Balance dead-ends and dream cures

Patterns of Speculation
March 14, 2003

How could they do this to me, an economist with a passion for physics that only a man in love with an elusive beauty would understand? How could I be unaware of the existence of "econophysics"? Near the start of Bertrand Roehner's book on the subject, I learnt that the neologism was coined by Eugene Stanley in 1997 - which did nothing to explain my ignorance. But then the author referred to the Santa Fe Institute and the huge databases made available to econophysicists by Richard Olsen - and soon it turned out that I was much less uninformed than I had feared.

Roehner is a professor in the physics faculty at the University of Paris VII who has been a visiting scholar in the economics department at Harvard University and at the Copenhagen Institute of Economics. But his work does not fit the typical pattern in this field of attempting to apply the mathematical tools of one's own branch of physics to other people's economic or financial problems. For example, he mentions Brownian motion only when necessary, and I could not detect a single reference to martingales.

In a certain way, the problems of economics and finance have more similarities to particle and quantum physics than to large-body Newtonian physics, in view of the optionality and indeterminacy of observed behaviour in economic data and the subatomic world. Optionality arises from the different instantaneous decisions that different traders can make when presented with the same economic facts, based purely on their emotional (charged) state; indeterminacy from the fact that prices and volumes are discrete, not continuous, and contain large gaps, including data that are confidential.

The mathematics here is not as mentally challenging as the concepts, which pose as many new questions as they provide answers. The axioms require much digesting and assessing before they can be accepted. The logical steps and inferences must be carefully examined. The author tries to help the reader by creating a ladder of examples drawn from indefatigable research in his price and volume databases. Sometimes this helps but at other times it distracts from the theoretical framework.

Roehner prefers theoretical frameworks to models. He justifies his choice as follows: "Indeed, our objective is not to build a model for a specific market but to present a theoretical perspective from which several properties of speculative peaks may be interpreted. In so doing we follow a standard physical approach; for instance, once the concept of damped vibrations has been understood and formalised, it may be applied to several physical systems." But he admits: "The main drawback of the framework approach is that, being a loose patchwork rather than a full-fledged theory, it may at first appear fairly unconvincing." Even so, it may be that not only economics and finance would benefit from the approach but also, say, cancer research. Despite the time they take to develop, such frameworks may be more productive of understanding in the end than the alternation between supposed dream cures and dead ends.

One sentence in the book is especially thought provoking: "A single event cannot be investigated scientifically, it can only be described." This insight should, but will not, lead to the pulping of thousands of pseudo-scientific books whose sole purpose is to pretend to explain single-event phenomena.

Also stimulating is the book's review of the complexity levels of problems in physics, biology and the social sciences, from the C1 level of two-body problems, studied extensively during the past two centuries, to the C4 level of N-non-identical-body problems, which include most problems in economics and meteorology. Maybe we should consider a still-higher level of complexity to cover problems where the interactions are not purely physical, but also metaphysical, as in economics and finance?

In the fields of securities trading and investments, in which I have operated for more than 30 years, Roehner has clearly done his homework. The three criticisms that follow are therefore small. He does not seem to attribute much importance to the role of arbitrageurs, the absence of whom in certain markets may explain the large regional difference in prices; he recognises the circular (speaking loosely) relationship between prices and volumes but does not dedicate at least a full chapter to it; and he seems to believe, or at any rate to concede in self-defence, that different markets tend to become fungible or at least permeable only at the peak of speculation.

Regarding the third criticism, Roehner does not investigate sufficiently the impact of the information deficit. For instance, property investors normally have good knowledge of the size of the land bank available for future development, as do investors in oil or gold, whereas it would be a divinely inspired equity analyst who could predict future supply in a high-technology sector, even in a narrow part of it. But from my empirical evidence of the behaviour of large unregulated investors, I can say with confidence that different markets are more permeable or fungible even outside the speculation peak than the author dares to suggest.

I shall not attempt to summarise here Roehner's proposal for a theoretical framework that would recognise a pattern in speculative bubble situations.

Professionally involved readers, for whom this book is a must-read, can enjoy discovering it for themselves as much as I did.

But they should be aware of two risks. City traders may be deceived into thinking that econophysics is a glorified version of technical analysis, chartism or just another attempt at high-frequency data analysis. While classically trained economists may feel tempted to throw out all the tautological baggage they learnt at university in the hope of getting quick results from econophysics. Unfortunately, the results will be neither fast nor easy to use. But I am sure we shall be hearing much more from econophysicists.

Rudi Bogni is a former investment and private banker, currently trustee or director of several institutions.

Patterns of Speculation: A Study in Observational Econophysics

Author - Bertrand M. Roehner
ISBN - 0 521 80263 6
Publisher - Cambridge University Press
Price - £35.00
Pages - 230

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