Foreseeing the next financial crisis...

The Physics of Finance 2013-12-20

My latest column in Bloomberg (out today, 15/11/2013) looks a little at the silly pronouncements of some economists (Nobel Prize winners Robert Lucas and Eugene Fama among them) to the effect that "financial crises are by their very nature unpredictable." These are, in my opinion, essentially meaningless statements if at all examined; they're the equivalent of an excuse: "don't blame us economists for not having a clue the whole system was about to explode!" The column argues -- and this is the important point -- that lots of economists haven't taken this easy and shameful way out, but have taken on the hard work of developing ways to measure systemic risks and, we hope, give us a better chance to detect important instabilities and imbalances in financial markets as they emerge. Many have even begun collaborating in their efforts with physicists, engineers and other such types. If they have a little success, then we might then just possibly do something to head off the worst trouble in potential future crises (IF the regulatory system doesn't suffer massive political interference at just the crucial moment, of course, which I recognize is a big IF). As part of another project, I've been perusing recent efforts to develop various measures of systemic risk, and thought some readers might be interested. I've only started, so this is a very incomplete list, but there's some interesting stuff here:

First, a few very much from within the mainstream econ literature:

Acemoglu, D., Ozdaglar, A., & Tahbaz-Salehi, A. (2013). Systemic Risk and Stability in Financial Networks.

Adrian, T., Covitz, D., & Liang, J. (2013). Financial stability monitoring.

Billio, M., Getmansky, M., Lo, A. W., & Pelizzon, L. (2012). Econometric measures of connectedness and systemic risk in the finance and insurance sectors. Journal of Financial Economics, 104(3), 535–559.

Bisias, D., Flood, M., Lo, A. W., & Valavanis, S. (2012). A Survey of Systemic Risk Analytics. Annual Review of Financial Economics, 4(1), 255–296. doi:10.1146/annurev-financial-110311-101754

Brunnermeier, M. K., & Oehmke, M. (2012). Bubbles, Financial Crises, and Systemic Risk.

Hansen, L. P. (2012). Challenges in Identifying and Measuring Systemic Risk.

Then, some others by people bringing a wider spectrum of ideas and methods to bear:

Battiston, S., Puliga, M., Kaushik, R., Tasca, P., & Caldarelli, G. (2012). DebtRank: too central to fail? Financial networks, the FED and systemic risk. Scientific reports, 2, 541.

Beale, N., Rand, D. G., Battey, H., Croxson, K., May, R. M., & Nowak, M. A. (2011). Individual versus systemic risk and the Regulator’s Dilemma. Proceedings of the National Academy of Sciences of the United States of America, 108(31), 12647–52. doi:10.1073/pnas.1105882108

Bookstaber, R. (2012). Office of Financial Research Using Agent-Based Models for Analyzing Threats to Financial Stability. Farmer, J. D., Gallegati, M., Hommes, C., Kirman, a., Ormerod, P., Cincotti, S., … Helbing, D. (2012). A complex systems approach to constructing better models for managing financial markets and the economy. The European Physical Journal Special Topics, 214(1), 295–324. doi:10.1140/epjst/e2012-01696-9

Haldane, A. G., & May, R. M. (2011). Systemic risk in banking ecosystems. Nature, 469(7330), 351–5. doi:10.1038/nature09659

Markose, S. M. (2013). Systemic risk analytics: A data-driven multi-agent financial network (MAFN) approach. Journal of Banking Regulation, 14(3-4), 285–305. doi:10.1057/jbr.2013.10

Poledna, S., & Thurner, S. (2013). Leverage-induced systemic risk under Basle II and other credit risk policies.

A. Frank et al., Security in theAge of Systemic Risk: Strategies, Tactics and Options for Dealing with Femtorisks and Beyond. International Institute for Applied Systems Analysis.

Thurner, S., & Poledna, S. (2013). DebtRank-transparency: controlling systemic risk in financial networks. Scientific reports, 3, 1888. doi:10.1038/srep01888

Isn't it curious that all these people are wasting their time and effort, since we know from just a few seconds' thought that crises are impossible to predict? In fact, doesn't the EMH tell us that? And isn't that sacred principle enough for us to stop all further thought? It's all a mystery to me why these people persist in what they're doing. [Sorry for the funny indent... I can't seem to get rid of it...]