A physicist's view on the current crisis

As an addition to my last week's piece, I would like to quote a very interesting opinion of a theoretical physicist, Mark Buchanan, writing for New York Times:

Well, part of the reason is that economists still try to understand markets by using ideas from traditional economics, especially so-called equilibrium theory. This theory views markets as reflecting a balance of forces, and says that market values change only in response to new information — the sudden revelation of problems about a company, for example, or a real change in the housing supply. Markets are otherwise supposed to have no real internal dynamics of their own. [...]

Nearly two decades ago, a classic economic study found that of the 50 largest single-day price movements since World War II, most happened on days when there was no significant news, and that news in general seemed to account for only about a third of the overall variance in stock returns. A recent study by some physicists found much the same thing — financial news lacked any clear link with the larger movements of stock values.

And later:

Certainly, markets have internal dynamics. They’re self-propelling systems driven in large part by what investors believe other investors believe; participants trade on rumors and gossip, on fears and expectations, and traders speak for good reason of the market’s optimism or pessimism. It’s these internal dynamics that make it possible for billions to evaporate from portfolios in a few short months just because people suddenly begin remembering that housing values do not always go up.

Buchanan does not only criticises the view, but provides support for his arguments by writing information about computer models of financial markets, based on the behaviour of individual actors. The models go deeper than classic equilibrium theory and allow to determine at what point a financial meltdown could take place, i.e. when market stability disappears and panic sell-offs start.

Sadly, at least according to Buchanan, economists look not very favourably on the models.

Is it a problem of the dominance of an old scientific paradigm (in the way Kuhn saw it), or maybe mainstream economists have valid claims? We shall return to the problem soon...