Monday, September 29, 2008

Critical Opalescence

People will be looking at the financial breakdown through many lenses, but one that might be worthwhile is the theory of critical phenomena. One thing that the banking deregulation and invention of new financial instruments did was result in a financial system that was more strongly coupled. As long as banks were essentially local and worked with only their own money, weak coupling theory and the appropriate regulations were sufficient.

Many of the financial instruments enabled by the Clinton and Bush repeals of financial regulations made possible the exotic "weapons of mass financial destruction" (as Warren Buffett put it). The supposed benefits are greater mobility of capital and greater efficiency. What many of the banks, and their string theorist "quants" failed to take into account was the possible presence of a second order phase transition.

In such a transition the microscopic transitions from, say, liquid to gas, which are always present but normally energetically suppressed, can grow to arbitrary size. Under favorable conditions, this manifests itself as a sudden clouding of a previously clear sample, the so-called critical opalescence.

We have reached that state in the financial markets, and nobody can understand what anything is worth, because it's all obscured by the critical opalescence.

Maybe next time they should hire recycled condensed matter physicists.