Weekly Insider (Lux announces & Forbes recap)

Two big announcements from Lux Research: First they opened a new office in the Middle East in Dubai. Second, they launched an exciting new Lux Water Intelligence Service and Technology practice covering:



-Desalination advances (hybrid reverse osmosis, forward osmosis, and freeze crystallization;

-Infrastructure integrity, (trenchless drilling, in situ rehabilitation, infrastructure assessment, and remote monitoring);

-Novel disinfection techniques (such as cavitation and high-energy irradiation for treatment of endocrine-disruptive substances);

-Waste management approaches (zero liquid discharge, wastewater mining, and brine disposal);

-Water/energy technologies, (pressure recovery, microbial fuel cells, and sludge gasification);

-Water rights and transportation, (private water districts and rights management exchanges to water exploration and long-distance transport business models).

If you want in, talk to John Schwartz at (john dot schwartz at luxresearchinc.com) or +1 (646) 649-9582.



Meanwhile, here’s just published article from Forbes colleague Courtney Myers doing an excellent job recapping her experience at Lux Research’s annual event:

How To Combat Energy Shortages (by Courtney Myers 10.28.08, 6:00 PM ET)

On a train ride from Boston to New York, I checked my laptop scanner for wireless signals and saw nothing.



The ticket lady called out: "Next stop! Kingston!"



I asked, "Excuse me, ma'am, does this train have wireless Internet?"



"No, on this train we're lucky to have electricity," she snapped.



Really? I had just spent three days at the Lux Executive Summit in Cambridge, Mass., listening to a passel of energy experts talk about emerging technology trends in renewable energy. Some of the ideas were truly mind bending: hydrophobic screens that allow air to pass through while water rolls off a dense network of nanostructures; wirelessly powered, rechargeable batteries; inventions that turn waste into electricity; and drinking water for pennies. But electricity and wireless Internet are still scarce on Amtrak?



The Lux conference featured 50 speakers, including inventor Dean Kamen, tech guru Bob Metcalfe and former presidential candidate John Kerry. The conference organizer revved up the tension by offering contradictions: "There's no shortage of energy!" yelled a videotaped Matthew Nordan, president of Lux Research, from a projector screen.



The retort from a live Nordan was just as pointed: "There's a shortage of creativity, courage and entrepreneurship aimed at producing more from an unexploited world."



Metcalfe, a venture capitalist and co-inventor of Ethernet technology, contended that the research universities are the key to our country's success in solving the energy crisis, as well as competing teams of research professors, scaling entrepreneurs and venture capitalists.



Metcalfe is known for grand pronouncements that are often--though not always--correct. He articulated "Metcalfe's law," which proposes that the value of a network rises proportionately to the square of the number of users in the system. In 1995, he predicted the Internet would suffer a catastrophic collapse within a year. He literally "ate" his words two years later, downing a liquid slush made of a printed copy of his prediction.



Last week in Cambridge, Metcalfe declared "Blue is the new Green," and so gave the energy movement a color and a new name: The Enernet. Metcalfe said blue seemed the logical choice since "the hippies stole green, the communists stole red, black is depressing."



Roger Duncan, general manager of public utility Austin Energy, described how 22% of new homes built within the next year in Austin will conform to the standards of the firm's "green" building program. The homes are designed to consume "net zero energy" by 2015--which means that with the addition of solar panels, they should not need any additional power from the grid.



Sen. Kerry's introduction made headlines last week when he said he felt sympathetic for the presidential candidates during these last few weeks in which they are berated by media questions like the infamous, "boxers or briefs question." Beginning to tell a joke, Kerry said he wanted to answer the question "commando," while Obama safely answered, "both," and McCain answered, "depends."



Kerry quoted promises made by presidents Richard Nixon and Gerald Ford that America would be energy independent by 1985. He also railed against administrations of the past 20 years--including the Clinton administration--for kowtowing to the oil industry.



Kerry also blamed the auto industry for turning a blind eye to the need to reduce U.S. dependence on oil--and conceded that the U.S. will need to continue drilling for the foreseeable future.



"Instead of sending a billion dollars a day to the Mideast, we should be sending it to the Midwest" to develop biofuels and build wind farms, Kerry said. "The Stone Age didn't end because we ran out of stones, and the oil age is not going to end because we run out of oil." He ended his remarks, however, without offering a concrete plan for change.



