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Looking into the financial world as if it's a natural ecosystem
"Economists should learn from ecology, climatology and other sciences studying complex systems; so they can better understand the formation of bubbles and crashes impacting the stability of the society."
This idea is published today in Science [sciencemag.org] by a group of scientists, including Cars Hommes, Professor of Economic Dynamics at the University of Amsterdam [www.uva.nl] and Marten Scheffer [wikipedia.org], Professor of Aquatic Ecology at Wageningen University [wageningenur.nl].
More than seven years ago, the US bank Lehman Brothers went bankrupt and nearly took the global financial system down with the fall. Such impending crashes and bubbles are often not noticed in advance. Even though they cause enormous damage — the write off from the banking crisis in 2008 is estimated at 14 trillion US dollars — those losses are often paid for by the taxpayer. It's not surprising that policymakers and central bankers want better insights to understand how economic crises arise and how they can be prevented or attenuated.
Economists have to learn from other 'complex' sciences, says Cars Hommes. One of the lessons is the importance of network structures. Even if individual banks are stable, that does not automatically guarantee a safe position considering the banking system as a whole. In the 2008 crisis this financial network played a role. "With the collapse of Lehman Brothers a domino effect was put in motion," said Hommes, "and other banks and financial institutions were sucked into the crisis."
The work of Marten Scheffer is another source of inspiration. The Wageningen ecologist discovered that lakes that have been cloudy for a long time can suddenly 'tumble' into a new situation — the water turns clear in an instant. Those sudden tipping points you can find in many situations, such as with migraines and with changing vegetation in rainforests. Or a banking system that seems to run smoothly but suddenly crashes anyway. "We would like to find generic indicators of the resilience of such systems," said Scheffer, "a widely applicable indicator which shows that the system is approaching a tipping point."
Scheffer warns for one peculiarity of financial markets, distinct from other complex systems. "People are constantly trying to predict the market because you earn money doing so. That is something that trees in the Amazon don't do."
"Economists should indeed take into account the behavior of individual cogs in the machine - such as bankers and traders" says Hommes. "The challenge is that their behavior is less rational than ever imagined. They are prone to herd behavior. Also, the behavior of individuals is not easily transposed to the behavior of financial markets, which are results from the interaction between all those cogs." "More is different," says Hommes, "that is what we know about complex systems."
Related links:
- FOC Project publications [focproject.eu] and Youtube channel [youtube.com]
- Institute for New Economic Thinking [wikipedia.org] Youtube channel [youtube.com]
- Nature: The economy needs agent-based modelling [nature.com]
