Saturday, March 13, 2010

Bubbles and Earthquakes

Posted by Jeff Lipshaw

My article on financial bubbles and earthquakes, The Epistemology of the Financial Crisis, is due out any moment in the Southern California Interdisciplinary Law Journal.   In it, I suggest there are parallels Images-2 between the science of earthquakes and the science of financial booms and busts and the epistemological crises that I claim ensued when the workings of the world managed to burst the bubble of faith in predictive sciences with respect to each of them.  What interested me as a lawyer in particular, as discussed in the piece, is the lawyerly equation of causation with blame.  I had a friendly debate a few weeks ago with one of my faculty colleagues who said she did assess this last bubble correctly before it burst.  I have no doubt she's right, but proving it's anything more than luck is far more difficult because of the counter-factuality problem - otherwise known as 20-20 hindsight - in historical causation.

It turns out I'm not the only person who has a dual interest in bubbles and earthquakes.  The Wall Street Journal has an article this morning about Professor Didier Sornette, the director of the Financial Crisis Observatory at the Swiss Federal Institute of Technology in Zurich.  As a geophysics professor at UCLA, he has studied earthquakes, which he concludes are more difficult to predict than anything else.  As a professor of finance, he tries to predict market bubbles, having now made several predictions and locked them away in encrypted files.

Once again, the counter-factuality problem raises its ugly head.  Even if it turns out he's right, it won't prove much.  Sporadic evidence confirming a theory doesn't carry much weight, even if we accord a lot of weight to theories (like quantum mechanics) that haven't been falsified, but have been confirmed in thousands of experiments and applications.  Nor will being wrong, I suspect, damage his career, the case in point being Ed Yardeni, who made his name for several years predicting the collapse of the world because of the Y2K problem.

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