The modern trend for physicists to work on problems in finance and economics began in the early 1990s and has gained momentum ever since. In the past few years, however, this field of 'econophysics' has come in for some strong criticism. Physicists, critics say, have mostly just re-discovered things that others already knew, and failed to build any valuable theory with explanatory power.
Is it true? Has econophysics really degenerated into irrelevance? It certainly doesn't seem that way to me. There is plenty of uninspiring work in the field, as in any area of science. Yet physicists have made quite a number of lasting contributions. Taking stock, I would suggest the following short (and incomplete) list of the 'good things':
(1) More than anything, physicists have helped to establish empirical facts about financial markets; for example, that the probability of large price movements decreases in accordance with an inverse cubic power law in many diverse markets. Work by physicists has also established other generic market patterns, such as the self-similar structure of market volatility. Did econophysicists initiate this kind of work? Of course not. Benoit Mandelbrot found the first evidence for fat-tailed distributions in the early 1960s. But research by physicists has made our knowledge of these empirical regularities much more precise.
(2) Physicists have identified instructive links between markets and other natural phenomena. For example, in the period following a large crash, markets show lingering activity which follows the famous Omori law for earthquake aftershocks. Such connections indicate that the explanation of these market dynamics may well not depend on facts specific to finance and economics; that more general dynamical principles may be involved.
(3) Physicists have also helped to develop more realistic models of markets, here mostly in collaboration with economists. In the mid-1990s, researchers first demonstrated how fat-tailed dynamics could arise naturally in models that represent a market as an ecology of interacting adaptive agents. Models of this kind have since become widespread and support some of the most sophisticated tests of policy proposals — for the idea of a financial transactions tax, for example, as currently planned by the European Commission.
“Has econophysics really degenerated into irrelevance? It doesn't seem that way to me.”
(4) Work in econophysics — through the study of minimal models — has revealed surprising qualitative features of markets; for example, that a key determinant of market dynamics is the diversity of participants' strategic behaviour. Markets work fairly smoothly if participants act using many, diverse strategies, but break down if many traders chase few opportunities and use similar strategies to do so. Strategic crowding of this kind can cause an abrupt phase transition from smooth behaviour into a regime prone to sharp, almost discontinuous price movements.
If this point seems esoteric, one recent study found more than 18,000 instances over the past five years when a stock price rose or fell by roughly 1% or more in well under a tenth of a second. These 'glitches' or 'fractures' may signal a transition of markets into a regime dominated by fast algorithmic trading. As algorithms compete on speed, they naturally rely on simple strategies, and this encourages strategic crowding. The underlying phase-transition phenomenon may therefore be quite relevant to policy (for example, N. Johnson et al. Preprint at http://arXiv.org/abs/1202.1448).
(5) Yale economist John Geanakoplos has argued for two decades that a key variable driving major economic booms and busts is the amount of leverage used by financial institutions. It goes up in good times, down in bad. Since the financial crisis, controlling leverage has become a new focus of financial regulators, and their work may well benefit from physics-inspired models of the dynamics of markets in which firms compete with one another through the use of leverage. One notable study found that such a market will naturally become unstable as leverage increases beyond a threshold (S. Thurner, D. Farmer and J. Geanakoplos Quantitative Finance 12, 695–707; 2012). This boundary of instability is not at all obvious to market participants, or made evident by standard economic theories. These models may well help improve financial regulation.
(6) Physicists have also helped to clarify other fundamental sources of market instability. For example, standard thinking in economics holds that the sharing of risks between financial institutions — through derivatives and other instruments — should both make individual firms safer and the entire banking system more stable. However, a collaboration of economists and physicists has showed that too much risk sharing in a network of institutions can decrease stability. An overconnected network makes it too easy for trouble to spread.
(7) On a similar theme, fundamental analysis by econophysicists has examined the relationship between market efficiency and stability. In economic theory, markets become more efficient — more able to pool collective wisdom and price assets accurately — as they become more 'complete', that is, equipped with such a broad range of financial instruments that essentially any trade can be undertaken. Econophysics research has shown, however, that completeness brings with it inherent market instability (F. Caccioli and M. Marsili Economics 4, 2010–20; 2010), a possibility never raised by standard economic analyses.
(8) The complexity of today's markets makes is essentially impossible for financial institutions to judge the risks they face, as the health of any decent-sized financial institution depends on a vast web of links to other institutions, about which little may be known. Econophysicists have recently developed a network measure called DebtRank, which aims to cut through network complexity and reveal the true riskiness of any particular institution (see the Focus on 'Complex networks in finance' in Nature Physics; available at http://www.nature.com/nphys/focus/finance). This idea may also provide a natural means for making markets more stable. If banks seeking to borrow funds were forced to do so from the least risky banks, systemic instability would be improved.
As I said, this is a very short list, and the product only of my limited view. Even so, these examples make econophysics look, to my eyes at least, like much more than a failed experiment.
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Nature Reviews Physics (2021)
Computational Economics (2021)