Dean Kamen, inventor of the portable dialysis machine, insulin pump, the Ibot chair and the Segway, and president of the research and development firm DEKA, figures the U.S. can be saved by scientific inspiration. He opened with a clip of himself and his robotic wheelchair on "The Colbert Report."



Kamen wants to make science look cool. He showed off pictures of some of his latest inventions: DEKA's Stirling Cycle Engine that boasts a peak generating capability of 15 kilowatts, weighs less than 300 pounds and runs on cow dung; and DEKA's "enhanced distillation" machine that takes anything "wet" and produces water, which Kamen says exceeds the U.S. standards for drinking water. Kamen hopes this device will help bring water to remote villages.



But Kamen's biggest fear is that U.S. will fall behind because students are failing academically. Less than half of the high school students in the 20 largest U.S. school districts who were supposed to graduate failed to do so, Kamen noted. That gives the U.S. the worst graduation record of any industrialized country. "We need to have an enormous set of resources in our lifetime keeping us ahead of the problem du jour," Kamen urged. "So, right now the best problem we can solve is creating the problem solvers."



True to his inventive nature, Kamen has indeed invented what he hopes will be part of the solution: a contest for high school students to build working robots that compete against one another in an annual contest.



The program, called "FIRST" ("For Inspiration and Recognition in Science and Technology"), has been a huge hit among students in both the U.S. and around the world. About 194,000 high-school age students in more than 40 countries took part in this year's FIRST competition, building 17,000 robots. The program has also expanded in recent years to include Lego leagues for grade-school children.



Recently, Brandeis University's Center for Youth and Communities conducted an independent study comparing students who participated in a FIRST robotics competition with those who had similar backgrounds and academic experiences but did not compete. The university's conclusions: FIRST students were three times as likely to major in engineering, 10 times as likely to have had an internship, apprenticeship or co-op job in their freshman year in college and "significantly" more likely to expect to earn a post-graduate degree.



"The kids weren't building robots, the kids were building self-confidence," said Kamen, who then begged the conference attendees to become the role models. "I need the enthusiasts of the industry giving these kids something to aspire to--and if it's not you, who is it?"



In an effort to choose a more efficient mode of transportation for getting work done, I ran a quick Google search for wireless Internet and found the world is not as disconnected as I thought. The Bolt Bus, which runs from Boston to New York to D.C., offers free wireless Internet. In January of this year, Massachusetts began offering free wireless Internet service on at least one coach of every train traveling the 45-mile commuter rail line between Boston and Worcester, Mass.



Outside of the U.S., most trains in Britain and Europe are wireless (Deutsche Bahn in Germany has had wireless high-speed trains since 2005). In the air, Southwest Airlines is the latest airline to test in-flight wi-fi.

Weekly Insider (Recap & Reverberating Controversy)

What an amazing event! From breakthrough announcements to bubble declarations to new product and service launches and even political gaffes that reverberated around the world—here are just a few headlines from coverage of Lux Research’s Lux Executive Summit:



1. Bob Metcalfe cheers global warming bubble…



2. Inventor Kamen pitches tech for world's poor--Speaking at the Lux Executive Summit, he said that scientists needed to apply their brains to solving the world's worsening problems. ...



3. Lux Research Introduces Water Technology Practice…The service was announced at the opening of the 4th annual Lux Executive Summit, the premier forum for science-driven innovation. ...



4. Kerry Jokes About McCain Wearing Diapers--Boxers of Briefs? John Kerry thinks Sen. John McCain would choose diapers instead, Kerry was speaking at an event Monday in Cambridge and ...



5. Water Innovations Alliance Launches at 4th Annual Lux Executive Summit--"Water is the lifeblood of the earth, for its people, industries, cities and environments," said leading emerging technology investor and Alliance co-founder Josh Wolfe of Lux Capital. "If water is the result of just three atoms, then think of what will result from the combination of entrepreneurs, investors, scientists, executives and political leaders. It is our imperative to bring clean, safe, abundant and accessible water to a needy world."



6. Lux Research’s Matthew Nordan gave a home run speech. Here’s what John Dodge, Design News wrote: “Conservation is a sham; Smart Consumption isn't….

