COMPLEXITY, RISK, AND FINANCIAL MARKETS.

BY EDGAR E. PETERS. NEW YORK: JOHN WILEY

AND SONS, 1999.

C omplexity, Risk, and Financial Markets completes a trilogy of books on chaos

and fractal analysis. Fractal analysis examines self-similarity or scale invari-
ance, a structure that is often present in seemingly random and otherwise
complex processes. Time series, for example, exhibit self-similarity if subsamples
resemble compressed versions of longer samples. Pioneered by engineers, mathe-
maticians, and natural scientists, fractal analysis is now routinely applied to financial
markets. Author Edgar E. Peters is a leading practitioner and also chief investment
officer at PanAgora Asset Management, a distinguished quant firm managing over
$13 billion. Peters published Chaos and Order in the Capital Markets in 1991
(expanded and corrected second edition 1996), a conceptual application of fractals
and chaos theory in economics and finance, followed by the more technical Fractal
Market Analysis in 1994, which remains an excellent introduction to fractal method-
ology, though recent advances have rendered it technically obsolete in some respects.
Chaos and Order in the Capital Markets includes a sophisticated and devastating cri-
tique of the efficient market hypothesis.
Complexity, Risk, and Financial Markets completes Peters’s trilogy by presenting
the underlying philosophical case for chaos theory, which turns out to be grounded
on distinctively Austrian views of information and market process. This book should
be read by Austrians interested in, or already familiar with, fractal analysis or chaos
theory, a statistical methodology developed extensively by Benoit Mandelbrot.1 In
addition, this book should also be read by practitioners of fractal analysis and related
statistical techniques, in order to receive an introduction to the Austrian School and
deepen their understanding of their methodological paradigm’s justification, implica-
tions, and limitations.
Although it can be read profitably on its own, Complexity, Risk, and Financial
Markets calls for some discussion of the context it occupies in the larger trilogy. In
particular, this book serves as a philosophical background and introduction to
Peters’s two earlier books, to which readers should go for more detailed critiques of

1See particularly Mandelbrot (1963a, 1963b, 1972); Mandelbrot and van Ness (1968);
and Mandelbrot and Wallis (1969) for the original applications to income distributions
and the distribution of financial returns. Fractal analysis of asset returns is of special
interest because it can provide conclusions about the market processes which generate
asset prices.

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85
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market efficiency and conventional quantitative economics, as well as a range of

empirical applications of fractal analysis. Peters’s applications use financial or macro-
economic data, and give readers a good feel for how these statistical methods can be
used in research. Though many applications are common to both earlier books, some
of the techniques described in Fractal Market Analysis have been superseded. Anyone
interested in conducting a fractal research program should refer in addition to more
advanced techniques.2 In addition, fractal analysis can be applied in many situations
where conventional econometrics and statistical inference are invalid. Chaos and
Order in the Capital Markets and Fractal Market Analysis remain outstanding guides
to interpreting fractal analysis as applied to finance, and constitute the best introduc-
tion to the literature.
Complexity, Risk, and Financial Markets is an engaging book, abounding in the
kind of memorable and succinct examples that can inject more life and relevance into
anybody’s classroom teaching. Simultaneously, it offers a broad, philosophical look at
how market economies self-organize into complex and sometimes chaotic systems.
Peters introduces uncertainty as a necessary precondition for the market order, which
arises spontaneously through the interaction of self-interested individuals. Very spe-
cific conditions are required for such an order to be stable, and Peters notes economic
markets are unstable in societies like Sudan and Bosnia, where uncertainty may be
high but where little complexity is present (p. 191).
Central planning aims at removing this uncertainty, but makes it impossible for
markets to function. Planned economies attempt to insulate their citizens from risk,
but can succeed only to a limited extent. A free market operates beyond the control
of any one individual. Investment in a planned economy should offer a guaranteed
return, but clearly things do not always go according to plan. Often, planned
economies suffer greater impact from uncertainty precisely because they lack the flex-
ibility and freedom of a market economy. Peters notes that uncertainty goes along
with freedom of choice, forming a necessary precondition for competition and inno-
vation, two things a planned economy attempts to do without.
Although he sees many problems with government intervention, he is frequently
critical of monopoly pricing (contrast particularly with Mises 1998, pp. 357–62), and
concludes government regulation is the best hope for solutions to market failure and
the business cycle. Deterministic markets, the ideal of central planning, cannot sur-
vive, as the first person to solve the riddle of deterministically chaotic market struc-
ture would eventually accumulate all wealth. In addition, however, Peters feels markets
must be regulated to ensure competition and equal access. Peters criticizes the Aus-
trian School for its rejection of antitrust regulation (pp. 181–83), and develops a
rationale for the Microsoft antitrust case (p. 113). He makes the argument that
antitrust regulation is necessary to ensure competitive markets. In his view, sponta-
neously evolved market order may be suboptimal, and then must be improved by gov-
ernment intervention.
Peters’s critique of the Austrian positions on antitrust, though well-reasoned and
thought-provoking, would likely be better received if he made more explicit what

