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Paolo Magrassi 2010 - Creative Commons Attribution-Non-Commercial-Share Alike 3.

Econophysics: enthusiasm, realism

Paolo Magrassi
www.magrassi.net

Excerpt from a paper currently under peer-review for publication in the proceedings of an international com-
puter science conference.

One “problem” of the 21st century world, particu- ken into a sum of mutually independent sub-
larly the economic and business worlds, is the phe- problems. When, on the contrary, the various as-
nomenal and increasing number of connections and pects/components interact with each other so as to
interactions. render impossible their separation for solving the
problem step by step or in blocks, then the situation
Financial markets are strongly interconnected.
is non-linear, or “complex”.
Economies are interconnected due to globalization.
Networks, such as power grids or transport, are in- Many systems can be highly complicated (from the
terconnected. Consumers are interconnected, and Latin complico, to fold) without being complex. For
influence each others’ behaviours, via communica- example, an anatomy book describing the taxon-
tions forms of all sorts. omy of the human body is very complicated: it
takes many volumes and a long time of reading, to
unfold the system completely and master the name
and the functional role of every individual compo-
nent. Still, the whole is equal to the sum of its parts.
In anatomy, a body is a set of organs.
By contrast, physiology is, in addition to compli-
cated, complex (complector: to encircle, to com-
prise, to unite under a single thought), because it
entails the study of the influences that each and
Increasing connectivity means that markets, prices, every organ can exert on others. One thing are the
supplies, demands, consumers, companies are all components; another thing is the system, even
more and more interacting and consequently giving though it is made of those and only those compo-
raise to enormous degrees of what mathematicians nents.
call non-linearity, a.k.a. complexity.
Linearity can be a useful approximation
And complexity often brings with it unexpected
phenomena, such as chaos and emerging behaviour, The “systems” and the “problems” that are encoun-
that can become threats for the survival of eco- tered in nature are essentially non-linear.
nomic agents. However, in many situations, one can resort to line-
Complexity can explain why illustrious analysts arity as a first-order approximation: if the effects of
and the mainstream of economic research can be non-linearity can be considered negligible, a
caught by surprise when global financial markets mathematical model can be built that represents the
collapse and robust economies plunge into deep re- system as if it were linear. This approach is fecund
cessions. in many situations, from electronics to ecology,
from computers to economics.
Let us look at some of the most radical proposals
that have been advanced to fix such situation, and As an example, an audio amplifier is not linear but,
underline as well some of their limitations. within certain frequency limits (i.e., as long as the
wavelength is much smaller than the circuit’s
Complexity physical dimensions), it will behave as if it were
and this is why it is a useful hi-fi device. Conse-
In common parlance, complexity can take many quently, its description throughout the electronics
meanings, but in science it is about non-linear sys- and audio literature will always be that of a linear
tems1. A problem/system is linear if it can be bro- system, even though strictly speaking it is not.
1 Linear models are useful because, within their lin-
Here we are using the dynamic/systemic view of com-
plexity. Another one is possible, i.e. the computa-
ear range, many natural systems resemble one an-
tional/structural one. Ultimately related to Gödel incom- other: their behaviour can be described with the
pleteness theorems, the structural view is predominantly
adopted in information theory and computer science, The two views are ultimately connected, although in sub-
where it has to do with the computability of algorithms. tle and convoluted ways, via the concept of entropy.

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Paolo Magrassi 2010 - Creative Commons Attribution-Non-Commercial-Share Alike 3.0

