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Sunday, November 27, 2005

Who Ya Gonna Call?

Another economist wannabee from the sciences. We get these every so often. This is from Discover magazine:

Discover Dialogue: Geophysicist Didier Sornette, The Dauphin of Disasters, by Jocelyn Selim, Discover: Didier Sornette is a professor of geophysics at UCLA ... He uses complexity theory to study the myriad causes and effects of catastrophic events, ranging from earthquakes to stock market crashes.

Is there a simple way to explain complexity theory?
It's an attempt to understand the organization of all the stuff of interest around us, from galaxies down to bacteria, by understanding the interplay between the positive and negative feedbacks of the various interacting elements. Negative feedback is often obvious—if there are too many rabbits, they eat all the grass, and the population goes down. Positive feedback is much less well appreciated and understood. For example, the more fax machines there are, the more attractive they become because you have more people sharing and extending information. ... We use empirical observation. ... [to develop] a complex system ... reflecting the interplay of positive and negative feedbacks ...

How can you extend that thinking to human behavior?
Systems influenced by behavior, like the stock market, are surprisingly simpler to predict because we have an extraordinarily large base of ... very good quality data. We now know, for example, that if people believe in incorrect things, they can influence events. If everybody believes that the stock market is going to go up, the stock market will go up ..., even if this is completely wrong on the basis of fundamental analysis ...

Is that how bubbles happen?
When prices skyrocket above a reasonable bracket, they become unstable because eventually they must return to a reasonable level. So ... a crash ... is not due to a specific event; it's the result of an instability that has matured over months or years. Think of putting a pen on your finger vertically. You may be able to hold it for a while, but it is a very unstable situation. ... [T]he fundamental explanation is that the pen was put in an unstable situation.

Should we use government intervention to stabilize the market?
I'll quote Alan Greenspan. In the aftermath of the burst of the new economy bubble in 2000 he said, "We probably should have not done anything because the result of our action would probably have been worse than the result of the bubble and the crash itself." Investors watch Greenspan a lot, right, and if he's calling for a correction, confidence can be lost. ... [T]hat's the big problem that any policymaker has to take into account—to discount how people will act.

So it's better to just let things be?
From a scientific point of view, it's an extremely interesting problem. It illustrates the interplay effect of positive and negative feedbacks. Southern California and Baja California in Mexico have nearly identical terrains and climate. In Southern California you have no small fires because the policy is to extinguish them immediately. But once in a while you have a huge, devastating, unstoppable fire. That doesn't happen in Mexico because little fires are allowed to burn corridors of biomass and thus develop the negative feedback of natural barriers. ...

Is it too late to put my money into real estate?
Stocks and real estate often operate on the "greater fool" theory. Suppose I buy a house that is very expensive, even though real estate prices are way up. I still buy it because I think I will be able to sell it later to a greater fool. It is based on this positive feedback of the appreciation of the price attracting speculators. ... A crash is dependent on the health of the economy as a whole and in the confidence of spenders.

Are we in a real estate bubble right now?
Yes. Sometime in the first semester of 2006 (and already in the second semester of 2005 in some states), we expect the bubble to transition to another regime. It might be a crash; it might be a plateau. But according to our analysis, the bubble will not continue beyond that.

How do I know you're right?
Well, in 2003, ... in the United Kingdom, ... we correctly predicted the end of the bubble there, around the summer of 2004. But this is only one success, which . . . could be luck. In science, ... one success doesn't prove anything. But as scientists we need to stick our necks out a bit; otherwise we lose accountability. ...

What do you think of gloom-and-doom predictions for the U.S. economy?
These statements are really based ... on overinterpreting a very complex system using unscientific methods. ...[T]he United States ... is a very special player, eh? It has the dollar, which is the world's currency. It has the army of the world; ... So it has a lot of things that are a positive leverage to its clear overspending. Is it sustainable? I don't believe it is. But the correction won't necessarily be a crash.

What else can you analyze with complexity theory?
We looked at the thousands of books and all the sales figures and the rankings on Amazon, and we were able to discover that book sales can take off for two reasons. A good review, like one on Oprah, can trigger an avalanche of sales. Or you can have a slow, steady word-of-mouth effect, like the one for Divine Secrets of the Ya-Ya Sisterhood ... We made a model taking into account both phenomena. We have been able to discover a ... universal law ... It appears to be universal with respect to describing social interactions. It's really a description of the peaks and the decay of fame. ...

"It might be a crash, it might be a plateau." There's a heck of a prediction. What specificity. And it might happen, oh, I don't know, "Sometime in the first semester of 2006." Turning points are a lot easier to forecast if you can put them in a large interval of time. He almost has network externalities nailed (the thing he says is not well understood - by him - at the beginning), hints at an understanding of a vehicle currency, seems to have some notion of self-fulfilling expectations, and if you read closely, you can see him trying to discover the Lucas critique. If he does, then he can build a theoretical model as opposed to a model that only predicts transitions to new states (telling us little about structural relationships) and maybe he can start catching up to, say, the mid 1970s. At that point, he might be able to say more about why bubbles happen than "the pen was put in an unstable situation." Economists know all about complexity theory. There's a reason (many actually) we don't use it. 

When Discover magazine has questions about geophysics, perhaps about the difficult problem of decomposing fluctuations in land elevation over time near coastal subduction zones into trend, seasonal, and cycle components to measure trend plate stresses for use in assessing earthquake probabilities, will they call a time-series econometrician? Perhaps they should.

    Posted by on Sunday, November 27, 2005 at 12:51 AM in Economics, Housing, Science | Permalink  TrackBack (0)  Comments (20)


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