Weekend Reader: Forecast: What Physics, Meteorology, And The Natural Sciences Can Teach Us About Economics

Weekend Reader: <i>Forecast: What Physics, Meteorology, And The Natural Sciences Can Teach Us About Economics</i>

This week, Weekend Reader brings you an excerpt from Forecast: What Physics, Meteorology, And The Natural Sciences Can Teach Us About Economics by Mark Buchanan. Buchanan provides a fascinating and unique take on the economy by comparing the unpredictability of the weather to the irregularity of the markets — and what this can teach us.

You can purchase the book here.

The Equilibrium Delusion

Like many towns sprawled across the great flat expanses of the Midwestern United States, Overland Park, Kansas, is no stranger to extreme weather. Each year, in spring and early summer, warm, moist air sweeping in from the Gulf of Mexico slips under sheets of colder air tumbling in over the Rockies. “Warm air rises,” that banal phrase of folk physics, here takes on life: gravity drives vast plumes of the warmer, lighter air to penetrate the colder layer above and billow upward to a height of ten miles. This is the first ingredient in a recipe for atmospheric violence. The second is surface winds, blowing to the North and from the West, which drive this incipient protostorm to rotate like into an unstable, spinning tower— creates near-perfect conditions for powerful tornadoes, some as much as a mile in diameter, with winds churning to 400 m.p.h.

To most of us, tornadoes seem freakish, unnatural, definitely abnormal. Yet the state of Kansas alone sees hundreds of them every year, and they come about through perfectly ordinary atmospheric processes. Broadly speaking, it’s all just part of what happens in the atmosphere: one event builds on another, and then another, and soon an ordinary gray sky becomes a violent, memorable twister. More technically, we could say the atmosphere is prone to what scientists call “positive feedbacks,” the consequences of which our human minds find hard to imagine.

Maybe you’ve heard the term elsewhere. Positive feedbacks are a longstanding concept in science— the process by which small variations in a given system can become increasingly large. They are commonplace in discussions of global warming. Melting glaciers turn white ice to blue water, reducing how much sunlight gets reflected back into the atmosphere; the process could accelerate planetary warming. Positive feedbacks arise in psychology, biology, electronics, physics, computer science, and many other disciplines. Yet even though many of us recognize this notion, we are dreadful when it comes to estimating its impact.

Take $1,000 and invest it in something that earns interest at a rate of, say, 10 percent each year. Leave it there for thirty years with the interest earned feeding back into the account. How much will you have? Well, 10 percent of $1,000 is $100, so you might think the amount should increase by $100 or so each year. Thirty years makes the total gain about $3,000, giving a total of $4,000. Of course, as the amount grows, you’ll be getting 10 percent of a growing number each year, so you’d expect something a little more than $4,000. Maybe, without a calculator, you’d guess $5,000 or $6,000? It already starts to feel hopeful to consider $10,000. But human intuition is no match for the mathematics. The actual total after thirty years is a little over $20,000. The amount feeds on itself and grows faster than anyone would expect.

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There’s more here than a lesson about money; it’s a lesson in human thinking and why the world so often surprises us.

As humans, we’re terrible at imagining the likely consequences of positive feedback. Take a piece of paper and fold it, and then take that doubled paper and fold it again, and then again, thirty times in all. Actually, don’t waste your time. You’ll find you can’t do it because the result, if you did, would be about seventy miles thick. Ask a friend to give you an apple today, two apples tomorrow, four the third day, and so on, for one whole month (thirty-one days). You’d better rent a large warehouse because on the final day alone you’ll get more than 2 billion apples. This is the power of positive feedback: each step not only makes things bigger, but also gears up the process itself, accelerating how fast things get bigger in a way that leads to consequences far beyond our expectations.

Positive feedback matters a lot more than we think, because in one form or another it lies behind almost everything that makes our world rich and surprising, changeable and dynamic, lively and unpredictable. It 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 revolutions and new religions, and it makes perfectly peaceful blue skies give rise, with little warning, to storms of terrifying violence, like those tornado-spawning storms in Kansas. Our brains lack intuition for all this. In meteorology, and in the rest of science, it’s taken years of learning from mistakes to recognize how and why positive feedbacks play such a crucial role in causing events we might not otherwise expect.

Yet outside of these areas, an intellectual blind spot to the power of positive feedbacks still holds us back. Nowhere is this truer than in the science of human systems, in social science, and especially economics and finance. Consider what happened, for example, on May 6, 2010.
Four Minutes of Mayhem

In addition to being a frequent site of tornado activity, Overland Park, Kansas, is also home to the headquarters of an important investment company named Waddell and Reed Financial, Inc. Founded on a shoestring by financiers Cameron Reed and Chauncey Waddell back in 1937, the firm started out with offices in department stores, but today it has grown to handle funds totaling more than $60 billion. It lacks a famous name, but it’s big enough to make investment decisions that— with the help of positive feedbacks— can threaten the stability of the entire global economy. In less than five minutes.

In the spring of 2010, a mutual fund run by Waddell and Reed had invested heavily in futures contracts for the Standard and Poor’s Stock Index, one of the most widely traded stock futures. Buying such a futures contract means that you agree to buy the S&P 500, not now, but on a certain fixed date in the future. The price you pay, however, is fixed now. They’re among the simplest “derivatives” products, which “derive” their values from the value of something else, in this case the S&P 500. If that index rises in value, the value of the future also rises, as it raises the likely future value of the index, too. Waddell and Reed were deeply into these futures as a hedge or balance against other investments they had, and their strategy seemed sound until the early days of May, when financial authorities in Greece admitted (under pressure) that levels of government debt were far in excess of the limits set by the European Central Bank. Suddenly, as European and international bankers met to find ways to keep Greece from defaulting, the future of the European monetary union was called into question. Investors worried. Between the market’s opening and noon on the sixth of May, stocks of the Dow Jones Industrials slid downward by 2.5 percent.

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At two thirty-two p.m., concerned that troubles in Europe were spreading to the United States, Waddell and Reed requested a broker at Barclays bank to get out of the stock index futures market. Using a computer program to make the trade, the broker began trying to sell $4.1 billion in so-called E-mini stock index futures. Selling has the effect of driving prices down, so the program was designed to work cautiously, selling a little at a time, spreading it over the day. For ten minutes or so, things went smoothly. But then, at two forty-one p.m., something kicked off an explosive chain of events. High-frequency traders, whose computers conduct thousands of trades per second, had been buying most of the contracts as Waddell and Reed sold them. Many of these traders make money as “market makers”: their computer programs stand ready to buy or sell at any moment, and they profit from slight differences in the prices they set for buying and selling. But according to the trade-by-trade data for the day, these programs seem to have purchased too many futures contracts, accruing an inventory larger than desired. At two forty-one p.m., one of these programs decided to bail out of market making and started selling aggressively, causing futures prices to drop off a cliff.

The result was a spectacular plunge as positive feedback involving completely automated trading clipped the value of E-mini futures by more than 3 percent in only four minutes. But this was only act 1 of the unfolding drama.

Reprinted from Forecastby Mark Buchanan. Copyright © 2013 by Mark Buchanan. Used by permission of Bloomsbury USA.

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