Forest Fire Model as a Supercritical Dynamic Model in Financial Systems

TL;DR

This paper models financial crises using a forest fire analogy on scale-free networks, revealing supercritical behavior and suggesting policy measures to prevent large-scale financial meltdowns.

Contribution

It introduces a novel supercritical dynamic model of financial crises based on the forest fire model, highlighting non-trivial scaling and control strategies.

Findings

Extreme financial events result from bursting of fat bubbles.

Supercritical behavior is independent of system size.

Prolonged benign periods increase risk of large crises.

Abstract

Recently, large-scale cascading failures in complex systems have garnered substantial attention. Such extreme events have been treated as an integral part of the self-organized criticality (SOC). Recent empirical work has suggested that some extreme events systematically deviate from the SOC paradigm, requiring a different theoretical framework. We shed additional theoretical light on this possibility by studying financial crisis. We build our model of financial crisis on the well-known forest fire model in scale-free networks. Our analysis shows a non-trivial scaling feature indicating supercritical behavior, which is independent of system size. Extreme events in the supercritical state result from bursting of a fat bubble, seeds of which are sown by a protracted period of a benign financial environment with few shocks. Our findings suggest that policymakers can control the magnitude of financial meltdowns by keeping the economy operating within reasonable duration of a benign environment.