Wednesday, May 12, 2010

A physicists view of financial bubbles

Thought this would be interesting to all of you folks who are interested in making sense of the recent financial crisis (and/or trying to figure out if there is a microfinance investing bubble in India). Physicists Didier Sornette, Ryan Woodard and some others have been working to create predictive 'bubble diagnostics'. These diagnostics are based on non linear positive feedback models that have their basis in imitative human behavior. They are running The Financial Crisis Observatory which they describe as "a scientific platform aimed at testing and quantifying rigorously, in a systematic way and on a large scale the hypothesis that financial markets exhibit a degree of inefficiency and a potential for predictability, especially during regimes when bubbles develop".

Last year they published a paper called Financial Bubbles, Real Estate bubbles, Derivative Bubbles, and the Financial and Economic Crisis in arXiv (arXiv is a database of physics papers that is openly accessible) that is more of an essay and a pretty easy read. Some of the data that they show is quite striking. For instance, the abrupt and extraordinary divergence between wages and consumption as a percentage of GDP beginning in the '80s (figure 6 on p15), showing just how dramatically US household wealth and spending came to depend on the stock markets and not any real indicator of productivity or output.

Somehow I'm not surprised by all the bubbling. It is hard to keep focused on creating real value when paper value is so much easier to generate ....

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