Paper Submitted to Sino-Australia Financial Forum for Graduates

A Study of Financial Crises in the Framework of Dynamic Evolution of Fictitious Economy: Based on the Theory of Dissipative Structure

By Qing Zhou

School of Economics and Finance, Xian Jiaotong University

Email: qzhou0308@gmail.com

Abstract
To illuminate and dissect the mechanism of financial crises using the dissipative structure theory, we may draw the conclusion that crises happened due to the fictitious economy evolutions. Applying the theoretical analogy approach, we can see that non-equilibrium is also served as a major drive for the evolution of the fictitious economy. The exponential growth of asset prices with an unexpected non-linear positive feedback expansion style acts as the micromechanism, which decides macroscopic state. In addition, the random fluctuations take the role of inducers, which induce a stable state further evolving to critical or even supercritical state. The random fluctuations make the financial crises cannot be accurately predicted or captured. Thus, fluctuations are very important to pre-warning of financial crises. This study explores potential ways for monitoring fluctuations in order to provide useful warning signs to authorities and suggest taking forward-look policies timely to prevent the fictitious economy achieving the dangerous supercritical point. Key WordsDissipative Structure; Fictitious Economy; Evolution; Financial crises

1. Introduction
Many theories tried to explain or predict the crisis. Unfortunately, most of them can only explain a small part of specific crisis. In fact, crisis is a kind of a dynamic process, but those theories used static framework. Our aim is to develop a theoretical and dynamic framework which can take the dynamic time process into consideration. We use the dissipative structure theory from non-equilibrium statistical physics as a tentative framework for explaining the fluctuations and evolution of the fictitious economy, which ultimately trigger financial crises. Many researchers suggested that complexity theory can be applied to economy study. Particularly, the self-organization theory can be used to economy evolution studies. However, few researchers performed the analyses for the evolution of the fictitious economy. To our best of knowledge, we only learn that some studies employed analogical methods in sociology (Chase-Dunn & Hall, 2002; Wallerstein, 2004; Gunaratne, 2007). Therefore, we will be benefit to borrow the similar ideas and apply to our study. In this study, not only theoretical analyses are performed, but the empirical evidence is also provided. Other novel methods such as SVM(support vector machine), VaR(Value at Risk), and Swarm with their drawbacks are proposed. This study may contribute to: i) Constructing a dynamic framework for understanding the evolution of the fictitious economy and financial crises; ii) Elaborating the importance of fluctuations and the reasons for why crises cannot be accurately predicted; iii) Proposing practical measures to cope with financial crises.

2. Theoretical Model and Analysis

Traditionally, economics tends to assume the stability, order, equilibrium and linear
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relationships. Since the economic system itself is a complex system, the traditional assumptions are limited to explain what occurs currently. Here, two core definitions of the dissipative structure theory are employed: i) Non-equilibrium: the source of an order; ii) Order achieved through fluctuation. Figure 1 Triangular Relationship Schemata
Determinism Function Structure

Fluctuation Random

Figure 1 illustrates that the function (micromechanism), the structure (macro structure) and the fluctuations of a system interacts with each other. The interaction of them is the pivotal basis to understand the macro state of a system. Macro structure is always determined by micromechanism. Fluctuations lead to the change of the macro structure. It has a dual character. For one hand, fluctuations are gradually decline if in equilibrium or near-equilibrium region, and insufficient to induce a macro state change. On the other hand, fluctuations can make the system evolve to a critical state which may lead to uncertain paths if in the non-equilibrium state. However, once random fluctuation is certain, the evolution path of the system will be determined and a new ordered macro-structure will be stabilized. The fictitious economy is a complex metastable system. It has the similar evolution mechanism as what has been discussed above. Thus, we can build our theoretical framework on this model and conduct our analysis of the evolution as following: i ) source of evolution; ii.) micromechanism of evolution; iii.) macroscopic scale of evolution; iv.) trigger of evolution state transition; v.) unpredictability of evolution.

