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July 31, 2010

A Richter Scale for Markets
By ERIC DASH

It’s tempting to pull out the old earthquake metaphor when talking about the latestfinancial crises. How else to describe the economic devastation — the tremors in thesubprime mortgage market, the seismic collapse of Lehman Brothers, and theaftershocks reverberating in Europe?
But some academics are now taking the metaphor seriously, pursuing a new
approach to economics they call econophysics. The field represents a significant
break from traditional economics, by studying financial earthquakes in much thesame way geologists study those on terra firma. “New approaches are needed toaddress the fundamental and practical challenges of our financial, economic andsocial system,” a group of econophysicists wrote recently in an open letter to George
Soros, the billionaire investor and philanthropist.
Macroeconomists construct elegant theories to inform their understanding of crises.
Econophysicists view markets as far more messy and complex — so much so that thebeauty and logic of economic theory is a poor substitute. Drawing on the tools of thenatural sciences, they believe that by sorting through an enormous amount of data,
they can work backward to find the underlying dynamics of economic earthquakes
and figure out how to prepare for the next one.
Financial crises are difficult to predict, the econophysicists say, because markets arenot, as some traditional economists believe, efficient, self-regulating andself-correcting. The periodic upheavals are the result of a cascade of events andfeedback loops, much like the tectonic rumblings beneath the Earth’s surface.
Scientists have found that earthquakes, natural and financial, share similar patterns.

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Small, subtle market gyrations are such regular occurrences that they are barely
noticed; extreme market shocks — the proverbial “Big One” — are very rare. So too
with earthquakes, which also adhere to a statistical relationship known as a powerlaw.
Economic earthquakes also trigger dangerous aftershocks. Just as 19th-century
Japanese geophysicists discovered that aftershocks continue to reverberate well after
a first major tremor hits, modern-day stock market seismologists have identified asimilar pattern with financial crashes.
“If you analyze them, this earthquake law is obeyed perfectly,” notes H. Eugene
Stanley, a Boston University physics professor who published a pioneering study offinancial markets in the scientific journal Nature. “A big shock causes smaller
aftershocks, and then ones smaller and even smaller.”
Indeed, financial crises come in clusters. The currency crisis in Thailand during thelate 1990s was followed by similar problems in Indonesia and South Korea. After
Lehman Brothers faltered, Washington Mutual, the Wachovia Corporation and scoresof smaller banks toppled over like dominoes.
Some econophysicists, as well as economists and politicians, suggest that theongoing turmoil in Europe was triggered by the lingering effects of the 2008 panicthat started in the United States.
Financial earthquakes also radically reshape the environment. The sudden release ofenergy in the Earth’s crust creates seismic waves that can move mountains; financial
crises can lead to the upheaval of regulations in place for years.
After the crash of 1929 and the Great Depression, the Glass-Steagall Act was enacted
to separate commercial banking from investment banking. Now, in the wake of therecent crisis, lawmakers have just completed the biggest overhaul of financial rules
since the 1930s.
“Great earthquakes shape landscapes,” said Didier Sornette, a geophysics professor
who now runs the Financial Crisis Observatory in Zurich. “Great crashes shape
regulation, the perception of risk, and the psychology of people.”

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But as with earthquake science, our understanding of financial crises is primitive.
Seismologists, for example, can monitor the Earth’s daily gyrations along the San
Andreas Fault and know that the chance of a devastating earthquake — one larger
than 6.7 on the Richter scale — over the next 30 years is greater than 99 percent. But
they can’t pinpoint exactly when or where one will hit, or how big it will be.
Economic earthquakes are even less predictable. One reason is that the real world is
a complex system that is constantly adapting. Another reason is that while there are
geological limits on the energy an earthquake can unleash, there are no constraints
on prices.
“The physical world cannot surprise us massively,” said Nassim Taleb, author of “TheBlack Swan,” a best-selling book about the influence of highly improbable events.
“The financial world can.”So if financial crises are hard to predict, can anything be done to prevent the damage
they cause? Lessons learned by earthquake scientists are instructive here as well.
After the Great Earthquake of 1906, architects and engineers greatly revamped San
Francisco’s building codes so the buildings would be able to withstand an evenheftier blow. Likewise, the recently enacted regulatory reforms are aimed atstrengthening the nation’s financial architecture. The new rules are intended to act
like shock absorbers to buttress the market’s wild swings.
“We want to fortify structures so they don’t collapse,” said Lawrence H. Summers,
the president’s chief economic adviser. Other administration officials suggest that theso-called systemic risk council of regulators can be on the lookout for early tremors
in financial markets, just as seismologists do. “If you have better monitoring systems
for earthquakes, you can take precautions and evacuate the population if a tsunami isabout to occur,” said Alan Krueger, the Treasury Department’s chief economist.
Or prepare for the next eruption in the markets. The Securities and Exchange
Commission recently asked a Princeton-trained nuclear physicist to lead its
investigation into the causes of a “flash crash” in May, when the stock market
plunged and then quickly rebounded, nonetheless stoking investor fears.

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Still, no panacea for calming the volatile markets is in sight.
“We can have sound financial institutions but still have major financial earthquakes if
the policies that governments pursue are fundamentally unbalanced,” said Lowell
Bryan, a senior partner at McKinsey & Company. “Nobody seems quite interested ingoing through the pain.”

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