Complexity Economics

In Chasing the Dragon, I wondered aloud whether we could dampen boom-bust cycles in the financial system with an economic equivalent of a controlled burn.  Kevin suggested that “generic countercyclical policies” might work.  Underlying both mine and Kevin’s thinking is the idea that you can possibly do better (for the world as a whole) by (a) understanding the entire economic system better and (b) enacting policies which are in line with that understanding.  In contrast to these assumptions are a point of view articulated by one of the readers on a different thread:

Like Johan Norberg I believe that government is largely responsible for creating the environment in which this financial crisis could happen (e.g. creating bad laws). It is therefore silly to wonder what government should do to solve the problem. They should stop messing up the system with all kinds of interventions. Just let the problems fade away by themselves.

It’s like management of Yellowstone park, where the biggest forest fires happened *after* government started trying to protect it. The prevented many small fires, and the system got unbalanced. Which resulted in a few massive fires. Then they learned to leave the system alone.

I single this comment out not to pick a fight with the reader, but rather because it is an excellent summary of the contrasting viewpoint, and one which many very smart people ascribe to.

Prophetically enough, I picked up Seed Magazine yesterday and found several articles which question the premises of the laissez-faire viewpoint:

  1. Ecology of Finance – “A growing cadre of biologists argues that ecosystem analysis of the world economy might help stave off a repeat of 2008’s financial catastrophe.”
  2. Rethinking Growth – “Herman Daly applies a biophysical lens to the economy and finds that bigger isn’t necessarily better.”
  3. Is Economics a Science – with commentary from Frederic Mishkin, Robin Hanson, James Galbraith, Steven Levitt, Stephen Dubner, Jim Miller and Nassim Nicholas Taleb.
  4. Network Dynamics in a Shrinking World – “When shrinking networks are researched, what is discovered is extraordinarily strange.”
  5. Industrial Ecology and the Rights of Ecosystems

Interestingly, the first article specifically invokes the forest fire metaphor: “‘You can build in what amounts to firebreaks. How you would limit epidemic spread’ — or financial panic — ’depends on the topology of the interactions.'”

The popular trend towards “complexity economics” started with Eric Beinhocker’s, The Origin of Wealth, a book I recommend to anyone who wants an excellent overview of the history of economics and the history of complex systems thinking.  Whether we can positively impact system dynamics through better understand and policy, or whether we will just make things worse, we will never actually know for sure.  There is no counterfactual universe we can compare to as a control.  But one way to get some indication is to simulate, as John Miller and Scott Page convincingly argue in Complex Adaptive Systems.

My own current belief is that while there’s no way even in principle to accurately predict the future in a system as complex as the global economy, using simulation and better models — which I believe complexity economic models to be — we can gain better understanding of the kinds of dynamics we can expect to see in general.  More importantly, I believe that we can do better than we have up to this point by using policy (i.e. new rules and incentives) to guide the economic system into dynamics that are favorable to humanity and away from dynamics that are unfavorable.  Not perfect, or even close to perfect.  But better.

Whether you agree with my stance or not, one thing is for certain: the complexity economics meme is on the rise.

  • “using simulation and better models…we can gain better understanding of the kinds of dynamics we can expect to see in general.”

    Sure, but “black swans” disrupt our models. Legalized hyper-risk (in general) is the swan that derailed our recent economic models.

    Federal lawmakers are effectively bought and sold by the same greed which brought us to our knees. Yes, better “policy, rules, and incentives” will prevent meltdowns and allow better models, but without massive changes to congressional lobbying and campaign law, we won’t see these changes.

    Effective models are based on known intentions and even a reasonable amount of planned uncertainty. But, by definition, greed seeks to disrupt the model by exploiting unplanned uncertainties. Reminds me of Rumsfeld’s infamous talk about the “known knowns” the “known unknowns” and the “unknown unknowns.”

    So, we’re stuck in a political catch-22. We need effective policy to control overt greed, but overt greed has become systemic in our lawmaking process.

  • Ben

    John L is right, of course, but I think it’s still useful to think about what the right policies would be, even if it will be difficult getting there due to lobbying, etc.

    The Yellowstone metaphor is indeed apt. No politician wants economic growth to slow during their watch (especially not as a result of their policies.) But “controlled slowing” (which may come from higher interest rates and decreased government spending) might be necessary to avoid drops as steep as the one we’re seeing now.

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  • John, Ben, the point is that all three of us agree that notwithstanding the political difficulties, the right intervention by government can have a positive impact on the financial system. This is in contrast to the laissez-faire attitude — I’ve been avoiding the term Libertarian since it may not reflect the mainstream Libertarian view, but rather a more hardline version — which says that nothing can do better that just pure, free markets (whatever that means) and therefore we cannot do better with intervention. That’s all :-)

  • John Pinniger

    An interesting discussion on Complexity Economics.
    1. The analogy with Yellowstone is fundamentally flawed, as nature has no inherent direction. It is self-regulating because there is no ‘direction’ in which it is being driven. The economy, by contrast, is being driven in multiple directions by the conscious will of the various players, e.g. the repeal of the Glass-Steagall Act of 1933 by Clinton, under pressure from greedy bankers, was, I believe, a major contributor to the current economic crisis. Time and time again, self-regulation has been shown not to work.
    2. Economics has failed us because of its lack of incorporation of several major factors. One is certainly the assumption that humans are rational – they are not. Another is that self-regulation will work – it clearly doesn’t. Probably the most telling is the input of costs into any economic calculation. To take the most extreme case – what is the economic cost of one barrel of oil? Incalculable! What is the cost of storing a kilo of plutonium for the next 500,000 years? Large enough to kill off any reactor being built, so it is never factored into the cost of a nuclear reactor. Very convenient, but it is slowly coming back to bite us.

    Regards

    John Pinniger

  • kevindick

    @John. I think you’re confused over the current state of economics. The literature is full of treatments of both the impact of less-than-rational behavior and the externality costs of natural resources. Just because you are not familiar with a topic doesn’t mean that it hasn’t been explored.

  • @John,

    1. You make an interesting point about the “directionality” of complex adaptive systems whose agents are able to attempt to change the entire system by changing the rules (i.e. humans) versus those who don’t have this possibility (i.e. every other natural system of study we know about). But I do think there are solid lessons to be learned about oscillatory and attractor dynamics in both types of systems. In particular the Yellowstone analogy actually is an argument against “self-regulation” in favor or a more stochastic policy that has the overall effect of dampening oscillations. What is your thought about the concept of stability through instability?

    2. Kevin is right. That’s not to say I am a fan of the standard economic arguments, which often involve closed-form symbolic math as opposed bottom-up simulation with emergent results/conclusions. I’d like to see the majority of economic analysis and argument move towards the latter as is only logical when dealing with such systems.