Since I read Social Atom by Mark Buchanan, I have been investigating agent-based models applied to economics and finance. Andrew Lo at MIT is working on behavioral finance models based on adaptive agents that evolve and are selected in a “survival of the fittest” environment. Rajiv Sethi refers to a Nature article applying agent-based models to macroeconomics.
What is interesting in agent-based models is that very simple rules at the individual agent level can create extremely complex system through interactions and networks of agents. Such networks would be able to model non-linear effects, by introducing stocks, flows and delays as suggested by System Dynamics theory.
That reminds me of a the Mandelbrot set fractals, where the iteration of an extremely simple equation generates an infinitely detailed image.
I think that a behavior rule for agents as simple as “do what the most successful agent did and avoid what failed/bankrupt agents did” would be enough to generate interesting results. As I develop my simple agent-based model, I will keep you posted with the results.
One of the discussions that I am following closely is the one related to the crisis of financial modeling. A side effect of the financial meltdown of August 2007 (subprime) - September 2008 (Lehman, AIG) and the following credit crunch, is that existing models, mostly based on the Efficient Market Hypothesis, showed all their shortcomings.
My take is that all pre-meltdown models were representing static snapshots of the markets based on equilibrium hypotheses. New models will have to add a temporal axis and describe markets as dynamic systems, at the cost of abandoning formal elegance, nice equations and closed-form solutions.
The bare existence of “stocks” (i.e. pools of money, investment funds, house inventories), each with its own incoming and outgoing “flows” (i.e. investment flows, equity commitments and exits, construction of new houses and house sales) and related delays (i.e. time between investment decision and time to measure investment results, especially in illiquid markets) creates a dynamic system regulated by differential equations whose solutions are exponential and periodic functions over time.
Accumulating and depleting stocks of vast size allow the financial markets to deviate from equilibrium positions for long periods of time. System unbalances can build up and grow exponentially over years before collapsing. Social interactions among investors (aka herd behavior) can inflate bubbles that are sustainable for much longer than any static model can predict, hence reinforcing herd behavior.
The presence of stocks and delays in the system makes it possible for sources of instability to accumulate until finally some random event triggers a chain effect reversing the same self-reinforcing loops into self-destructive loops.
Some more food for thought:
I agree with Chris Martenson when he says that the switch from deflation to inflation will be sudden and driven by social snowballing effects, independently from what will trigger it.
But it could be sooner than that. Or later. The point here is that we really don’t know and because our monetary system operates on faith, it means that we have to be prepared for the fact that a shift could happen at any time. Nobody can predict when a school of fish will suddenly turn to the left. Who knows what final trigger will cause a critical minority to suddenly determine that they’d rather hold things than paper?
It is more about the structure of system than contingent causes and effects and guessing the tipping point trigger: $800 billion sitting in banks’ excess reserves or unsustainable government debt issuance synchronized for every country on earth, add massive systemic risk to the global economy.
The structure of the financial system just added more feedback loops that are ready to be triggered and unleash their effects in avalanche patterns.
While this finding seems counterintuitive, since a quick rise in popularity would seem like a good thing, it shows that a backlash to perceived fads should be taken into account. As the researchers explain, people who want to ensure the persistence and success of particular items should seek to popularize the items at a slow but steady pace.
The meltdown of our financial system that started in the summer of 2007 and then accelerated in September 2008 after Lehman Brother’s default, has been taken by many commentators and politicians as evidence to confidently state that free markets have failed. My point of view on this matter is rather different.
First, the market is not a time-independent stateless mechanism. It does not give at every time the optimal price given the current situation, but it reacts to a series of events and evolves in a more complicated way. It has “memory”, meaning that the outcome depends not only on current inputs but also on previous events. It is built of stocks (outstanding debt, inventory of unsold houses, inventory of oil, etc.) and flows (debt increase or repayment, number of houses sold per year, production and consumption of oil, etc.). In calculus terms, the market behavior can be modeled as a dynamic system defined by a set of differential equations where some functions (the “stocks”) are related and linked with their own derivatives (the “flows”). A differential system yields results that have exponential or oscillatory nature, can cause overshooting and undershooting with respect to an equilibrium state. In the past months, price fluctuations have been wild but that does not entail a market failure, simply a non-trivial response to a complex system.
Second, the market is just telling us things that we would like not to hear: many people have bought houses that they could not afford, many lived a lifestyle above their means, banks have lent too much money at spreads that were too low compared to the risk they were undertaking, managers have been paid too much money for poor results, governments have created pension systems that are blatant Ponzi schemes that can only be sustained by a growing workforce, and so on.
So before jumping ship and support a heavily regulated market, I would suggest to listen to what answers the free market is giving us.
