Seizures in the financial markets can be compared to seizures in the brain that happen during epileptic fits says PhD student, Dror Kenett.
The 31-year-old physicist has been involved in a unique research project focusing on the study, analysis and modelling of financial systems. He works within the arena of “econophysics” — a field of physics that applies theories developed by physicists to solve economic problems. The research study was headed by Tel Aviv University’s Professor Eshel Ben-Jacob and Dr Gitit Gur-Gershgoren, chief economist of the Israel Securities Authority.
Their findings show that the collective way in which stock markets behave during a crisis resembles the way in which a brain behaves during a seizure.
Dr Kenett explains: “You can think of different regions of the brain as different economic markets. Each region has its own dynamic and behaviour. Yet once a brain seizure starts, all the regions start acting together — just as when there is a crash in the markets.”
He says that in epilepsy, one part of the brain takes over and interferes with normal brain activity. The brain falls under the influence of one single focus of correlation. The same dysfunction can be seen in the financial markets. “The excessive dominance of the financial sector distorted healthy activity in other sectors, leading to ‘market stiffness’. This ‘market stiffness’ was demonstrated in the emergence of ‘market seizure’ behaviour. In epilepsy, there is the over dominance of the epileptic focus on the functioning of all other regions of the brain. This can result from excess activity or from a lack of inhibition.
“And this is what we see in the markets; when the markets start to go down, the correlations between the different stocks and companies become stronger and stronger, keeping this downward momentum going.”
So, analysing the financial crisis is about more than just the banks borrowing too much then? “Yes, it is much more than that,” says Dr Kenett, who has devoted most of his academic career to applying methods and theories from statistical physics to financial and economic systems. He believes that a new way of looking at financial systems is needed in order to prevent future economic crises.
“Economics as a science is mainly driven by theories, and many of the leading economic theories are based on the physics of 100 years ago, particularly the notion of equilibrium. But physics has really evolved over the past 100 years — and systems are actually not always in equilibrium.”
He explains: “In 2008, before the crisis, there was a report by the chairman of the US Federal Reserve, which noted that the markets would return to equilibrium. But there is no such thing. Physicists realise this and are trying to export this understanding to economics.”
What’s more, he says: “There is a view that traders have access to all the market information enabling them to make a rational decision, but obviously this is not the case in real life, and physicists are now coming up with new tools to deal with this. Changing prices of stocks and shares are not ‘normally’ distributed, as was thought in the past. We are working on creating tools to deal with these non-linear behaviours of the markets.
“Technology for trading is becoming more and more advanced, and increasingly different from the previous ruling economic market theories. These past theories are becoming obsolete.”
He cites comparing financial fluctuations to earthquakes as an example of using physics to gain a current insight into how the markets react.
“Some studies have managed to identify the similarities between markets after a crash and what happens in aftershocks following a major earthquake.”
Dr Kenett is currently a research associate at the Center for Polymer Studies, Department of Physics at Boston University, working under influential physicist Professor H Eugene Stanley.
He has also been working with Professor Ben Jacob and the Kiel Institute of World Economy in Germany, on a market “seismograph”. A type of weather map for the markets, it measures the interconnections between the major stock markets across the globe (the UK, China, US, India, Germany and Japan) and could, says Dr Kenett, help each country predict when a financial crisis is imminent. “We wanted to give a different perspective on how these markets are interconnected.
“This allows us to look at financial contagion and how events can spread from one market to another. Of course this is extremely important today.
“We focus not on the index prices in an individual market but on the average correlation of countries’ stock markets against one another and whether their markets are related. It is possible to observe that as things go bad in the economy, the correlations become stronger — people act collectively, leading to a spread of financial decline.”
The idea is to monitor the “well-being” of all markets separately and then, to quantify the interaction between these markets to understand how the events in one market will affect all the other markets.
Their findings show, for example, that changes in correlations in the UK can predict in some ways, changes in Germany. Dr Kenett says this methodology will enable countries to better foresee a crisis, allowing policy makers to implement strategies that will protect them from becoming dangerously intertwined with struggling markets. Like Greece? “Yes. You need to know when your interaction with a different market is dangerous. Germany could n’t afford for Greece to go down. It’s a very problematic situation. This could have been prevented with the right tools.”
Born in the US, Dr Kenett grew up in Israel obtaining three different physics degrees from the Tel Aviv University. His father, Ron Kenett, who he cites as his role model, is a professor of statistics and president of the Israel Statistics Association. He teaches at the Torino University in Italy, and is research professor at New York University Polytechnic Institute