“Energy conservation is a sham", we were told at the Lux Executive Summit on Monday in Cambridge, Mass. The speaker was consulting company Lux Research president Matthew Nordan, an able and provocative presenter, who also charged that the financing model to back energy startups is broken (what in finance isn’t broken?).

“We’re chromosomally incapable of consuming less. [Consuming more] is essential to what it means to be human. The experience of more is written into our DNA. {I want] to get more than I had yesterday,” he said, adding the idea of “doing without” just doesn’t click. And what the hell? There’s 1.8 trillion barrels of heavy crude lying under Venezuela AND we only use 10% of the water that falls as rain from sky, according to Nordan.

“As long as we have water, we have infinite energy,” he claimed.

The view sounds like it could be written into the platform of the republican party, doesn’t it? But Nordan moderated it a bit by saying we must “consumer better’ and achieve a level of sustainable consumption. It was a clever way of urging consumers to energy more efficiently, an eons-worn concept engineers think about every day.

And don’t think that cars powered by lithium batteries are necessary sustainable. By Nordan’s calculations, 42% of the world’s lithium carbonate (it’s a salt) will be used up if just 6.4% of the world’s car are powered by lithium ion batteries.

Nordan’s notion of sustainable consumption is wholly based on development of new technologies. In fact, our energy future rests on coming up with new solutions. As an example, Nordan held up a screen coated with a nano-powder from nGimat that lets breezes through, but stops water. The idea is to cool your porch in the summer without letting in rain. Combined Heat and Power is another promising technology.

He also urged the energy companies who came to this conference to “out compete on customer experience” and “engineer system level efficiency.”

As for financing, he makes a good point. The angel, VC and private equity model that worked so successfully for software companies is completely inadequate.

“The model breaks when you feed it materials, energy and environmental technologies because they need 2.5 time as much,” he said, noting that Google required $25 million in startup capital compared to Bloom Energy which will have to spend 10 times to see if its idea is feasible.

“You need big plants to find out if the idea is viable at scale,” he said. He proposes a 10-year financing cycles that includes incubators, corporate partners staggered exits which are partial deployments….”

Weekly Insider (A Tiger & Zebra in Crisis)

Here’s a long one, making some new “calls” and revisiting some prior “calls” written here. All tickets sold for the Lux Executive Summit. See you Monday with Dean Kamen, John Kerry, Bob Metcalfe, Shai Agassi, Nobel Laureate, Sir Harry Kroto and many more.



Meanwhile: according to myriad market commentators, we seem to have hit more bottoms than an abusive orphanage. There was the SocGen bottom in January, the Bear Stearns bottom in March, the Feddie & Frannie bottom in July, the Lehman bottom in September, the bailout bottom of October.



You can’t call bottoms.



The only thing you can know is that you have no idea what Mr. Market will do day to day, week to week or month to month. Investors that claim they manage volatility or investors that demand it are being proved wrong daily. “Managing volatility” is like managing the emotions of the deranged homeless man on the corner. He might be well-fed and calm, or have low blood sugar and be dangerous. Your choices: cross the street and avoid him (ie. not be in the market) or you can keep a safe distance (ie. a margin of safety)—nearly every other strategy is a post facto explanation of how you “managed” to walk past him unscathed when you might’ve just gotten lucky.



The only thing you can control is doing the work to get a reasonable estimate of a company’s worth, realize that by buying a share of stock you’re buying an ownership stake in that business and know that Mr. Market will knock on your door erratic and emotional every day, jubilant or depressed and offer to buy your share or sell you his share at a price. That price is only a price—it may be much more, much less or a fair approximation of what your business is worth. Buy when the price being offered is much lower than your approximation of what its worth—a margin of safety.



As Mark Twain said, it ain’t what you don’t know that kills you—it’s what you know for sure that just ain’t so. What does everyone know for sure that just ain’t so? Inflation is abating. A global slowdown? Sure. But mark my words: forget Al Gore, the award of “Most Green” goes to the Fed with its unprecedented “emissions” of the dollar variety. The cost of capital for a brief period was infinite (nobody would lend money at any price). The cost of capital will rise, the massive issuance of Treasuries, and the anticipation of it, will further steepen the yield curve (allegedly a favorite trade of legendary hedge fund manager Julian Robertson) with long-term rates rising with greater anticipation of inflation. Julian runs Tiger Management, which has spawned the most successful hedge fund managers in history.



