Network Theory, Complex Systems, Avalanches, Pandemics and Financial Crises

Summary: In my previous articles, I have stressed that sudden, violent, temporary events like earthquakes, hurricanes, tsunamis, avalanches, pandemics, and financial crises are all examples of phase transitions experienced by complex systems in far-from-equilibrium situations. They are completely different animals from the slow, gradual adjustment back to equilibrium assumed by essentially all macroeconomic models, including the ones used by the economists at the Fed and other central banks. There is no way to use those models to understand either the pandemic or the resulting financial collapse, and no analytical framework for understanding when the economy will return to “normal.” This post is to give you a guide to the scientific literature behind the new ideas so you can better understand today’s crisis and when it will end.

Far From Equilibrium Phase Transitions

In my last post, I linked the reader to an academic research paper I recently published in the Journal of Economics and Finance that describes the theoretical foundations of the far-from-equilibrium phase transitions we call pandemics and financial crises. You can download the paper, Economics as Energy Framework: Complexity, Turbulence, Financial Crises and Protectionism, here.

Several people have written saying they would like to dig into the scientific papers behind the ideas. In this post, I give you a link to the syllabus for the course I teach to the Economics and Finance PhD students  at Claremont Graduate University. You can access and download the syllabus by clicking on this link.

I designed the course for third year PhD students who have already learned the standard models well enough to know that they don’t work well in the real world. The problem with standard theories–from general equilibrium macroeconomics to so-called modern portfolio theory–is they are based upon the silly idea that markets are in equilibrium at all times. If they were, of course, nothing would happen–physicists refer to thermal equilibrium as heat death. That, of course, would result in a tragedy of epic proportions–there would be no need for economists to exist at all.

All of the interesting things in the world happen away from equilibrium where there are incentives (temperature, pressure, price, wage, or return differentials) big enough to make something happen. In fact, the really interesting changes (avalanches, tsunamis, earthquakes, hurricanes, wars, revolutions, collapsing ecosystems, and financial crises) only happen when systems find themselves in far from equilibrium states. I designed the course to help students change their thinking to accommodate the sudden, violent change that we experience in real life.

I won’t try to explain the course here but it may be worth a quick look at a few of the ideas. The real prize, though, is the list of some 1200 scientific papers in the references section on pages 8-28. they are the papers that I plowed through over 25 years in developing the ideas I describe in the article and that are the foundation for what I think of as Weather Map Investing.

If you just want a taste of the ideas, I suggest that you start by reading a few of the classic papers, in the following order:

• First, read Friedrich von Hayek’s classic 1939 and 1945 papers on knowledge and economics where he describes how a market economy solves the division of knowledge problem by building an extraordinarily efficient communication network that transmits a signal called price to deliver information on relative scarcity to those people, and only those people, who need it to make decisions. In my opinion these are the two most important papers ever written in economics.
• Second, read Irving Fisher’s 1933 The Debt-Deflation Theory of Great Depressions. This tiny (25 pages plus charts and footnotes) is Fisher’s extraordinary 49-step dynamic description of what happens when a market economy collapses into depression. I consider this the second most important paper in economics (counting von Hayek’s papers as one) because it presages so many later developments, including behavioral economics and finance, self-generating systems, poised systems, the critical point, and the importance of distance from equilibrium. Of note: Fisher was the star student of Josiah Gibbs, America’s greatest thermodynamicist.
• Third, read Per Bak’s little book How Nature Works, where he explains the results of 5000 papers in physics studying the mathematics of the cascading system failures we call avalanches. He explains criticality, poised systems, and punctuated equilibria. His conclusion “Almost all changes are small; almost all change is big” is hugely important for investors to understand. For painful example, more workers have lost their jobs in the last three weeks than all of the jobs created since the bottom of the 2008 subprime debt crisis.
• Prigogine’s 1996 book The End of Certainty describing the new area of science called “far-from-equilibrium physics” for which he won the 1977 Nobel Prize in Chemistry. (The first half of the book is easily readable by people without propellers on their heads. For the rest–good luck). He describes how and why far-from-equilibrium systems behave in ways that are qualitatively different than systems at or near equilibrium. And he explains why it is a mistake to bet that correlations can be stable indicators of anything.
• Finally, Melanie Mitchell’s wonderful textbook Complexity introduces beginners to the subject now known as complex adaptive systems that uses all of the above ideas to study how the real-world works. she gives a good description of network theory, explains the cascading network failures we call financial crises, and guides you to research on what makes some networks fragile and some robust.

I hope that you enjoy grazing through the references. If you are especially curious about any of them write a comment and I will do my best to explain them in a later post. If I can’t do it, I will ask one of my dissertation students to tackle it for you. Hope you enjoy.

Dr. John

The views and opinions expressed in this article are those of Dr. John Rutledge. Assumptions made in the analysis are not reflective of the position of any entity other than Dr. Rutledge’s. The information contained in this document does not constitute a solicitation, offer or recommendation to purchase or sell any particular security or investment product, or to engage in any particular strategy or in any transaction. You should not rely on any information contained herein in making a decision with respect to an investment. You should not construe the contents of this document as legal, business or tax advice and should consult with your own attorney, business advisor and tax advisor as to the legal, business, tax and related matters related hereto.