same equations even if the contexts are very differ- ability of preys. These, on the other hand, depend of
ent, such as mechanics, electronics, chemistry, bi- the availability of food, and eating too much of it
ology, economics, and so on. A linear oscillator is a would cause the preys population to contract, pos-
model described by the same mathematical equa- sibly beyond sustainability.
tion, whether it be a metal spring, an electric circuit
or a standalone El Niño. The preys–predators–food system is intrinsically
non-linear: none of its components may be studied
(Complex systems, on the contrary, each have their in isolation from the others. And indeed, the Lotka-
own mathematical formalization and, in many Volterra equations are a classical example of simple
cases, not even that: equations are substituted by non-linear model of an ecological situation. Pur-
numerical computer simulations.)
posely simplified, the Lotka-Volterra model may
lead to the formulation of the so-called logistic
Non-linearity map:
Huge scientific and technological advances have xn+1 = r xn (1 - xn)
been made using simplifying linearity assumptions,
before computers started allowing to venture into with x0 representing the initial condition, i.e. the
non-linear territory, giving birth to “complexity sci- initial population at discrete time interval t0.
ence”, a.k.a. “complexity theory”.
There had been, in fact, several explorations of non-
linear territory made by scholars since the 19th cen-
tury. As an example, French mathematician and
physicist Henri Poincaré was the first to discover
how an apparently simple system subject to deter-
ministic laws, such as that composed of three orbit-
ing celestial bodies (e.g., Sun, Earth and Moon),
can exhibit a complex (chaotic) behaviour. Other
scholars, including, e.g., Alexander Bogdanov,
Norbert Wiener and Warren Weaver, made ad-
vances and contributed creating complex system
thinking in the first half of the 20th century.
Figure 1: The logistic map
However, the field has acquired new lymph only
with the advent of electronic computers, as they al- By varying the parameter r, a number of weird
low to simulate whenever mathematics does not do things happen (see Figure 1), particularly for r
the job because equations are unknown. equal or greater than 3.57, when periodic oscilla-
tions (corresponding to the increases and decreases
Fundamental, in this respect, was the work of of a population depending on ecological conditions)
mathematician and climatologist Edward Lorenz. start being replaced by pure chaos.
Lorenz made apparent (Lorenz 1963) and formal-
ized the problem that Poincaré touched upon in his Thus, a “toy” ecological problem can, like Poin-
three-body system: When observing the evolution caré’s three bodies, end in chaos. In addition to sen-
of a complex system, finite variations may originate sitivity to the initial conditions, a second (and re-
from infinitesimal variations in the initial condi- lated) property of complex systems is indeed de-
tions. terministic chaos: the underlying laws (physical,
biological, etc.) may be orderly and even determi-
In other words, even two infinitely similar begin- nistic, yet chaotic behaviour is possible.
nings will look different in the future, because the
evolution of the system will differ substantially in Complex systems can surprise
the two cases, with a divergence ever-larger in time.
Making long-term forecasts becomes impossible in A third essential property of complexity is emerg-
principle. ing behaviour: even when the laws governing its
components are well-known, a complex system
Examples of complexity may show a behaviour that cannot be explained on
those grounds.
A striking exemplification of the above is to be
found in another small system such as the one com- Popular-science literature on complexity tends to
posed of a population of predator animals, a popu- furnish us with examples from the living world or
lation of preys and the food available to the latter. other high-level natural systems (flocks of birds and
A linear model turns out simplistic and inadequate colonies of ants behave in ways inexplicable based
for the situation: the population of preys is a func- on what we know of the capabilities of the indi-
tion of the predators’ population but, in turn, the viduals), however emerging behaviour has been
latter will expand and contract based on the avail- known to physicists since Phil Anderson showed it

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Paolo Magrassi 2010 - Creative Commons Attribution-Non-Commercial-Share Alike 3.0

