Can We Predict the Next Financial Crisis?

Source: Thinkstock

Source: Thinkstock

Financial crises always seem to come out of nowhere. Despite the best guesses of economists, it seems that every few decades another one turns every prediction on its head. How could there possibly be a way of predicting the unpredictable?

One French academic, however, has made it his mission to do just that — predict the supposedly unpredictable. Didier Sornette, a professor of entrepreneurial risks at the Swiss Federal Institute of Technology, has helped developed a theory that he calls “dragon-kings” that could help economists plan for potential financial catastrophes before they ever happen.

So, what are “dragon-kings?” To explain, Sornette provides as an example the distribution of city sizes in France, which, he says, follow the traditional power law; France, like most nations, has many small cities and just a few larger ones. “On a log-to-log scale, this distribution gives a straight-line,” Sornette says, but there’s one exception. “Paris,” Sornette notes, “is an outlier and many times larger than it ought to be if it were to follow the power law,” per the MIT Technology Review.

“Paris is an outlier because it has been hugely influential in the history of France and so has benefited from various positive feedback mechanisms that have ensured its outsize growth,” Sornette notes. “London occupies a similarly outlying position in the distribution of cities in the United Kingdom.”

Sornette describes a number of outliers that deviate from traditional power law, outliers that he says are the result of positive feedback mechanisms, which make them much larger than their peers. Such outliers, Sornette says, can be used to describe everything from extreme weather events, to financial collapses, to epileptic seizures, to human birth. These are dragon-kings. They are entirely unaccounted for by current ideas about power law, since they are “absolutely non-linear,” as Sornette says.