Mark Buchanan, physicist, author
and scholar of complex systems, says positive feedback is behind almost
everything that makes our world rich, surprising and dynamic. In his
newest book Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics,
Buchanan writes that positive feedback makes "seeds sprout and grow
into trees, matches burst into flame, and single cells divide and
proliferate into living thinking human beings. It drives political
revolution and new religions, and it makes perfectly peaceful blue skies
give rise, with little warning, to storms of terrifying violence...”
believes an intellectual blind spot to the power of positive feedback
has held back our understanding of human systems and social sciences.
Economics is often misunderstood, he asserts, because theorists in the
field have viewed economic systems as inherently stable and
self-regulating and they’ve thought that people make rational economic
decisions with full awareness of future possibilities. Even after the
financial meltdown of 2008, he writes, many economists have strained to
rationalize those views in spite of evidence that debunks them. With his
prediction that future crises are inevitable unless economic models are
changed to take into account what’s been learned about other complex
systems, Buchanan imparts urgency to his insights that markets follow
power law distributions and small events can trigger huge consequences.
In a detailed analysis of the May 2010 "flash crash,"
for instance, Buchanan shows positive feedback was among the forces
involved when the Dow Jones Industrial Average plunged nearly 1,000
points (9 percent of its total value) in 13 minutes and 27 seconds.
Within 21 minutes stock values rose back to previous levels, but anyone
unfortunate enough to unknowingly sell as prices hit rock bottom
suffered serious losses. Buchanan tells the story of one investor who
was "mugged” by the crash, losing $15,000 in a matter of seconds. The
cause of the crash remains controversial, though government reports
found no evidence of illegal manipulation or any "fat finger” mistake
caused by someone hitting a wrong button. Buchanan explains that high
frequency trading (HFT), which made up 73 percent of the volume of
trading in 2010, usually produces greater liquidity in the market-except
when it doesn’t.
work best when money and assets flow easily among buyers and sellers
without delays and obstructions, and when that happens, the market is called liquid. Generally, speed is good. But exceptions
are possible. A high percentage of trading now takes place at the speed
of light. Hundreds of companies sell algorithmic trading platforms that execute trades so fast virtually no time elapses between the push of a button and the completion of the trade.
explains that the bid-ask spread in trading reflects how much market
makers think they need to charge to make a profit. In turbulent periods,
HFT market makers charge more, so the spread widens. In the flash crash
the spread ballooned, and HFT firms with algorithms running on autopilot fled the
market. Trading came crashing to a halt and liquidity disappeared.
Buchanan describes the positive feed back effect: more volatility meant
less liquidity, which brought more volatility, and which brought less
liquidity. Physicists have found wilder behavior in stock movements, and
more mini crashes, in very short time periods since 2005. Buchanan
suggests as trading moves to inhumanly short time scales, increasing
"black swan" events in microscopic time can be expected.
science has shown that people don’t respond well to things that happen
in less than a second, Buchanan writes, and what happens in markets in
sub-second times may reflect a fundamental change as trading "becomes
uncoupled from the influence of human decision making."
and meteorology hold clues to the working of economic systems, though
Buchanan doesn’t suggest any one explanatory theory. If a predictive
model were developed, he said, its existence would change how people
behave, making its predictions inaccurate. Meteorologists have
different models and theories for different aspects of weather, such as
tornadoes and thunderstorms on the plains, hurricanes developing at sea,
or a blanket of fog over the earth’s surface, and their predictions
have vastly improved. In the same way, he writes, economists need an
assortment of models and theories to understand economic phenomena such as rapid fluctuations
driven by high frequency trading, daily movements driven by trend-
following speculators or instabilities that form over months or years as
a result of social change, such as the trend in sub prime lending.
Forecast is provocative, carefully researched, absorbing and lucidly
written. Buchanan illuminates complex material and tells stories that
give it a human face.