in the case of groups of electrons in a semiconduc- These are obviously simplifications of reality, a
tor (Anderson 1972). (This observation, along with fact well-known to economists (Scarf 1960) (Son-
the chaotic behaviour seen in very small determi- nenschein 1972) (Stiglitz 1975) (Anderson 1988).
nistic systems, shows how intimately the natural
It is a known fact that the price of an equity or
world is permeated with complexity).
commodity may influence the price of another one;
It is important to realize that what makes a system that economic agents do not behave rationally (a
complex are the interactions between the compo- Nobel price was awarded in 2001 to Daniel Kah-
nents –the ultimate cause of non-linearity (Bridg- neman for this realization); that markets are per-
man 1927)–, not the number of components them- fectly efficient only under very rare circumstances
selves. What makes it hard to tackle is that, in addi- (Nobel to Joe Stiglitz in 2002 for this proof); and
tion to the laws governing the components, we need that they can occasionally crash abruptedly, going
to study the system’s overall behaviour: the analytic long distances far from “equilibrium”.
approach must be complemented with the holistic
These realizations notwithstanding, economic the-
one.
ory and practices continue to be based on those lin-
Clearly, though, an increasing number of interact- ear simplifications. Models are adjusted here and
ing components will give raise to increasing com- there occasionally, but the perverse effects of non-
plexity, possibly exponentially: complex and com- linearity continue to be considered negligible or not
plicated makes things worse. sufficient to call for a radical overhaul of the para-
digm.
Linear economy
Is the economy becoming non-linear?
That is why, in today’s economic world, we are
more and more often confronted with complexity: it Yet, nearly catastrophic crises seem to occur even
is caused by the number of interactions within (and more frequently. These can be sudden and deep
between) the systems that surround us (Lo 2009), perturbations of global finance or of the “real”
which are complex and complicated at the same economy; or they can take the form of shocks
time. Sources of complexity include: propagating through business’ supply and demand
chains, which are no longer sequential but network-
• global financial systems;
shaped.
• networks (such as the Internet, power grids or
These shocks can have unpredictable repercussions
transport networks);
and affect sectors which appear totally unrelated to
• enterprises, as these are increasingly intercon- those where the crisis burst, and they are a cause for
nected in supply and demand chains, ecosys- concern not just for national and supranational in-
tems, and “clouds”; stitutions and the financial companies, but for en-
terprises in general.
• consumers, since their behaviours are mutually
influencing due to connections of all sorts (TV, The question may thus be raised (Bouchaud 2008):
mobile communications, Web, social networks, are those five assumptions still fair and realistic, in
email). 2010? Are their distortions still of negligible mag-
nitude?
At the heart of the current economic doctrine stand
some crucial linearity assumptions, such as: Think of Einstein’s Relativity. In most of everyday
situations, including some highly sophisticated
1. Markets are almost always at equilibrium or
technologies, we are not concerned about the ef-
slightly around it;
fects of Relativity, because the objects we deal with
2. Markets are efficient, cannot be “fooled”, and do not usually move at speeds close to light’s or
smooth out all imperfections in the large num- travel intergalactic distances. The relativistic effects
bers; are negligible.
3. Buyers and sellers behave rationally; However, GPS systems in our cars and smart
phones would not work unless their hardware and
4. Buyers and sellers take all available informa-
firmware took Einstein’s Relativity into account.
tion into account in forming expectations of fu-
There goes an example where the approximation
ture prices;
«this theory does not matter in practice» was cor-
5. Prices are independent of one another, and each rect 25 years ago but is wrong today: our “models”
moves stochastically in the neighbourhood of have had to be enriched to take into consideration
its expected value (the one in 4), with a Gaus- its practical effects.
sian distribution whose standard deviation is
Similarly, we ought to be careful not to underesti-
the measure of “risk”.
mate the appearance, in the economic world, of
facts that may render obsolete and wrong the linear

