Are stock market crashes built into the financial system?

New Scientist : 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.The implication is that extreme market events, such as a one-day crash capable of wiping out millions of investors, occur naturally in financial markets even in the absence of any extraordinary circumstances.By contrast, most economists and financial analysts regard such events as strange and unpredictable outliers. “This is, at least in part, because basic market theories can’t explain these large fluctuations in any natural way,” says physicist Gene Stanley of Boston University, a leader in such analyses. Two other papers make a similar claim, and argue for more investment into mathematical model research:The Wharton School of economics at Penn State University asks Why Economists Failed to Predict the Financial Crisis

Of all the experts, weren’t they the best equipped to see around the corners and warn of impending disaster?Indeed, a sense that they missed the call has led to soul searching among many economists. While some did warn that home prices were forming a bubble, others confess to a widespread failure to foresee the damage the bubble would cause when it burst. Some economists are harsher, arguing that a free-market bias in the profession, coupled with outmoded and simplistic analytical tools, blinded many of their colleagues to the danger."It’s not just that they missed it, they positively denied that it would happen,” says Wharton finance professor Franklin Allen, arguing that many economists used mathematical models that failed to account for the critical roles that banks and other financial institutions play in the economy. “Even a lot of the central banks in the world use these models,” Allen said. “That’s a large part of the issue. They simply didn’t believe the banks were important."Over the past 30 years or so, economics has been dominated by an “academic orthodoxy” which says economic cycles are driven by players in the “real economy” âmdash; producers and consumers of goods and services âmdash; while banks and other financial institutions have been assigned little importance, Allen says. “In many of the major economics departments, graduate students wouldn’t learn anything about banking in any of the courses."But it was the financial institutions that fomented the current crisis, by creating risky products, encouraging excessive borrowing among consumers and engaging in high-risk behavior themselves, like amassing huge positions in mortgage-backed securities, Allen says.As computers have grown more powerful, academics have come to rely on mathematical models to figure how various economic forces will interact. But many of those models simply dispense with certain variables that stand in the way of clear conclusions, says Wharton management professor Sidney G. Winter. Commonly missing are hard-to-measure factors like human psychology and people’s expectations about the future, he notes.

In a related report eight American and European economists argue that academic economists were too disconnected from the real world to see the crisis forming:

The paper, generally referred to as the Dahlem report , condemns a growing reliance over the past three decades on mathematical models that improperly assume markets and economies are inherently stable, and which disregard influences like differences in the way various economic players make decisions, revise their forecasting methods and are influenced by social factors. Standard analysis also failed, in part, because of the widespread use of new financial products that were poorly understood, and because economists did not firmly grasp the workings of the increasingly interconnected global financial system, the authors say.

They go on to say that

“The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold,” they write. “In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real world markets.”