2See particularly those described by Calvet, Fisher, and Mandelbrot (1997), Che-
ung (1993), Lo (1991), and Mandelbrot, Fisher, and Calvet (1997).
BOOK REVIEWS 87

kinds of intervention he felt could be justified. Like all complex systems, free mar-
kets must be stable but must also be free to grow and adapt. The structure must be
decentralized to be capable of incorporating many individuals’ subjective goals. Free
markets need rules that do not constrain uncertainty, but also encourage cooperation
and trust, promote coordination, protect property rights, and ensure competition.
Implicitly, Peters seems to require very strict limitations on the kinds of market regu-
lations he would accept, and it is a weakness of his argument that these limitations
are not made more explicit. It is not entirely clear that Peters’s position on antitrust
regulation is really different from Mises’s.
Self-organizing systems like the market order, patterns which emerge sponta-
neously from the actions of independent and (externally) uncoordinated individuals,
result when individuals respond to one another, a broad class of behavioral responses
conventionally categorized as feedback. Adam Smith recognized this principle when
he described the coordination of productive activity in a free market as the working
of an invisible hand.
Peters contrasts the approaches to uncertainty taken by mainstream or Keynesian
economics and subjectivist or Austrian economics. Mainstream economics assumes
uncertainty can always be modeled mathematically, and that everyone should arrive
at the same assessment of an uncertain event’s probability, at least given the same
information. The Austrian School notes every individual always perceives a unique
information set, and that each individual values every item of information in a unique
manner. Even if participants had identical information, their assessment of its impor-
tance would be subjective. One person’s behavior may be quite different from
another’s, even facing identical choices.
Peters invokes the Austrian theory of subjectivism to criticize mainstream theo-
reticians’ frequent recourse to representative agents. Peters motivates his presentation
by providing examples of how market participants attempt to project a spurious order
on their understanding of the world (pp. 11–14). Chaotic behavior, which can display
seemingly nonrandom structure, but is generated by random, uncoordinated influ-
ences, can thus inspire conspiracy theories, convenient assumptions which explain
observed regularities.
Peters praises the Austrian School for its recognition of the diversity and unique-
ness of market participants, supporting a more realistic economics. Investors, for
example, are not all alike—each has a unique and subjective combination of time hori-
zon and risk tolerance. In contrast, mainstream and Keynesian economics ignore dif-
ferences among individual agents by assuming, for simplicity and analytical conven-
ience, that everyone is identical, or that differences among market participants do not
matter and can be ignored. The diversity of individual goals and actions enables entre-
preneurs to create profit opportunities by better satisfying individual wants. The Aus-
trian School views knowledge as subjective, and unique to the individual who acts on
that knowledge. Far from consisting of identical agents, the real economy consists of
perfectly unique agents who react differently in response to the same information.
A market process is a complex process because it works toward individuals’ goals
of moving goods and services to those who value them the most, and because the mar-
ket works for its own survival. The market is not a living being, but in some ways acts
as if it were. In Peters’s view, mathematics has finally caught up with the Austrian
School’s intuitive models (p. 63), and he believes that quantitative, though possibly
nondeterministic, models will emerge based on Austrian insights.
88 THE QUARTERLY JOURNAL OF AUSTRIAN ECONOMICS VOL. 7, NO. 1 (SPRING 2004)

