Aug 01 2013

State of the Wave: The Physics of Finance As We Approach the 1960s-Style Critical State

For most people the financial Panic of 2008 is probably the most famous evidence that conventional economic models — like those long-used by the Fed and other central banks — are simply not adequate. In fact, many decades have been littered with officially unforeseen recessions and initially minimized expansions. So many that in 2010 economist Russ Thomas (Hoover Institution & George Mason Univ) finally asked, “Is the dismal science really a science?” (Wall Street Journal, 2/26/10).

Thomas’ bottom-line is revealing:
“The economy is a complex system, our data are imperfect and our models inevitably fail to account for all the interactions.”

Momentum is growing in this direction. For example, after asking whether economics is “a science or a religion” physicist Mark Buchanan concluded recently (Bloomberg, 7/17/13) that,

Economics is riddled with hidden value judgments that make its advice far from scientific … (and) economists would do well to derive their prescriptions from observations of how the world really works, with a healthy respect for its complexity.

In 2010, The Economist (7/22/10) reported on growing insight into complexity in the economy using Agent-based Models or ABMs, with an eye toward forecasting major fluctuations.

ABMs do not suffer from key assumptions that limit traditional (dynamic stochastic general equilibrium) economic models including a theoretical equilibrium that attracts all prices or that markets must be fundamentally rational. Instead an ABM assigns specific rules for each agent (e.g., an individual, a firm) including for example, how it regards fundamentals or technical analysis of market data. Agents can also interact with each other and learn from experience, and thus mirror real-world activities.

Michael Casey (Wall Street Journal, 7/10/13) concludes that

the Universe’s dynamic tendency toward disequilibrium and instability … (is) a direct challenge to the prevailing economic theory that markets are inherently self-correcting and always reverting to equilibrium.

Mark Buchanan sees sudden events like the 1987 stock market crash as an “avalanche” in economic behavior. In the 1980s physicist Per Bak and his colleagues originated the term “avalanche” in reference to his famous sand pile analogy to explain the behavior of a fractal system that has self-organized to a “critical state.”

This is an increasingly popular theme with econophysicists. For example, European geophysicist Didier Sornette founded the Financial Crisis Observatory in Zurich and developed his “Crash Risk Index” to monitor the approach of market-related critical states. Researchers at Oxford University, the Santa Fe institute, and elsewhere envision a super-ABM — by linking many ABM modules — that can anticipate avalanches across the globe.

Although the details in some physics-based models are proprietary (because of their commercial potential), the physics of finance has achieved significant success and recently even became a marketing tool. The Paris-based Capital Fund Management, whose chair is physicist Jean-Philippe Bouchaud, prominently features this on their website:

Research in the statistical properties of financial instruments and the development of systematic trading strategies are carried out at CFM by a team of Ph.D’s, most of them former physicists from prestigious international institutions …

And we should remember that on September 15, 2008, Scientific American magazine republished an article by Benoit Mandelbrot (who originated the concept of a fractal) on “How Fractals Can Explain What’s Wrong With Wall Street,” with this note:

This story was originally published in the February, 1999 edition of Scientific American. We are posting it in light of recent news involving Lehman Brothers and Merrill Lynch.

This is a glimpse of the exponentially expanding world of the physics of finance that provides theoretical support for our empirical model of the Maslow Window. Indeed, Maslow Windows appear increasingly to be the manifestation of “critical states” in the international economic system.

Twice-per-century, rhythmic pulses of unprecedented activity — in great explorations (e.g., Lewis and Clark), monumental macro-engineering projects (e.g., the Panama Canal), and major wars (e.g., World War I) — produce transformational, 1960s-style decades called Maslow Windows powered by “critical states.”

The last one was in the early 1960s and it led to the first human landing on the Moon.

Over the last 200+ years, the approach of a Maslow Window is signaled by a financial panic (e.g., Panic of 1893) that precedes it by 6-7 years. Such panics are now understood as “avalanches” in the complex international economic system due to the development of “critical states” over decades of self-organization.

Based on 200-year patterns, the Panic of 2008 signaled that we were within 6-7 years of the opening of the next Maslow Window (~2015).

Recovery from the Panic/Great Recession duo typically results in a JFK-style economic and technology boom that momentarily creates an “ebullient” population ready to tackle major projects like Apollo despite the rather bumpy road (e.g., Cuban Missile Crisis). The rapid-fire juxtaposition of both “good” (e.g, Apollo, Peace Corps) and “bad” events (e.g., CMC, Cold War) is understood now as characteristic of a complex system in a critical state subject to major avalanches (technological, economic, or geopolitical) in both positive and negative directions. Once in the critical state almost anything can happen.

Our recent statistical study of the costs of NASA space programs — over the history of the agency — showed they are fractal, in the same fundamental sense as financial markets. Thus the fact that Apollo became a featured element of the 1960s is now understood as being due to the development of its critical state.

The ongoing, linked North Korea/Iran nuclear crisis is, in some ways, reminiscent of the Cuban Missile Crisis and signals that the opening of the next Maslow Window is imminent. Just how imminent is still uncertain. Until the JFK-style boom appears the Maslow Window cannot blossom.
For scenarios that lead to a near-term JFK-style boom, click: “State of the Wave: 10 Space Trends for 2013 — Featuring the Approach of the New International Space Age”

Historically, wars and/or major international conflicts punctuate Maslow Windows. For example, the 1960s Maslow Window began with the Cuban Missile Crisis (nearly triggering a nuclear war) and ended as the Vietnam War destroyed any remaining societal ebullience.

This is to be expected because in 1998 geophysicist Donald Turcotte and his colleagues discovered that wars are fractal and subject to self-organized criticality — like financial systems and NASA space programs! According to Turcotte:

World order behaves as a self-organized critical system independent of the efforts made to control and stabilize interactions between people and countries.

The early war/conflict is always smaller than the major war that abruptly terminates the Maslow Window. Widespread affluence-induced ebullience early in the Maslow Window may moderate conflicts at that time, while the terminal war accelerates collapse of the Maslow Window; the classic example is World War I.

The fact that Maslow Windows are bookended by wars and/or major international conflicts is now understood as a natural consequence of the fractal nature of wars and the development of a critical state before and during each Maslow Window.

The fractal nature of financial systems, wars, and NASA space programs informs us why “avalanches” in these entities cluster exclusively during the self-organized critical states of Maslow Windows. Expanded ABM’s will reveal the details of these mutual relationships in time (hopefully!) to illuminate our near-term, 1960s-style transformative future.

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