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approximations underlying the dominating eco- Another one, and considered more promising by
nomic paradigm, which is one of Rational Expecta- many, is heterogeneous mean-field approximation,
tions and Efficient Markets. And a new fact in that where the problem of N interacting particles is
sense is the quantity of interconnections between treated as that of a single particle immersed in a
economic agents, both at the macro and the micro chosen field of forces.
level. (A steep change in quantity can sometimes
Yet another model takes a thermodynamics of non
imply a qualitative change: take 1 gram of paraceta-
equilibrium approach to show the analogy between
mol and your headache will go away; take 100
Prigogine’s dissipative structures and financial
grams, and your life will be in jeopardy).
markets.
Indeed, according to an increasing number of
A vast class of models are agent-based models:
scholars, markets of the 21st century global world
here, the domain under investigation is explored via
can no longer be modelled as linear systems. The
computer-based simulation, a technique much more
linearity assumption will be showing more and
accepted in physics (and chemistry and biology)
more of its flaws as interconnections increase, be-
than in economic research, where, according to
cause interconnectedness is the main source of non-
many, it should be pursued more actively. Numeri-
linearity: its growth beyond a certain threshold is
cal investigation of a model does not prove any-
the fact that makes the linear approximation unreal-
thing, yet provides a formidable tool, a «telescope
istic.
of the mind multiplying human powers of analysis
and insight just as a telescope does our powers of
Econophysics vision», as Mark Buchanan wrote a few years ago
Radical new views of economics are being at- on the New York Times.
tempted in econophysics, a discipline born in the In the case of econophysics studies, simulations of-
mid-1990’s that is trying to a) import more ele- ten consist in defining economic agents (people,
ments of empirical research in economics (a disci- firms, banks, regulators, …) and the rules of the
pline currently resembling more mathematics than game, then letting the game run to study the possi-
physics) and b) have economics research adopt ble outcomes.
some of the methods devised in the natural sciences
for describing complex systems2. Agent-based simulations, sometimes also referred
to as complex adaptive systems or cellular auto-
Non-linearity, systems operating far from equilib- mata, were inaugurated by John H. Conway (Gard-
rium, and “organized disorder” (deterministic ner 1970) and first formalized by John Holland
chaos, emerging behaviour) are the tools of the (Holland 1975). It is impressive to notice how,
trade in econophysics today: just about the opposite given extremely simple “organisms” or “agents”
of what happens in the REH/EMH paradigm, where and a few governing rules (1 organism and 4 simple
markets have no internal dynamics (no interconnec- rules in Conway’s Game Of Life), rich and complex
tions between individual agents and choices) and forms of “life” can evolve over time.
chaos may only be stochastic, i.e., the “disorgan-
ized complexity” (Weaver 1948) of Brownian mo- Econophysics simulations of this sort often lead to
tion and equilibrium thermodynamics. situations very different from the perpetual quasi-
equilibrium of efficient markets. For example,
Some physicists and a few maverick economists are catastrophic meltdowns can take place abruptedly,
increasingly recognizing in complex models of the something that in EMH models may happen only
physical world (especially, although not only, con- with infinitely low probabilities (contrary to em-
densed matter) situations that resemble economic pirical evidence). Examples of this kind of simula-
or financial contexts. tions are to be found in, e.g., (Thurner 2010),
(Westerhoff 2004) or (Macal 2004).
New economic models being proposed
One such model is that of spin glasses, a domain Caution is appropriate
characterized by an extreme fragility with respect to Given the increasing complexity of economy, it is
small changes in parameters and the de facto ab- plausible that a radically new theoretic approach
sence of equilibrium. may be needed, to provide us with a more realistic
view of systems that we are currently treating as if
they were linear while their non-linear effects are
perhaps no longer negligible. However, one must
2
A broader, if banal, view of econophysics describes it be cautious in jumping to conlcusions.
as a discipline aimed at using in general the mathematical
methods of physics in the economy: however, this has To begin with, econophysics research needs to be
been done all the time since Leon Walras and Vilfredo strengthened by a more robust and deeper participa-
Pareto, in the 19th century. tion by economists. Its literature indicates a certain
propension to underestimate the degree of aware-

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ness that economic research has reached in many Furthermore, some econophysics seems to ignore or
sectors which are the subject of econophysics. not to care about the corrections that economists
apply over time to the simplified (linear) models.
Another occasional distortion of econophysics re-
Some others go as far as to invoke the adoption of
search consists in claiming the need for new theo-
statistical mechanics models in economics when, as
retical models without having taken the time to ac-
we already pointed out, this has been done for 150
tually confute the existing ones. Many high-level
years now.
economists, while admitting the limitations and im-
perfections of the current paradigm (REH/EMH), Finally, econophysics will suffer from the social
are not worried at all about its sustainability and limitations typically imposed on interdisciplinary
fitness. research: it is easier to win a tenure, get a PhD as-
signment or publish on top-tier journals by partici-
As an example, according to some of them the 2008
pating in a study that resonates with the dominant
financial crash was not but the efficient-market an-
paradigm and focuses on a limited domain, rather
ticipation of a to-be economic recession. In this
than by venturing in distant and subversive territo-
view, finance was the victim, not the cause, of the
ries.
economic meltdown, as Eugene Fama told J.
Cassidy in the January 11, 2010 issue of the New All these factors will substantially slow down the
Yorker. victory, if it ever takes place, of a new economic
paradigm jointly built by economists and physicists.

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