Here’s what “Tigers” and Zebras have in common and how Zebras connect to interest rates and investment returns.



Primatologist Robert Sapolsky has lived with animals for decades. He wrote a book called why “Zebras Don't Get Ulcers”. We get ulcers because we are under constant and continuous self-imposed stress (mostly psychological) that didn’t exist in our evolutionary history. Here's why Zebra’s don’t get ulcers: they have short intense bursts of stress—more like a lightning bolt—as a lion gives chase. They run, their heart rate increases, adrenaline floods their system, emotion runs high (for fear is a great motivator) blood is quickly pumped to the muscles and in a few moments either it’s over or the Zebra is.



Everything that matters to the Zebra long-term basically shuts down. Their reproduction and maintenance of their immune system are deferred. Who needs to worry about sex drive or fending off microbes in days or weeks if you might not live in minutes.



Here's the connection to markets. When there's stress and panic—all long-term focus shuts down. The Zebra runs for safety. So do investors. They flood into short-term debt, willingly accepting negligible yields. Famed hedge fund manager Julian Robertson recently said his favorite trade is curve steepener, shorting long term rates and buying short term, or at least betting the yield curve gets steeper.



Julian is betting long term rates go up. He’s not alone: Fed funds futures show increases into next year.



Think about it: at moments in recent weeks, the cost of capital was basically infinite. People wouldn't part with cash at any price. Dangle a lure with shiny metal and feathers and neon and you couldn't catch cash. There was no 'river running through it'. The river was frozen—with fear.



When things are good, forecasting periods go far and wide. When the sun is shining and times are good, people can see far and wide. Visibility is measured not in miles but decades. When you're in the storm, good luck seeing not feet but days ahead of you. Short-term liquidity, short term interest rates plummet—people seek near-term safety.



What it means is this: far out projects need big discount rates—now much bigger. Because with less visibility the risk has grown. And the bigger the risk, the lower the confidence and the higher the hurdle to jump over to compensate you to take such a risk. Discount rates rise. Interest rates rise. And project finance: it gets crushed. Caveat emptor for anyone still chasing sunbeams or moonshine constructing large capex intensive solar installations or ethanol distilleries. Things that made sense when you had low borrowing costs and massive government subsidies just don’t when borrowing costs skyrocket and states have record deficits. They can’t give tax breaks when they need to raise taxes.



Consider California, in a major fiscal crisis. They just issued billions in debt through a bond called “a revenue anticipation note”. That’s a nice way to say interest coming from taxes paid in. Know what that means? Government revenue means taxes. The people that just lent the government money (at record high short-term muni rates) expect to get paid back, with interest. That interest comes from collecting tax dollars. Do you think alternative energy companies are likely to see more or less tax rebates? Yeah, me too.



The slowdown will test their green commitment. The state has to raise money, or run out of it by the end of the month. So the federal government might have to bail it out too. Which means YOU might bail it out. Nobody liked AIG taking their bailout and spending it on manicures and martinis. And nobody is going to like CA coming up short because it chose not to anticipate revenue by shutting down nuclear plants, subsidizing millions in inefficient solar cells. What should the governor do? Cut education? What about healthcare? Green is about to turn red.



Here’s a check on the accuracy of some of my quips meant to serve you over the past few months:



12 months ago--November 16, 2007: “The Future, Predictors & Inventors”

So running with the herd was the absolute logical and rational thing to do in our evolutionary past—when our biggest threat was being eaten by Pleistocene felines. Today your biggest risk is more likely to be not having cash when you need it (whether in the form of owing too much credit card debt, owning a mortgaged condo in Miami, having a Northern Rock or maybe E-Trade account, or running a U.S. business with Euro denominated inputs). But all these things and then some are known. They are priced in. Some more than should be (oversold); some less than should be (overbought). Like a pendulum, expectations can swing to excess of true north.

Which got me thinking: what does everyone take as given that would shock them if it weren’t true? Here’s a few to chew on. Everyone touts oil surpassing $100. With Iran showing its nuke blueprints to UN, could it be the first of many components of fear residing and price deflating? Could speculators (accounting by some estimates for some 20-40% of the current price) get left holding the barrel?