2.1. Source of Evolution: Non-Equilibrium

After solving the Fisher equation, we conclude that when returns on fictitious and real assets are equal, the fictitious economy and real economy achieve equilibrium state. In equilibrium state, the monetary circulation and financial circulation are relatively static. But the static state is an extremely narrow balanced growth path in which the fictitious economy is hard to evolve forward. Actually, the non-equilibrium sate has actual, psychological and behavioral basis. Therefore, it is not rare to see the deviation of the fictitious economy from real economy (non-equilibrium state). As what have been discussed, the fictitious economy has its source of evolution.
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In the vicinity of equilibrium state, the effect of fluctuations gradually decays through the internal adjustment mechanism of financial market itself or the regulation of central bank policy. The fictitious economy can maintain relatively stable. But in a state of non-equilibrium, the positive feedback mechanism brings the fictitious economy self-organizes into a critical state of extreme sensitivity, in which any small fluctuation can lead to a supercritical state and further trigger the systematical collapse (financial crises). In the term of dynamic time process, financial crises can be defined as an ending point of instability of the financial order and as the starting point of the new order. In summary, the non-equilibrium widely exists and acts as a source for the evolution of the fictitious economy and new financial order.

2.2. Micromechanism of Evolution: Bubble

The fictitious economy evolves and deviates from the real economy as the process of bubbles forming and collapses as bubbles bursting. Financial crises also follow what appear to be bubbles in asset prices. Hence, micromechanism can be detected through exploring the path of the bubbles formation. We have built a mathematical model trying to integrate as much factors as possible to explore the micromechanism causing bubbles. We find out that risk shifting problems, non-linear positive feedback inflation style of asset prices and credit uncertainty all contribute to the Asset prices + Credit Assets Prices bubble formation micromechanism. The root of these is information asymmetry and agency problem. The mathematical model is shown below: 1. Hypothesis (1) There are two assets, a safe asset and a risky asset. The safe asset: it pays a fixed return r to the investor and maintains a fixed price PS . The risky asset: The return R of the risky asset is normally distributed with a mean of and a variance of 2 and the price PR is variable. (2) There are three participants, an investor, a bank and a central bank. The investor is risk-neutral and decides the investment debt ratio . Only under the condition that the expected return of the risky asset is greater than r , the investor will choose the risky asset. The bank is risk-neutral and invests in the safe asset with the return rate r in a perfectly competitive credit market. Therefore, the expected return of credit is r . The central bank controls the amount of credit D . (3) The investor and the bank have asymmetric information about the investment in assets. The investor holds more information than the bank, so the bank has to pay additional monitoring cost J for further information. 2. Modeling

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At time T , the investor distributes his capital, X R on the risky asset and X S on the safe asset, the total amount is X R PR + X S PS , in which X R PR + X S PS is borrowed from the bank. Then the expected income is: 1+RX R PR + 1+rX S PS . At time T +1 , the investor has to pay (1 + r )( X R PR + X S PS ) back to the bank. When the equilibrium achieved: ( X R PR + X S PS ) = D . When the expected return of the investment on assets exceeds the repayment, supervision of investors investment decisions is not required. That is to say R* exists when 1+ RX R PR + 1+ rX S PS - (1+ r)(X R PR + X S PS )l = 0

Then we can get: R* = r

D(1 + r )

X R PR
1

So the monitoring cost expected to be:

r D (1+ r ) 1

F=J

(r

D (1+ r )

X R PR

N ( R)dR = J

1 [e 2
1

X R PR 2 2

)2

2 e 2 ] 2

(Model 1)

The derivative is

' FPR=J

1 [e 2

(r

D (1+ r ) 2

X R PR
2

)2

(r

D(1 + r )

X R PR

)]

D(1 + r )

X R PR2

When R* = r

D(1 + r )

X R PR

> , FP <0 , it reveals that when the critical ' R

value of expected return rate surpass the mean, bank monitoring costs decrease with the rise in asset prices, so the financing costs get lower, stimulating credit expansion. When R* = r D(1 + r ) 1

X R PR

, FP 0 , it shows that when the critical ' R

value of expected return rate is under the mean, bank monitoring costs increase with the rise in asset prices, raising the financing cost leading to credit contraction. The emergence of this phenomenon is due to the critical value of expected return is less than the historical average, so even if asset prices rise, banks should be still cautious. As the price increases, the risk rises, bringing higher monitoring costs and then the
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contraction of credit. Now it can be seen that when the market is full of optimism about the future returns, the increase of asset prices promotes the expansion of bank credit. Because of the asymmetric information and agency problems mentioned above, when the asset price increases, investors receive a profit which is at least equal to the amount of repayment for bank loans, but when asset prices fall, the greatest degree of loss of investors is to give up the seriously shrinking collateral assets, shifting the risk to the banking system. The investors optimization problem is to select a debt ratio and to make allocation among different assets, namely: Rmax D (Model 2) max * [( R r ) PR X R + (1 )(1 + r ) ]N ( R )dR
R

