Wednesday, October 1, 2008

A good statement on the sociological messiness of economic markets . . .

. . . by a physicist.

From today's New York Times:

Certainly, markets have internal dynamics. They’re self-propelling systems driven in large part by what investors believe other investors believe; participants trade on rumors and gossip, on fears and expectations, and traders speak for good reason of the market’s optimism or pessimism. It’s these internal dynamics that make it possible for billions to evaporate from portfolios in a few short months just because people suddenly begin remembering that housing values do not always go up.

Really understanding what’s going on means going beyond equilibrium thinking and getting some insight into the underlying ecology of beliefs and expectations, perceptions and misperceptions, that drive market swings.

The author is Mark Buchanan, a theoretical physicist. His point is that real-life actions mess up traditional equilibrium-based economic models. To combat this, he favors an "agent-based" approach to understanding markets.

The idea is to populate virtual markets with artificially intelligent agents who trade and interact and compete with one another much like real people. These “agent based” models do not simply proclaim the truth of market equilibrium, as the standard theory complacently does, but let market behavior emerge naturally from the actions of the interacting participants, which may include individuals, banks, hedge funds and other players, even regulators. What comes out may be a quiet equilibrium, or it may be something else.

. . . .

If we’re really going to avoid crises, we’re going to need something more imaginative, starting with a more open-minded attitude to how science can help us understand how markets really work. . . . Better market models alone will not prevent crises, but they may give regulators better ways for assessing market dynamics, and more important, techniques for detecting early signs of trouble. Economic tradition, of all things, shouldn’t be allowed to inhibit economic progress.


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