Could the China growth story be oversold? Could government spending for the Beijing Olympics artificially prop things up? Could a report emerge that shows the size of the China economy is just a fraction of what everyone thought it was? Sound crazy? Remember the telecom stats that the Internet was doubling every 90 days which instantaneously dropped the cost of capital to near-zero and fueled the dot-and-tele-com boom on an entirely erroneous assumption? Could bio-fuels prove to be bio-fools?



8 months ago--Feb 15, 2008: “Cynic’s Conference Guide…”

The cost of capital for any technology for which there’s sufficiently high enthusiasm is close to zero. The two are inversely correlated. This means the marginal entrant has low barriers—which means the number of entrants grows exponentially. This characterizes “solar” today. The ecosystem cannot support the sheer number of companies competing to turn sunbeams into electrons, along the same points of differentiation: cost per watt and efficiency. Companies that got public early will use their stock currency to acquire those with interesting technologies as they postpone their own IPOs, face investor fatigue and eventually falter. It is a predictable pattern in capital markets. And the four most dangerous words are “this time it’s different”. It never is.



8 months ago--Feb 22, 2008: “Imagining Improbable & Friedman or Goldman”

Of course: today's disasters are tomorrow’s safeguards. Insurance, material safety data sheets (in chemistry labs), laws all came respectively from explosions, corrosions and corruptions.

So, what disasters loom? Start with what everyone takes as granted? What would take people by surprise? Will Gold, oil and every other commodity you can name continue their ascent? Is it more likely the Chindia demand narrative and gospel keeps people in the pews? Or do already high expectations and fewer incremental buyers on the margin mean vulnerability for surprise? Why is their virtually no media coverage of the rise in Oil as primarily a function of dollar decline and speculation? Over time, commodities approach their marginal cost of extraction. And being commodities: they’re undifferentiated and compete on price. When have VCs ever in history made money chasing ways to produce a commodity? Why do people keep insisting that solar is attractive when Oil is at $100 when we barely produce any electricity from oil? 50 years ago, sure—but oil is a declining piece of our energy pie as more and more things become electrified. What effect would an “unexpected” decline in commodity prices have on emerging markets? I’ll return to this in a moment.

The same thing holds for emerging markets. Given their higher risk and uncertainty they’ve historically traded at discount. Not so today. And as I note above: gold, oil, copper and the commodity cabals are all currently through the roof. But the roof of housing has caved in. Commercial real estate appears to be next. Demand slows. Prices fall. And if prices fall, then those emerging markets so heavily dependent on the outrageous prices for commodities (benefiting the owners of capital, yet crippling the population) will begin losing money. As they say of emerging markets: it’s where emergencies emerge. All the same people claiming “decoupling” were claiming “globalization” before. You can’t have both. You must choose: Friedman or Goldman (ie. Thomas Friedman (the world is flat) or Goldman Sachs, which started the “decoupling” meme).



6 months ago—April 18, 2008: “Timeless Space & the Mismeasure of Risk”

Of course we have terrible innate grasps of very low probability things, vastly over inflating the salient and available and under appreciating the unimagined.



Consider in markets what I’ve now dubbed “The Mismeasure of Risk”: volatility. Price movement isn’t risk (the real risk is that you don’t have money when you need it). Volatility is opportunity. And it allows for more rapid transfer between people with vastly different expectations of the future. The wilder the price swings, the more likely you are to bump into someone who completely disagrees with you and is willing to trade their claims on the future for yours. And this overreaction of counterparties allows you to either buy pieces of businesses (which are in your opinion attractively priced with even higher expected returns—from someone with the precisely opposite view) or conversely sell pieces of business you already own at much higher prices to people with much higher expectations. Volatility increases the odds you can do both.



Time is what matters most. Just as time is the friend of the great business and the enemy of the not-so great business, so to time, like volatility, makes friends with the long-term investor and antagonizes the short-term one.



I predict (nay, hope) lots of things will change in investment management in the coming years. The way risk is measured for one. Just because everyone else uses the same wrong measure doesn’t mean it’s worth anything. Sharpe Ratios and Beta are the opposite of fax machines. The more people that use them, the worse the system is. I enjoy taunting my friends at hedge funds and fund-of-funds who report monthly numbers or allow their investors to withdraw every month. How can you possibly make long-term decisions when your investors expect and demand steady linear performance? Expecting the implausible leads to attaining the inevitable—blow-ups and permanent loss of money. And that is the real risk.



