An interesting NYT article about economic theory, by a theoretical physicist, and why new econometric models and computational approaches are needed.
He also explains one of the underlying causes of the market-seizing credit crisis - a financial manifestation from the 'The Tipping Point' and 'The Black Swan': a quickly developing, self-reinforcing crisis of confidence caused by an unexpected confluence of forces; a tail-eating downward spiral that nobody thought could happen.
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"For example, a computational 'agent' model being developed ...looks at how the level of credit in a market can influence its overall stability."
"Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous."
"In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere."
"That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain."
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