Mark Buchanan, physicist, author and scholar of complex systems, says positive feedback is behind almost everything that makes our world rich, surprising and dynamic. In his newest book Forecast: What Physics, Meteorology and the Natural Sciences Can Teach Us About Economics, Buchanan writes that positive feedback makes "seeds sprout and grow into trees, matches burst into flame, and single cells divide and proliferate into living thinking human beings. It drives political revolution and new religions, and it makes perfectly peaceful blue skies give rise, with little warning, to storms of terrifying violence..."
He believes an intellectual blind spot to the power of positive feedback has held back our understanding of human systems and social sciences. Economics is often misunderstood, he asserts, because theorists in the field have viewed economic systems as inherently stable and self-regulating and they've thought that people make rational economic decisions with full awareness of future possibilities. Even after the financial meltdown of 2008, he writes, many economists have strained to rationalize those views in spite of evidence that debunks them. With his prediction that future crises are inevitable unless economic models are changed to take into account what's been learned about other complex systems, Buchanan imparts urgency to his insights that markets follow power law distributions and small events can trigger huge consequences.
In a detailed analysis of the May 2010 "flash crash," for instance, Buchanan shows positive feedback was among the forces involved when the Dow Jones Industrial Average plunged nearly 1,000 points (9 percent of its total value) in 13 minutes and 27 seconds. Within 21 minutes stock values rose back to previous levels, but anyone unfortunate enough to unknowingly sell as prices hit rock bottom suffered serious losses. Buchanan tells the story of one investor who was "mugged" by the crash, losing $15,000 in a matter of seconds. The cause of the crash remains controversial, though government reports found no evidence of illegal manipulation or any "fat finger" mistake caused by someone hitting a wrong button. Buchanan explains that high frequency trading (HFT), which made up 73 percent of the volume of trading in 2010, usually produces greater liquidity in the market-except when it doesn't.
Markets work best when money and assets flow easily among buyers and sellers without delays and obstructions, and when that happens, the market is called liquid. Generally, speed is good. But exceptions are possible. A high percentage of trading now takes place at the speed of light. Hundreds of companies sell algorithmic trading platforms that execute trades so fast virtually no time elapses between the push of a button and the completion of the trade.
Buchanan explains that the bid-ask spread in trading reflects how much market makers think they need to charge to make a profit. In turbulent period, HFT market makers charge more, so the spread widens. In the flash crash the spread ballooned, and HFT firms with algorithms running on autopilot fled the market. Trading came crashing to a halt and liquidity disappeared. Buchanan describes the positive feed back effect: more volatility meant less liquidity, which brought more volatility, and which brought less liquidity. Physicists have found wilder behavior in stock movements, and more mini crashes, in very short time periods since 2005. Buchanan suggests as trading moves to inhumanly short time scales, increasing "black swan" events in microscopic time can be expected.
Brain science has shown that people don't respond well to things that happen in less than a second, Buchanan writes, and what happens in markets in sub-second times may reflect a fundamental change as trading "becomes uncoupled from the influence of human decision making."
Physics and meteorology hold clues to the working of economic systems, though Buchanan doesn't suggest any one explanatory theory. If a predictive model were developed, he says, its existence would change how people behave, making its predictions inaccurate. Meteorologists have different models and theories for different aspects of weather, such as tornadoes and thunderstorms on the plains, hurricanes developing at sea, or a blanket of fog over the earth's surface, and their predictions have vastly improved. In the same way, he writes, economists need an assortment of models and theories to understand differing economic phenomena--rapid fluctuations driven by high frequency trading, daily movements driven by trend-following speculators or instabilities that form over months or years as a result of social change, such as the trend in sub prime lending. Forecast is provocative, carefully researched, absorbing and lucidly written. Buchanan illuminates complex material and tells stories that give it a human face.
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