5 months ago--May 2, 2008:

Meanwhile as I’ve been tirelessly quipping, the “biofools” and “commodidiots” are starting to feel pain. I’m hearing claims of biofool boondogglers having committing crimes against humanity for the poorly thought out unintended consequences and the resulting food crises their swindle has caused. And the latter have startups and investors chasing commodity markets that they mistook for technology problems (when they’re simply just US dollar problems). Most of the so-called ‘drivers’ justifying crazy startup valuations aren’t really a technology thing—it’s a dollar thing. The US government’s plan is clear: inflate our way out of debt crises. When you owe a fixed number of dollars to someone, that lender loses when those dollars become worth less in real terms. But be sure by year end 2008 interest rates will be higher. And remember the flood of speculative and easy money that's flown into 'green' could just as easily go from ‘green with envy’ to ‘green with nausea’.



4 months ago--June 6, 2008: “Devolving Rackets & Evolving Kudos”

Bob Metcalfe said, "I call it the global warming bubble. What bubbles do is they're an accelerator in technological investments to be made; they cause the status quo to be questioned. The trick of course...is to have a chair when the music stops."I’ve also spilled a lot of ink on the foolhardy behavior in chasing moonshine and sunbeams (ethanol and solar). As Eric Hoffer said, “Every great cause beings as a movement, becomes a business and eventually degenerates into a racket.” Or as 18th century French philosopher Voltaire said, “It is dangerous to be right in matters on which the established authorities are wrong”.



3 months ago—July 25, 2008: “Beliefs, Severed Tetherballs, Adventures…”

For the pursuit of truth might be noble social currency but it’s far harder to spend than the green paper or metal coin variety. I look upon a great deal of the cheery consensus and righteous rhetoric with a heaving not a helping of cynicism. Years from now you will look back, past the Web, past the Homes, past the Hedges, past the Oil Fields at much of the present day ‘Greenery’—and regret being a sucker.

Weekly Insider (VIX & Lux event days ahead)

Wow. It is raining volatility and people are paying extraordinary prices for umbrellas. With the VIX (a rough volatility index) at 70 today, talk to someone you trust about considering selling volatility (sell out of the money puts to establish positions or cost average down existing positions; or sell out of the money calls where you’d be otherwise happy to sell your shares). See you in Boston in 11 days.

Weekly Insider (Market Physics, Mark Buchanan, Market Doesn't Compute)

The following essay was published this week, called “This Economy Does Not Compute”, written by Mark Buchanan, a theoretical physicist and author most recently, of “The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You.”…

A few weeks ago, it seemed the financial crisis wouldn’t spin completely out of control. The government knew what it was doing — at least the economic experts were saying so — and the Treasury had taken a stand against saving failing firms, letting Lehman Brothers file for bankruptcy. But since then we’ve had the rescue of the insurance giant A.I.G., the arranged sale of failing banks and we’ll soon see, in one form or another, the biggest taxpayer bailout of Wall Street in history. It seems clear that no one really knows what is coming next. Why?

Well, part of the reason is that economists still try to understand markets by using ideas from traditional economics, especially so-called equilibrium theory. This theory views markets as reflecting a balance of forces, and says that market values change only in response to new information — the sudden revelation of problems about a company, for example, or a real change in the housing supply. Markets are otherwise supposed to have no real internal dynamics of their own. Too bad for the theory, things don’t seem to work that way.

Nearly two decades ago, a classic economic study found that of the 50 largest single-day price movements since World War II, most happened on days when there was no significant news, and that news in general seemed to account for only about a third of the overall variance in stock returns. A recent study by some physicists found much the same thing — financial news lacked any clear link with the larger movements of stock values.

Certainly, markets have internal dynamics. They’re self-propelling systems driven in large part by what investors believe other investors believe; participants trade on rumors and gossip, on fears and expectations, and traders speak for good reason of the market’s optimism or pessimism. It’s these internal dynamics that make it possible for billions to evaporate from portfolios in a few short months just because people suddenly begin remembering that housing values do not always go up.

