Science reinvents the economy: Predicting the big one
According to classical models of economics, financial crises don't happen. People, firms and other economic "agents" act rationally, in their own self-interest and with profound insight. They would never be duped into investing in a market that was enormously inflated and about to crash. The result is a stable, self-correcting equilibrium. Prices too high? People stop investing. Too low? People start buying again.
Clearly, then, there is a lot wrong with classical economics. "Most economic analysis still takes place within a totally inadequate set of concepts," says Jean-Phillippe Bouchaud, physicist and co-founder of the hedge fund Capital Fund Management in Paris, France. "Theories of finance can learn a lot by connections to the rest of science."
For instance, studies over several decades have shown that market fluctuations have a lot in common with processes such as earthquakes that originate in systems that are very much out of equilibrium and naturally subject to abrupt upheavals (Physica A, vol 387, p 3967). This means price fluctuations on the stock market do not have a bell-shaped "normal" distribution, with the bulk in the mid-range and a steady decline towards each extreme. In fact, the distribution has a much fatter tail of large price fluctuations, subverting a crucial assumption that underlies much of economic theory.
