Didier Sornette: How we can predict the next financial crisis

TL;DR

In this talk, Didier Sornette discusses the concept of "dragon-kings," extreme events in financial markets that can be predicted and understood.

Transcript

Translator: Joseph Geni Reviewer: Morton Bast Once upon a time we lived in an economy of financial growth and prosperity. This was called the Great Moderation, the misguided belief by most economists, policymakers and central banks that we have transformed into a new world of never-ending growth and prosperity. This was seen by robust and steady GD... Read More

Key Insights

• 💥 The Great Recession in 2007 and 2008 shattered the belief in endless economic growth and prosperity, leading to the need for real-time financial bubble diagnosis and prediction.
• 📈 A universal power law can represent 99% of the peak-to-valley amplitude of financial markets, but outliers called "dragon-kings" occur 100 times more frequently than expected based on this statistical model.
• 🐉 Dragon-kings are extreme events caused by dependencies that standard risk management tools often fail to identify, leading to unexpected crashes.
• 💥 The root cause of a dragon-king event is the slow maturation of a bubble, similar to the slow heating of water reaching boiling point. This process is non-linear and fundamentally endogenous, making it difficult to predict using traditional techniques.
• 🦢 The dragon-king concept is different from the black swan concept, as most extreme events can be knowable and predictable with the right tools and strategies.
• 🌱 An early warning signal for dragon-kings is super-exponential growth with positive feedback, which exhibits a critical time when the system will break or change regime.
• 💡 The dragon-king theory has applications beyond finance, including predicting ruptures in structures, identifying problems with pregnancies and epileptic seizures, and understanding the dynamics of success in various fields.
• 💰 The theory of dragon-kings offers insights into the financial crisis and the importance of addressing the structural causes of perpetual money machine thinking, as strategies like quantitative easing and austerity measures have failed to resolve the underlying instability.

Questions & Answers

Q: What is the concept of the Great Moderation?

The Great Moderation refers to a time when there was a belief that the economy was experiencing continuous growth and stability, characterized by steady GDP growth, low inflation, low unemployment, and controlled financial volatility.

Q: What event broke the illusion of the Great Moderation?

The Great Recession of 2007-2008, also known as the great crash, shattered the illusion of the Great Moderation. The losses in the financial sector cascaded into significant losses in world GDP and the global stock market.

Q: What is the Financial Crisis Observatory's goal?

The goal of the Financial Crisis Observatory is to diagnose financial bubbles in real time and predict their critical time in advance.

Q: What is the concept of "dragon-kings" in relation to financial markets?

"Dragon-kings" refer to extreme events or outliers in financial markets that occur more frequently than predicted by standard risk management tools. They are generated by specific mechanisms that may make them predictable and controllable.

Q: What is the root mechanism of a dragon-king event?

The root mechanism of a dragon-king event is a slow maturation towards instability, also known as a bubble in financial markets. The climax of the bubble is often followed by a crash or significant disruption.

Q: How does the dragon-king concept differ from the concept of black swans?

The dragon-king concept suggests that most extreme events are knowable and predictable, while black swan events are often considered unpredictable and unknowable. The dragon-king concept empowers individuals to make predictions about extreme events and take responsibility for them.

Q: What are some early warning signals predicted by the dragon-king theory?

One early warning signal predicted by the dragon-king theory is super-exponential growth with positive feedback. This refers to a rapid increase in investment returns that are enhanced by previous growth, creating an unsustainable trajectory. The mathematical solution of this model exhibits finite-time singularities, indicating a critical time when the system will change regime.

Q: How does the Financial Bubble Experiment work?

The Financial Bubble Experiment involves monitoring the markets, identifying bubbles and excesses, and publishing reports with predictions of critical times. These reports are kept secret with encrypted techniques and released six months later for authentication, ensuring transparency and accuracy in predictions.

Summary & Key Takeaways

• The Great Moderation was a period of financial growth and prosperity, but the Great Recession in 2007 and 2008 broke this illusion.

• The Financial Crisis Observatory was created to diagnose and predict financial bubbles using a theory called "dragon-kings," which represent extreme events that are knowable and predictable.

• This theory has been successfully applied to various systems including finance, biology, and medicine, and can help identify early warning signals and prevent future crises.