The first-order condition is: PR =

U =

U V (1 1 ) 2
2 *2

1 Rmax R R R* R R* 2 D erf max erf ( ) *(1 + r ) V = 2XR (e 2 e 2 ) + 2 XRr[erf ( max ) erf ( )] 2 2 2 2

The numerical simulation result is shown in Figure 2:

Figure 2 Numerical Simulation of the Risky Asset Price

Figure 2 shows that as the leverage ratio increases, the price of risky asset is enhanced. When the leverage ratio below 0.9, the rate of increase is relatively gentle, but when up the critical point 0.9, it almost increases in a straight line. In an optimistic atmosphere, more than 100% leverage ratio is allowed. Once the expectation mutates, the unsustainable credit will be reduced and the excessive leveraged investment will be unsustainable leading to the collapse of asset prices, and then the collapse of the fictitious economy. 2

erf ( x) =

e t dt
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2.3. Macroscopic Scale of Evolution: Deviation Ratio

The importance of the observations on the fictitious economy evolution is its causing effects on macroeconomic, so the macroscopic scale or the external form of the evolution is the deviation ratio of the fictitious and real economy, namely the observable measure of the fictitious economy. Actually, the macro-state is the "structure" (macro structure) in the previously discussed triangular relationship schemata. As constrained by the real economy, the deviation ratio has its limits. At the critical point, market expectations as a whole is mutated by accidental events and finally contribute to the overall changes in macro-state.

2.4. Trigger of Evolution State Transition: Fluctuations

The value of the fictitious assets is based on capitalized pricing model supported by concept and expectation with an operation character more uncertain and volatile than that of real economy, so any fluctuations which can reverse expectation will bring a transition of state. Historically, the probability of the system driven to non-stable region by accidental fluctuations is not always equal to zero. Fluctuations may come from political policies, monetary policies, or natural factors. When the fictitious economy departs from the real economy and evolves to a critical state, namely the transition threshold, accidental fluctuations can bring the fictitious economy to a supercritical point at which the financial crises are unavoidable.

2.5. Unpredictability of Evolution

The fictitious economy is a complex system includes many micro components who interact with each other, so when approaching a critical point, the fictitious economy has a variety of possible future evolving path. Any fluctuations can bring the system into any possible evolution paths. Therefore, it is naturally unpredictable, and accidental fluctuations exacerbate the uncertainty. In the process of the evolution, some events can be predicted, but the investor expectations and political events which involve subjective things will be difficult to forecast. Thus, in the absence of substantial and accurate information, accurate prediction of the occurrence of the crisis is difficult. Although we can trace the footprints of history and explore the inherent causes of the crisis and general laws, but the occurrence of random events is difficult to control. Therefore, "no two crises are exactly the same." It is difficult to predict the exact time of a large-scale collapse.

3. Empirical Evidence
In this chapter, we present some empirical evidence of non-equilibrium and provide proof for the micromechanism. The data sample has been selected from the United States, Britain, Japan and Australia with a time range from1979 to 2008. Here the claims on private sector to real GDP ratios has been used as credit index, stock indices and real estate price index as a fictitious asset price index, real GDP as the real economic indicators. Take the value of the indicators in 2000 as the base value 100 for
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indexation process. In order to eliminate heteroscedasticity effects, the indicators have been substituted by their logarithm, respectively LCG, LSP, LHPI and LGDP.

3.1. Existence of Non-Equilibrium

In order to visually describe the relationship between the fictitious and the real economy, stock price index, real estate price index and real GDP of the four countries have been chosen for descriptive analysis.
Figure 3 Non-Equilibrium of the Fictitious Economy and the Real Economy

As shown in Figure 3, there are deviations between fictitious asset prices and the GDP growth of the four countries. The difference between the four countries is the different degree of deviation. The degree of the United States and the United Kingdom are higher than that of Australia and Japan. As the critical area is the most sensitive area for asset prices, the financial crisis must be ignited in the region where the fictitious economy deviates from the real economy to the highest extent. The most convincible evidence is what happened in the US in 2008. In short, these tests confirmed that non- equilibrium widely exists and the financial crisis is always accompanied by a fictitious asset prices decline, and these will finally bring a new financial order.

3.2. Tests of Micro-Mechanism

We apply co-integration test to explore the long-term interaction of credit and asset prices. Firstly, we apply unit root test to the LSP, LHPI, LCG and their first-order differences, and use the LLC test, IPS inspection and MW tests to ensure
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the robustness of the results.

