, these theories don’t match up too well with the history of economics and finance, which is one of perpetual if episodic crises, always finding their origins in imbalance and disequilibrium, in waves of exuberance or fear inducing herding and so on. The scientific terms would be positive feedbacks, the kind of thing that routinely drives violent storms to brew up from blue skies for perfectly ordinary processes. Economic theory has not made a serious effort to tackle such processes in the way atmospheric scientists have.

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In Cyprus, in Europe, and globally, we’ll no doubt end up muddling through, and the most helpful economists will be those steeped in history, rather than armed with elegant equations. But there are some encouraging signs that economic thinking could take a turn for the better, if the more reactionary elements in the field can be pushed aside.

For example, derivatives were probably the most important innovation of financial economics over the past few decades; they’ve come to dominate global markets. Before the crisis, economic theorists positively encouraged this trend, arguing that more derivatives could only make markets more efficient, as they give investors the ability to tune their investments more precisely. That turns out to have been a dangerous illusion based on equilibrium thinking.

Since the crisis, physicists and other natural scientists, working with a few open-minded economists, have examined this matter again in models that do not assume a balance equilibrium, and found that we actually should have expected derivatives to create instability. An entire industry was founded and defended on an illusion, and helped bring down the world economy.

Another area of profound neglect in traditional economics has been the understanding of the bewildering tangle of linked institutions that make up the financial system. It’s grown far more complex than ever in recent decades, primarily because of financial derivatives, yet we barely understand how such complexity changes the way networks operate. What we do know suggests we should worry when there’s too much complexity.

Recent research – again initiated by scientists outside of economics, especially in ecology and physics – suggests that any adequate understanding of the financial system must focus on the detailed pattern of links among institutions, or the network “topology.” While the idea of “too big to fail” has gained wide notice, equally importance is “too central to fail” – the notion that some institutions, even if not particularly large, may play such a central role in the system by virtue of their links to others that their failure would imperil the entire system.

It will take a concerted effort to monitor these networks in detail – and new regulations to make information on all links between institutions available to banking authorities – if we are to really understand where the risks lie. The network perspective is still some way from making confident proclamations of recipes for specific regulations on derivatives or banking transparency and so on, but its insights already eclipse those of traditional financial economics, and any work on crafting better regulations should certainly take these insights into account.

If we do, then next time we might not be so surprised. And the authorities charged with making difficult decisions may not be left in the lurch.

Mark Buchanan is the author of Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics, published by Bloomsbury on 11 April 2013.