Saturday, February 02, 2008

The physics and epidemiology of bank runs

Philip Ball's Nature News column -- now available on his blog -- has an overview of the efforts towards understanding catastrophic economic events, such as the Societe Generale fiasco, using ideas from physics, epidemiology and much else.

... State support of failing banks is just one example of the way that finance is geared to risky strategies: hedge fund managers, for example, get a hefty cut of their profits on top of a basic salary, but others pay for the losses [3]. The FRBNY’s vice president John Kambhu and his colleagues have pointed out that hedge funds (themselves a means of passing on risk) operate in a way that makes risk particularly severe and hard to manage [5].

That’s why, if understanding the financial market demands a better grasp of decision-making, with all its attendant irrationalities, it may be that managing the market to reduce risk and offer more secure public benefit requires more constraint, more checks and balances, to be put on that decision-making. We’re talking about regulation.

Free-market advocates firmly reject such ‘meddling’ on the basis that it cripples Adam Smith’s ‘invisible hand’ that guides the economy. But that hand is shaky, prone to wild gestures and sudden seizures, because it is no longer the collective hand of Smith’s sober bakers and pin-makers but that of rapacious profiteers creaming absurd wealth from deals in imaginary and incredible goods.

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On the Societe Generale fiasco, check out some of the posts on Marc Andreessen's blog -- here, here, here, here, here, and here. Pure snark!


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