Really understanding what’s going on means going beyond equilibrium thinking and getting some insight into the underlying ecology of beliefs and expectations, perceptions and misperceptions, that drive market swings.

Surprisingly, very few economists have actually tried to do this, although that’s now changing — if slowly — through the efforts of pioneers who are building computer models able to mimic market dynamics by simulating their workings from the bottom up.

The idea is to populate virtual markets with artificially intelligent agents who trade and interact and compete with one another much like real people. These “agent based” models do not simply proclaim the truth of market equilibrium, as the standard theory complacently does, but let market behavior emerge naturally from the actions of the interacting participants, which may include individuals, banks, hedge funds and other players, even regulators. What comes out may be a quiet equilibrium, or it may be something else.

For example, an agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

It’s important to stress that this work remains speculative. Yet it is not meant to be realistic in full detail, only to illustrate in a simple setting the kinds of things that may indeed affect real markets. It suggests that the narrative stories we tell in the aftermath of every crisis, about how it started and spread, and about who’s to blame, may lead us to miss the deeper cause entirely.

Financial crises may emerge naturally from the very makeup of markets, as competition between investment enterprises sets up a race for higher leverage, driving markets toward a precipice that we cannot recognize even as we approach it. The model offers a potential explanation of why we have another crisis narrative every few years, with only the names and details changed. And why we’re not likely to avoid future crises with a little fiddling of the regulations, but only by exerting broader control over the leverage that we allow to develop.

Another example is a model explored by the German economist Frank Westerhoff. A contentious idea in economics is that levying very small taxes on transactions in foreign exchange markets, might help to reduce market volatility. (Such volatility has proved disastrous to countries dependent on foreign investment, as huge volumes of outside investment can flow out almost overnight.) A tax of 0.1 percent of the transaction volume, for example, would deter rapid-fire speculation, while preserving currency exchange linked more directly to productive economic purposes.

Economists have argued over this idea for decades, the debate usually driven by ideology. In contrast, Professor Westerhoff and colleagues have used agent models to build realistic markets on which they impose taxes of various kinds to see what happens.

So far they’ve found tentative evidence that a transaction tax may stabilize currency markets, but also that the outcome has a surprising sensitivity to seemingly small details of market mechanics — on precisely how, for example, the market matches buyers and sellers. The model is helping to bring some solid evidence to a debate of extreme importance.

A third example is a model developed by Charles Macal and colleagues at Argonne National Laboratory in Illinois and aimed at providing a realistic simulation of the interacting entities in that state’s electricity market, as well as the electrical power grid. They were hired by Illinois several years ago to use the model in helping the state plan electricity deregulation, and the model simulations were instrumental in exposing several loopholes in early market designs that companies could have exploited to manipulate prices.

Similar models of deregulated electricity markets are being developed by a handful of researchers around the world, who see them as the only way of reckoning intelligently with the design of extremely complex deregulated electricity markets, where faith in the reliability of equilibrium reasoning has already led to several disasters, in California, notoriously, and more recently in Texas.

Sadly, the academic economics profession remains reluctant to embrace this new computational approach (and stubbornly wedded to the traditional equilibrium picture). This seems decidedly peculiar given that every other branch of science from physics to molecular biology has embraced computational modeling as an invaluable tool for gaining insight into complex systems of many interacting parts, where the links between causes and effect can be tortuously convoluted.

Something of the attitude of economic traditionalists spilled out a number of years ago at a conference where economists and physicists met to discuss new approaches to economics. As one physicist who was there tells me, a prominent economist objected that the use of computational models amounted to “cheating” or “peeping behind the curtain,” and that respectable economics, by contrast, had to be pursued through the proof of infallible mathematical theorems.

If we’re really going to avoid crises, we’re going to need something more imaginative, starting with a more open-minded attitude to how science can help us understand how markets really work. Done properly, computer simulation represents a kind of “telescope for the mind,” multiplying human powers of analysis and insight just as a telescope does our powers of vision. With simulations, we can discover relationships that the unaided human mind, or even the human mind aided with the best mathematical analysis, would never grasp.

Better market models alone will not prevent crises, but they may give regulators better ways for assessing market dynamics, and more important, techniques for detecting early signs of trouble. Economic tradition, of all things, shouldn’t be allowed to inhibit economic progress.