From The Physics of Finance:
Research in so-called "econophysics" -- the application of ideas and
concepts from physics to problems in finance and economics -- tends to
be quite controversial. Many economists in particular seem to find it
fairly annoying, although quite a few others either work in the area or
do work that is closely associated in conceptual terms. Physicists in
the area have been criticized on various occasions for being ignorant of
prior work in economics (sometimes true), of using less than rigorous
statistics (I haven't seen anything convincing on this) and of employing
unrealistic models.
There is plenty of uninspiring work in the field, as in any area
of science. Out of politeness, and to avoid boring anyone, I won't make a
list. But physicists have made quite a number of lasting
contributions to a deeper understanding of finance and economics; in
some cases, I think, they have helped to change the direction of
research in economics. So I thought it might be worth making a short
list of the things that I think have indeed been success stories. Here
goes:
1. More than anything, physicists have
helped to establish empirical facts about financial markets; for
example, that the probability of large market returns decreases in
accordance with an inverse cubic power law in many diverse markets. This
seems to be a universal result, at least approximately. I've written
about this work
here. Work by physicists has also established other generic market patterns
such as the self-similar structure
of market volatility. I very nice review of these patterns is
this one by Lisa Borland and colleagues.
Now, did econophysicists initiate this kind of work? Of course not. Benoit
Mandelbrot found the first evidence for fat tailed distributions in
the early 1960s (and Eugene Fama even wrote about that work in his
first paper!). But research by physicists has made our knowledge of
these empirical regularities much more precise.
2. Physicists have also identified
instructive links between markets and other natural phenomena. For
example, in the period following a large market crash,
markets show lingering activity which follows the famous Omori law for earthquake
aftershocks (events become less likely in simple inverse proportion
to the time after the main shock). Such connections indicate that the
explanation of such market dynamics may well not depend on facts
specific to finance and economics; that more general dynamical
principles may be involved.
3. Physicists have also helped develop
more realistic models of markets, here mostly in collaboration with
economists. In the mid-1990s, researchers at the Santa Fe Institute
first demonstrated how fat-tailed dynamics could arise naturally in
models representing a market as an ecology of interacting adaptive
agents. Models of this kind have since become widespread and used to
perform some of the most sophisticated tests of policy proposals --
for the idea of a financial transactions tax, for example, as
currently planned by the European Commission. For this, econophysics
deserves some credit. For a nice review, see
this paper by economist Blake Lebaron (I've summarized it
here).
If you doubt that the early work at Sante Fe had a real effect on
encouraging this work, pushing the study of computational models of
heterogeneous adaptive interacting agents to the forefront of market
modelling, take a look at
this 2002 review
by economist Cars Hommes. As seminal work in this area, he cites papers
in the early 1990s by Alan Kirman, by Brad DeLong and colleagues and by
the group at Santa Fe which involved a key collaboration between
economists and physicists. This work helped kick off, as he describes
it, a transformation (still ongoing) of style in modelling markets:
In
the past two decades economics has witnessed an important paradigmatic
change: a shift from a rational representative agent analytically
tractable model of the economy to a boundedly rational, heterogeneous
agents computationally oriented evolutionary framework. This change has
at least three closely related aspects: (i) from representative agent to heterogeneous agent systems; (ii) from full rationality to bounded rationality; and (iii) from a mainly analytical to a more computational approach...
Hommes makes it sound here as if this transformation and paradigm shift
is now widely accepted in economics. I'm not so sure about that as there
still seem to be plenty of people eagerly working away on rational
representative agent models.
4. Work in econophysics -- through the
study of minimal models such as the minority game -- has also revealed surprising qualitative
features of markets; for example, that a key determinant of market
dynamics is the diversity of participants' strategic behaviour.
Markets work fairly smoothly if participants act using many diverse
strategies, but break down if many traders chase few opportunities
and use similar strategies to do so. Strategic crowding of this kind
can cause an abrupt phase transition from smooth behaviour into a
regime prone to sharp, virtually discontinuous price movements.
If this point seems esoteric,
one fairly recent study found more than 18,000 instances over five
years where a stock price rose or fell by roughly 1% or more in well
under a tenth of a second. These "glitches" or "fractures"
may signal
a transition of markets
into a regime dominated by fast
algorithmic trading. As algorithms compete on speed, they naturally
rely on simple strategies, which encourages strategic crowding. The
underlying phase transition phenomenon may therefore be quite
relevant to policy. I know of nothing in traditional economic analysis
that describes this kind of phase transition or does anything to
elucidate the kinds of conditions under which it might take place.
5. Yale economist John Geanakoplos
has argued for two decades that a key variable driving major economic
booms and busts is the amount of leverage used by financial
institutions. It goes up in good times, down in bad. Since the
financial crisis, controlling leverage has become a major new focus
of financial regulators, and their work may well benefit from
physics-inspired models of the dynamics of markets in which firms
compete with one another through the use of leverage. A
notable study by Geanakoplos and two physicists found that such a market will
naturally become unstable as leverage increases beyond a threshold.
This boundary of instability is not at all obvious to market
participants or made evident by standard economic theories. Such
models may well help improve macroeconomic policy and financial
regulation (I've written a little more on this
here)....
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