Economists and physicists may seem like unlikely bedfellows, but then opposites often attract. Their union has recently produced a peculiar baby, a field of research known as “econophysics”.
Physicists and mathematicians have a long history of looking for patterns in human behaviour in much the same way as planets and particles.
The orthodoxy is that while individual humans are not predictable like planets, groups of humans do nonetheless seem to follow patterns, often the result of herding behaviour.
The herding instincts of humans have their uses. If everyone followed a unique path, there would surely be chaos.
Besides, herding seems to be a core element of how our brains are wired: the most social animals are also the most imitative. But when this instinct attaches to matters monetary, problems quickly emerge.
These problems are exacerbated by another human trait that can be both good and bad: optimism.
The expectation that all will be well in the future, combined with an in-built desire to jump on passing bandwagons, can lead to bubbles of many kinds, the most damaging of which involve finance.
As J. K. Galbraith put it in The Great Crash, 1929, bubbles are blown when “the vested interest in euphoria leads men and women, individuals and institutions to believe that all will be better, that they are meant to be richer and to dismiss as intellectually deficient what is in conflict with that conviction”.
What goes up, must continue to go up!
There has been much speculation about whether Australia is currently experiencing a property bubble, with house prices elevated way beyond what is expected given fundamentals.
Last year, The Economist found that Australia had the most overvalued housing market in the world, inflated by 63.2%.
People continue to buy at these elevated prices since they expect prices to rise further still in the future. This expectation has the air of a self-fulfilling prophecy, further amplifying the rise in prices.
There is also a panic factor: given dramatic price rises, first-time buyers must “get in quick” to avoid being priced out of the market.
We see all the elements of an accident waiting to happen: herding combined with (misplaced) optimism about future returns.
The formation of bubbles is, in one way, very simple to understand: adding more of something makes it bigger, and the bigger that something is, the more attractive it is seen to be.
As with gravitation, there is a critical density beyond which the whole thing is unsustainable, causing an implosion.
Crashes are the economic universe’s black holes.
But, as with such complex phenomena as earthquakes and avalanches, the patterns we find concern statistics of events rather than particular events.
So perhaps gravitation is not really the correct analogy here: bubbles are collective, cooperative phenomena of the kind found in statistical physics, and crashes are more like financial earthquakes.
Didier Sornette, Professor on the Chair of Entrepreneurial Risks at Swiss Federal Institute of Technology Zurich, trained as a geophysicist, and knows well the complexities of earthquake prediction.
Bubbles are modelled as systems in a “critical phase,” with very strongly interacting components adopting the same behaviours.
The herding instinct is central to this enterprise, and is modelled by long-range correlations that spread over the system.
In such critical, highly cooperative scenarios (known as critical or tipping points) even very small shocks to the system can trigger calamitous effects, such as crashes.
In these cases it doesn’t make sense to say that some individual event caused the crash: the system was led into an unstable state over time by internal processes. Crashes are systemic.
Sornette’s group has claimed to find “signatures” that precede crashes. This overturns the standard assumptions about the structure and dynamics of economies, since it denies perfect efficiency and, therefore, introduces elbow-room for making predictions.
Though controversial, this econophysics approach has met with some degree of success, especially given the enormous complexity in predicting events within the social domain.
The Australian market would seem to offer up a prime candidate for just this sort of analysis. If Sornette’s group is right, we should be able to:
1) Identify whether we are indeed experiencing a bubble.
2) Predict (however approximately) its endpoint.
Thanks to the standard (i.e. random) model of economics, the usual course of action with respect to bubbles and crashes is to perform autopsies after the event.
But econophysics opens up the possibility of performing preventative economic surgery, ensuring that any property bubble ends with a whimper, rather than a bang.