Everyone knows physicists are the smartest of them all. Thus, prefixing your field’s name onto the word “physics” provides automatic doubleplusgoodness. At least it means you can publish economics in physics journals. Example:
Rising cost of oil ‘due to speculation’ – [E]conophysicists Didier Sornette of ETH Zurich, Switzerland, and Wei-Xing Zhou of the East China University of Science and Technology, together with Ryan Woodard of ETH Zurich, claim that speculation must have driven some of the escalation in oil prices. They have found evidence for a “bubble” — an indicator of speculation — in prices since 2003, when the cost of an oil barrel was four times lower than it is today.
Bubbles are a controversial topic in academic finance because there is no clear way to define them. However, Sornette’s group says it can pin them down by examining the precise rate of growth in prices.
In an economy without speculation, the price of commodities tends to grow by a fixed percentage every year; this is an exponential rate of growth. But when an economy is influenced by speculation, the percentage increase can grow too. This gives rise to a power-law growth or, as the researchers call it, a “super-exponential growth”.
Sornette’s group has looked at three different models to see if oil prices exhibit super-exponential growth…The researchers found that all three models fitted the oil-price data well, implying that the growth has indeed been a bubble (Physica A submitted; preprint at arXiv:0806.1170v2).
Could it be that there is no financial speculation, but that the demand for oil from China and India is growing super-exponentially, like a bubble? Sornette’s group cites figures on world oil supply and demand from the International Energy Agency that suggest this cannot be the case. Sornette told physicsworld.com that he is “99% certain” speculation is influencing current oil prices.
Sornette group first came up with his theory of super-exponential growth as a symptom of economic bubbles in 1996. In 2005, they used it to predict the burst of the US housing bubble.
Basically, prices have been going up really fast and the authors have noticed this pattern in prices is associated with speculative bubbles when supply and demand aren’t changing much. To say oil prices have gone up due to speculation, they have to rule out large shifts in supply and demand.
The authors make the decent assumption that supply — by which, I think they mean oil coming out of the ground — doesn’t change that fast. Their job, they say, is to show demand didn’t change that much. Given small changes in demand and small changes in supply, the price increases must be due to speculation. They use demand and supply data from some non-publicly available source to assess the speed of demand shifts. Its not clear what these data are, but, charitably, they must be quantity data where the difference in supply in demand is the change in inventories. So they’re using quantity data to assess demand shifts. They don’t find big changes in quantity, so they assume small shifts in demand.
In other words, they ignore elasticities. Apparently, its ok to ignore behavioral responses in econophysics. I guess this is understandable given physicists don’t have to worry much about they budget constrained, preference maximizing behavior of quarks.
The problem is if supply (or demand) for oil is inelastic, even small changes in demand (or supply) will induce large changes in price and the authors method for determining the existence of speculation goes out the window. I’m guessing both demand and supply for oil are inelastic so it could be both demand shifts caused by China and supply shifts caused by speculators inducing the large price increases. Given the huge rise in demand and the fact that inventories are finite (thus limiting the effect of speculators), it seems more likely the price changes are due to the former rather than the latter.
UPDATE: Rapture is near… I’m really liking the bloggy version of Paul Krugman.