Though developed extensively in Chaos and Order in the Capital Markets,

Peters extends his critique of the efficient market hypothesis, which he views as
being fallaciously based on homogeneous expectations and valuation. In the Austrian
view, these are subjective factors, and thus heterogeneous. It would be impossible for
one price to reflect everyone’s information even if everyone has the same information,
because our evaluation of the facts is subjective and unique (p. 91). Peters emphasizes
differences in investment horizons as the principal source of heterogeneity in the
investment market, rather than differences in risk tolerance. He suggests the stability
of financial markets is directly proportional to the diversity of participants’ knowl-
edge bases and investment horizons. When long-term investment funds dry up, short-
term assets experience bubbles, and volatility increases. When no particular criterion
dominates the market, valuation is less likely to be distorted, and volatility declines.
Peters suggests the business cycle results from the complexity necessary for finan-
cial markets to provide liquidity without systematically favoring one investor over
another. His treatment of business cycles is particularly weak from an Austrian per-
spective; his discussion owes more to Schumpeter than Hayek or Mises. Peters’s view
of business cycles is that they are a natural and inevitable part of the market process,
rather than externally imposed by credit manipulation. Adoption of the Schumpeter-
ian business cycle seems more due to the author’s admiration for Schumpeter’s the-
ory of the entrepreneur than conscious rejection of Austrian capital theory.
In financial markets, investors compete to employ capital in the most productive
manner, and to provide liquidity to whoever is willing and able to pay the most. The
market has no mind of its own, but rewards investors who succeed in this competi-
tion, and this steady process of creative destruction drives the business cycle. In
Peters’s view, the Great Depression and the Asian financial crisis led to market
reforms which laid the foundation for future prosperity. It is somewhat disappointing
that there is little reference to Mises’s and Hayek’s theories of the business cycle. Aus-
trian capital theory’s emphasis on the discoordination caused by credit inflation as
the driver of the business cycle may have been more relevant to Peters’s thesis. The
Austrian conception of the government and/or the central bank’s attempt to manipu-
late and control investment spending leading to malinvestment seems highly comple-
mentary with Peters’s critique of central planning.
Complexity, Risk, and Financial Markets presents a coherent overview of how
local randomness, existing at the level of diverse and independent individuals, inter-
acts to form the global structure of a market economy, which is stable and yet con-
tinuously in flux. It can be read profitably on its own, or as the philosophical intro-
duction to the trilogy it forms in conjunction with Peters’s (1994, 1996) two other
books on fractal analysis. Although Austrians will occasionally take exception to
minor conclusions, Peters’s trilogy remains the best introduction to fractal market
analysis, and the final volume demonstrates the largely Austrian foundation on which
the economic interpretation of fractal analysis is based.

ROBERT F. MULLIGAN
Western Carolina University
BOOK REVIEWS 89

REFERENCES

Calvet, Laurent, Adlai Fisher, Benoit B. Mandelbrot. 1997. “Large Deviations and the Dis-
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Cheung, Yin-Wong. 1993. “Tests for Fractional Integration: A Monte Carlo Investigation.”
Journal of Time Series Analysis 14: 331–45.
Lo, Andrew W. 1991. “Long-term Memory in Stock Market Prices.” Econometrica 59 (3):
1279–313.
Mandelbrot, Benoit B. 1972. “Statistical Methodology for Non-periodic Cycles: From the
Covariance to R/S Analysis.” Annals of Economic and Social Measurement 1 (3):
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———. 1963a. “New Methods in Statistical Economics.” Journal of Political Economy 71 (5):
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———. 1963b. “The Variation of Certain Speculative Prices.” Journal of Business 36 (3):
394–419.
Mandelbrot, Benoit B., Adlai Fisher, Laurent Calvet. 1997. “A Multifractal Model of Asset
Returns.” Cowles Foundation Discussion Paper no. 1164. Yale University.
Mandelbrot, Benoit B., J.W. van Ness. 1968. “Fractional Brownian Motion, Fractional
Noises and Application.” SIAM Review 10: 422–37.
Mandelbrot, Benoit B., James R. Wallis. 1969. “Robustness of the Rescaled Range R/S in
the Measurement of Noncyclic Long-run Statistical Dependence.” Water Resources
Research 5 (4): 976–88.
Mises, Ludwig von. [1949] 1998. Human Action. Scholar’s Edition. 5th ed. Auburn, Ala.:
Ludwig von Mises Institute.
Peters, Edgar E. [1991] 1996. Chaos and Order in the Capital Markets: A New View of
Cycles, Prices, and Market Volatility, 2nd ed. New York: John Wiley and Sons.
Peters, Edgar E. 1994. Fractal Market Analysis: Applying Chaos Theory to Investment and
Economics. New York: John Wiley and Sons.