Complexity Theory and Financial Regulation

By Cars Hommes - May 7, 2016 - -
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Complex systems are characterized by many interacting particles or agents. Such systems often exhibit critical transitions: seemingly unpredictable, catastrophic changes at the macro level. Examples are water suddenly freezing into ice, a lake suddenly polluted due to an influx of agricultural fertilizers or a financial market falling into a global market crash when traders panic. A problem with undesired critical transitions is that they are hard to reverse. A crucial insight from complex systems is that “more is different”: the emergent macro behaviour of a complex system cannot be reduced to or understood from the micro behaviour of a single individual. The macro behaviour of a complex economic system cannot be understood from the properties of a single, representative agent, but rather must be studied by the global interactions of heterogeneous consumers, firms, banks and other institutions.

This paper, which argues that policy analysis should be based on complexity theory, network analysis and more realistic behavioural agent-based models, calls for an interdisciplinary research effort for an online policy dashboard. Complexity theory has the potential to construct generic early warning signals from time series data. An example study of the Dutch interbank lending network shows that a more accurate heterogeneous network model could have detected a structural change of the banking network already in 2005, three years ahead of the crisis. That does not mean that we know what exactly causes this transition in the complex financial network structure. To gain a better understanding, a behavioural network formation model would be helpful in identifying potential critical transitions and guiding policy to prevent the system from moving beyond a tipping point.

Complexity theory has been very successful in understanding and predicting critical transition in natural systems (ecology, weather forecasting and epidemiology, for example). When carefully adapted to social systems, complexity theory offers great potential for economists, who should be looking over the boundaries of their own field for interdisciplinary cooperation. Financial and economic crises are simply too costly to neglect the potential of complex systems.

TI Key Publication

Stefano Battiston (University of Zurich), J. Doyne Farmer (University of Oxford and Santa Fe Institute), Andreas Flache (University of Groningen), Diego Garlaschelli (University of Leiden), Andrew G. Haldane (Bank of England), Hans Heesterbeek (University of Utrecht), Cars H. Hommes (UvA), Carlo Jaeger (Beijing Normal University, Potsdam University), Robert May (University of Oxford) and Marten Scheffer (Wageningen University), (2016), Complexity theory and financial regulation. Economic policy needs interdisciplinary network analysis and behavioral modeling, Science 351, 6275, 818-819. Read the article in Science.

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