Table 1 Panel Unit Root Test
Section Number4 Time Range30 Level LCG 1st Difference -3.94152 (0.0000 Level LHPI 1st Difference -3.93911 (0.0000 Level LSP 1st Difference -4.65138 (0.0000

Homogeneous unit root test

LLC

-0.74627 (0.2278)

-0.03732 (0.4851)

0.16441 (0.5653)

Breitung

0.96569 (0.8329) 0.31095 (0.6221) 8.07408 (0.4263) 4.13677 (0.8446) 38.3536 (0.0003 42.5685 (0.0001

2.84121 (0.9978) -1.52837 (0.0632) 14.6615 (0.0661) 2.67694 (0.9530) 23.3551 (0.0029 19.0705 (0.0145

1.17801 (0.8806) -0.00662 (0.4974) 9.93884 (0.2693) 4.35086 (0.8242) 38.3536 (0.0000 42.5685 (0.0000

IPS Heterogeneous unit root test Fisher-A DF Fisher -PP

* The lagging order criteria established under the SIC

As can be seen in Table 1, the three time series variables are first-order stationary. We further applies panel co-integration test to determine whether there is a long-term relationships between variables. When examining LCG, LHPI and LSP co-integrated relationships, a variety of the Pedroni (1999) co-integration test methods have been used. Taking the small sample nature of the data into account, in the Pedroni test, only Panel ADF and Group ADF statistics are used. Table 2
Co-integration Test
Pedroni Test Statistic P-Value Panel ADF 3.703969 0.0004 Group ADF 3.330942 0.0016

Table 2 shows that at 1% significance level, the ratio of bank credit, real estate prices and stock prices co-integrated, which means long-term stable relationship exists among the three. The micromechanism has now been partly proved. Therefore, the non-equilibriumsystem instabilitycollapsenew stable state macroscopic appearance can be deduced.

4. Conclusions and Suggestions

We apply the dissipative structure theory to the discussion of the financial crisis
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in the framework of dynamic evolution of the fictitious economy. It can be concluded that financial crises are limit forms of the collapses of the fictitious economy system which are caused by the evolution. Financial crisis can be seen as the ending point of instability of the financial order and as the starting point of a new order. Fluctuations are very important as they can decide the evolution path of the fictitious economy after a critical point. Thus, whether a financial crisis will happen largely depends on whether a fluctuation can bring the fictitious economy to a supercritical state where the financial crisis is unavoidable. Since the fluctuation is a random event, the financial crisis can not be accurately predicted. What we can do is to monitor fluctuations to pre-warn possible crises, and then take preventive approaches playing negative feedback roles to make random fluctuations decay before the transition from critical point to supercritical state. The study could be possibly supplemented by more empirical tests and be further advanced in the following ways: (1) More convincing evidence should be found through collecting and collating materials on the financial crisis to carry out comparative analysis, although many previous researchers have done the same work, the comparison here is a dynamic one. The difficulties lied with the definition of the crisis and the fictitious economy bubble. (2) Inferred from what have been discussed previously, the key to the success of early warning is to accurately monitor fluctuations. Here, I would like to suggest three ways in doing this: (i) SVM (support vector machine) has been applied to solve the small sample size, high dimensional, nonlinear and local minima problems. It can be used to the study of pre-warning of fluctuations which acts in nonlinear micromechanism. (ii) VaR (Value at Risk) can be used for pre-warning as it can warn the possible loss of small fluctuations. The difficulties are which calculation method of VaR should be chosen. Among them, GARCH models capture the most features of complex system. But none of them combines all the complexity characteristics of the fictitious economy system. (iii) Complex systems modeling methods based on Swarm platform can be applied to the simulation of individual behavior and system evolution. The difficulty is how to build the huge number of agent behavioral models referring to the theory of behavioral finance.

Main References
Allen, F., & Gale, D., 2007. Understanding Financial Crises. Oxford University Press. Bernanke, B.,& Gertler, M.,1989. Agency costs, collateral, and business fluctuations. American Economic Review, vol. 79, pp.14-31. Allen, F., & Gale, D., 1998. Bubbles and Crises. Working Paper of the Wharton School, University of Pennsylvania WallersteinI., 2001. Unthinking Social Science: The Limits of Nineteenth-century Paradigms. Philadelphia:Temple University Press. WallersteinI., 2004. World-Systems Analysis: An Introduction. Durham, NC:Duke University Press2004.

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