Earthquakes and the Financial Crisis

Physics may be the key to preventing financial meltdowns like the one we’re facing now.

The problems that have brought our economy crashing down, according to at least one leading econophysicist, stem in part from the fact that economists don’t really understand the odds of major crashes like the Great Depression or our current recession. Physicists, on the other hand, know lots about it.

You see, the economy bounces around in much the same way that natural systems change. The classic example is earthquakes: really devastating earthquakes are much more frequent than we used to think. Understanding how likely big earthquakes are is crucial when it comes to designing buildings that’ll be safe in places like San Francisco and Tokyo. If you underestimate the odds of big quakes, lots of people will die.

The same is true of the economy. If you underestimate the likelihood or size of a major crash you probably won’t do what’s necessary to prevent it, and you certainly won’t be prepared to deal with a crash when one comes along.

Many economists assume that booms and recessions are like a grades that students get on school test. When a test is well designed, a plot of the grades is a nice, smooth curve (often called a bell curve or normal distribution). Most student get Bs, Cs and Ds, and a few get As and Fs.

If you plot earthquakes, the curve is different. There are more As (major earthquakes) than you would expect. Physicists call it a “heavy-tailed distribution” because there are more earthquakes at the outer areas of the curve than there are in the normal distributions typical of class grades.

The red line in the graph here is a heavy-tailed distribution. It’s not terribly different from the black line that traces out a normal distribution, which may explain why people historically have realized it, but the modest difference leads to much larger risks. (The blue curve is a short-tailed distribution, but don’t worry about that for now.)

Building codes in earthquake-prone places take the heavy-tailed distribution into account to make sure we can keep damage and injuries as low as possible. Now that we now know that booms and busts in the economy also make up a heavy-tailed distribution, we should be as careful handling our money as San Francisco architects are with their sky scrapers.

What does that mean in the real world? The solutions are complicated, but I’m sure economists can figure them out if they take heavy tails into account. (I have a few suggestions, but I’m not an economist so I’ll keep them to myself.)

It’s ironic that some people have been trying to make physicists and mathematicians the scapegoats for the recession, as Uncalm noted in her blog post back in October, when they are probably the best people to prevent this sort of thing happening in the future.

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