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Econophysics: A New Field for Understanding Hurricanes, Earthquakes and Financial Markets

Posted By Prucia Buscell, Thursday, August 5, 2010
Updated: Thursday, February 17, 2011
The traditional notion that financial markets are efficient, self-regulating, self-correcting systems based on rational human decisions is eroding. But scientists don't think market behavior is random or mysterious either. Proponents of a new field called econophysics view markets as complex systems much like earthquakes and hurricanes that are characterized by nonlinear dynamics.

One such scholar is Didier Sornette, a professor of geophysics, physics and finance, who has studied earthquakes, epileptic seizures, and the popularity of YouTube videos. A Wall Street Journal feature by Eleanor Laise describes Professor Sornette as man who enjoys personal and professional risk and has a passion for predicting events in complex systems. He likes to windsurf, water ski and ride motorcycles at frightening speed. He also likes to contemplate how similar principles might underlie such diverse phenomena as the rupture of rocket tanks and disruptions of financial crashes. Last year he launched a controversial Financial Bubble Experiment to show that financial markets are not impenetrable and that reasonable forecasts are possible.

Sornette is director of the Financial Crisis Observatory at the Swiss Federal Institute of Technology in Zurich. In the experiment, he and colleagues predicted that four specific assets would form financial bubbles within a six month period.

A PhysOrg.com story notes that to date, no one has a reliable method of saying whether a particular market or asset is in a bubble state, and further, no universal agreement exists on what a bubble is. Research by Sornette and his group, whose members view the question through the lenses of physics, math, geology, earth science, and economics, may change that. Their experiment shows financial markets have an identifiable structure, and are subject to phases of growth that can change slowly or radically. They call the changes "regime shift," and a crash is an extreme example. The PhysOrg story reports all four of the selected assets experienced regime shift as Sornette and colleagues predicted, and two were in bubble state. A bubble is said to occur when the price of any commodity rises far above its actual value.

Greater understanding of markets and bubbles can help prepare for economic upheavals, these scientists believe. Financial and geological earthquakes change environments. In a New York Times story "A Richter Scale for Markets" by Eric Dash, Sornette is quoted as saying: "Great earthquakes shape landscapes. Great crashes shape regulation, the perception of risk, and the psychology of people."

But forecasting is still ambiguous and the impact of a major event can have extraordinary reach. The Times story notes that a group of econophysicists wrote to billionaire philanthropist George Soros urging his support for a multidisciplinary approach toeconomics.

Recent financial crises, they wrote, have "damaged the economic system to the extent that several countries are on the verge of bankruptcy, and social systems have become dangerously vulnerable. The problem we have seen may be just the beginning of a larger crisis. The situation may get totally out of control, endangering social peace and cultural achievements." They urged support for FuturIcT, a trans-disciplinary initiative in which scholars from all over the world will attempt to build computer simulations to develop new understanding of economic and social systems.

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