Recently I asked a few friends in both America and Bangladesh about their familiarity with the term “econophysics”. I was not disappointed with their answers even though the term in the limelight of both disciplines since the mid-1990s is yet to be in common parlance. Given my pedigree in both physics and economics, I felt somewhat peremptory or even obligatory about writing a piece on what econophysics is all about.
It is well known that both physics and economics use mathematics (math) as an indispensable tool for problem solving in their respective fields. This commonality brought physics and economics to mutual affinity. Additionally, the intuitive reasoning to arrive at an internally consistent implication required of both physics and economics had made it possible for me to obtain an advanced degree in economics after 18 years of my M.Sc. degree in physics from Dhaka University.
The term econophysics is a composite concept – a hybrid discipline stitched by combining physics and economics – first introduced by a theoretical physicist Eugene Stanley in 1995 at a conference on Dynamics of Complex Systems held in Kolkata, India. The term is analogous to similar terms involving the application of physics to different areas such as astrophysics, geophysics, biophysics, petrophysics, neuroohysics and so on with econophysics tiptoeing into the bandwagon.
Physicists’ interests in applying physics models to economic problems grew out of the notion that several traditional economic theories such as rational expectations, the efficient market hypothesis, and the view of equilibrium are too axiomatic and formal to analyse complex systems such as financial markets. They argue that prevailing theories “dealt with homogeneous agents and equilibrium, while many of the more interesting phenomena in financial markets fundamentally depended on heterogeneous agents and far-from-equilibrium situations.”
Econophysics hypothesises that the economy should be treated as though behaving like a collection of electrons in atoms or a cluster of water molecules that interact with each other. That attracted statistical physicists to study the statistical properties of complex economic systems consisting of many economic units such as firms, individuals, families, households etc. The physics models used in econophysics include Kinetic exchange models of markets, percolation models, chaotic models developed to study cardiac arrest, earthquakes to name a few. For example, the multi-agent Kinetic exchange models developed from the statistical physics of energy distribution are used to explain the robust and universal features of income/wealth distributions – one that economists have been struggling to demystify for over a century.
The consideration of economic agents as particles allows econophysicists to treat markets as complex macroscopic systems with internal structure that is microscopic in character. For a layman, this simply means that each of the four markets (that is market for goods, money, labour, and bond) is macroscopic and agents in each market are microscopic having an internal character. In this internal microscopic structure, economic particles are assumed to interact among themselves to generate systemic macroscopic properties.
The fascination of physicists with economics dates to 1700 when Daniel Bernoulli (1700 -1782)— Duch born mathematician originally developed the utility-based theory of preferences. One of the founders of neoclassical economic theory (which focuses on supply and demand as the driving forces behind production, pricing, and consumption), former Yale University Professor of Economics Irving Fisher (1867- 1947) was originally trained under the renowned Yale physicist, Josiah Willard Gibbs (1839-1903). Likewise, Jan Tinbergen, (1903-1994) who won the first Nobel Memorial Prize in Economic Sciences in 1969 for having developed and applied dynamic models for the analysis of economic processes, studied physics with Paul Ehrenfest (1880-1933) at Leiden University. In particular, Tinbergen developed the gravity model of international trade that has become the workhorse of international economics
The works of Léon Walras (1834-1910) is an inescapable part of econophysics as demonstrated by Bruna Ingrao (1915-2015) and Giorgio Israe (1945-2015) that general equilibrium theory in economics is based on the physical perception of mechanical equilibrium. Walras’s law states that markets have a inertia of motion showing a tendency to attain overall economic equilibrium—as though there is an invisible hand steering excess supply towards falling prices and excess demand towards price hikes.
Some of the pioneering work in econophysics has been devoted to stock markets primarily because of the abundance of high-frequency data since the 1980s. These data are believed to contain a body of stylised facts from which meaningful empirically observable universal generalisations could be ascertained. Interests of econophysicists are to dig out new examples of generalised facts to explain current and previously realised stylised facts using statistical physics-rooted approaches with the aim of synthesising these facts and giving them a theoretical foundation.
Econophysicists showed analogies between finance theory and diffusion theory. For example, the Black Scholes equation (BSE) for option pricing in the stock market is a diffusion-advection equation derived from diffusion theory. Using physics models econophysicists have (https://en.wikipedia.org/wiki/ Econophysics - cite note-17) found that “more developed countries have stock markets with higher entropy (disorder) and lower complexity, while those markets from emerging countries have lower entropy and higher complexity”.
Econophysics research papers have been published mostly in Journals dedicated to physics and statistical mechanics. These papers are yet to intrude into foremost economics journals. Additionally, mainstream economists are yet to be enthused with econophysics and only a handful of economists such as Mauro Gallegati (Italian), Steve Keen (Australian), Paul Ormerod (British), and Alan Kirman (French) have shown both enthusiasm and disappointment with econophysics. However, Nobel laureate and founder of experimental economics Vernon Smith (won 2002 economics Nobel Prize) has used “econophysics to model sociability via implementation of ideas in Humanomics”. So far, some successful impacts of econophysics are realised in applied areas of quantitative finance primarily because the scope and goals are quite different from those of economic theories. Some econophysicists have introduced models for price fluctuations in financial markets and contributed original ideas on previously established models.
Other notable contributions that econophysicists have made in financial markets include the inverse cubic power law (ICPL) which states that the “probability of large price movements decreases in accordance with an inverse cubic power in many diverse markets.” Econophysicists have shown that post-stock market crash activities follow similar dynamics with earthquake aftershocks. According to Omori law, the number of aftershocks drops off rapidly at first and then decays more slowly. Based on their empirical analysis, econophysicists conclude “market behaviour may not be due to facts specific to finance and economics instead a more general dynamics are involved.” They argue that markets reveal the least volatility if buyers and sellers use diverse strategies but break down to instability and chaos if many traders chase few stocks and use similar strategies to do so. Such behavior called strategic crowding tends to induce an abrupt phase transition from smooth behaviour into discontinuous and erratic price fluctuations.
Econophysicists have also helped to clarify other fundamental sources of market instability. The traditional view of economists is that risk sharing among financial institutions in a network — through derivatives, credit default swaps and so on – should make both individual firms safer and the entire banking system more stable. However, econophysicists have found that too much risk sharing with too many institutions can compromise stability while over connected networks make it too easy for financial shocks to spread and escalate.
The list of contributions of econophysicists in the field of economics that I cited is short. I used my discretion to pick and choose a few that do not require advanced math to explain. If advanced math could solve numerous economic problems and issues, then economists could have solved them all by now. Unlike laws in physics, laws in economics are not immutable.
During his later life John Maynard Keynes, one of the greatest macroeconomists of our time, upheld the notion that, “The study of economics does not seem to require any specialised gifts of an unusually high order. Is it not, intellectually regarded, a very easy subject compared with the higher branches of philosophy and pure science? Yet good, or even competent, economists are the rarest of birds. An easy subject, at which very few excel!”
Dr Abdullah A Dewan, formerly a physicist and a nuclear engineer at BAEC, is professor of economics at Eastern Michigan University, USA. adewan@emich.edu