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Complexity and Economic Policy

August 29, 2016

NAECAlan Kirman, École des hautes études en sciences sociales Paris, and Aix Marseille University

Over the last two centuries there has been a growing acceptance of social and political liberalism as the desirable basis for societal organisation. Economic theory has tried to accommodate itself to that position and has developed increasingly sophisticated models to justify the contention that individuals left to their own devices will self organise into a socially desirable state.  However, in so doing, it has led us to a view of the economic system that is at odds with what has been happening in many other disciplines.

Although in fields such as statistical physics, ecology and social psychology it is now widely accepted that systems of interacting individuals will not have the sort of behaviour that corresponds to that of one average or typical  particle or individual, this has not had much effect on economics. Whilst those disciplines moved on to study the emergence of non-linear dynamics as a result of the complex interaction between individuals, economists relentlessly insisted on basing their analysis on that of rational optimising individuals behaving as if they were acting in isolation. Indeed, this is the basic paradigm on which modern economic theory and our standard economic models are based.. It dates from Adam Smith’s (1776) notion of the Invisible Hand which suggested that  when individuals are left, insofar as possible. to their own devices, the economy will self organise into a state which has satisfactory welfare properties.

Yet this paradigm is neither validated by empirical evidence nor does it have sound theoretical foundations. It has become an assumption. It has been the cornerstone of economic theory although the persistent arrival of major economic crises would seem to suggest that there are real problems with the analysis. Experience suggests that amnesia is prevalent among economists and that, while each crisis provokes demands for new approaches to economics, (witness the birth of George Soros’ Institute for New Economic Thinking), in the end inertia prevails and economics returns to the path that it was already following.

There has been a remarkable tendency to use a period of relative calm to declare victory over the enemy. Recall the declaration of Robert Lucas, Nobel Prize winner and President of the American Economic Association in his Presidential Address in 2003 in which he said: “The central problem of depression-prevention has been solved.”

Both economists and policy makers had been lulled into a sense of false security during this brief period of calm.

Then came 2008 and, as always in times of crisis, voices were raised, mainly by commentators and policy makers enquiring as to why economists had anticipated neither the onset nor the severity of the crisis.

When Her Majesty the Queen asked economists at the London School of Economics what had gone wrong, she received the following reply: “So in summary your majesty, the failure to foresee the timing, extent and severity of the crisis … was principally the failure of the collective imagination of many bright people to understand the risks to the systems as a whole.”

As soon as one considers the economy as a complex adaptive system in which the aggregate behaviour emerges from the interaction between its components, no simple relation between the individual participant and the aggregate can be established. Because of all the interactions and the complicated feedbacks between the actions of the individuals and the behaviour of the system there will inevitably be “unforeseen consequences” of the actions taken by individuals, firms and governments. Not only the individuals themselves but the network that links them changes over time. The evolution of such systems is intrinsically difficult to predict, and for policymakers this means that assertions such as “this measure will cause that outcome” have to be replaced with “a number of outcomes are possible and our best estimates of the probabilities of those outcomes at the current point are…”.

Consider the case of the possible impact of  Brexit on the British economy and the global economy. Revised forecasts of the growth of these economies are now being issued, but when so much depends on the conditions under which the exit is achieved, is it reasonable to make such deterministic forecasts? Given the complexity and interlocking nature of the economies, the political factors that will influence the nature of the separation and the perception and anticipation of the participants (from individuals to governments) of the consequences, how much confidence can we put in point estimates of growth over the next few years?

While some might take the complex systems approach as an admission of our incapacity to control or even influence economic outcomes, this need not be the case. Hayek once argued that there are no economic “laws” just “patterns”. The development of “big data” and the techniques for its analysis may provide us with the tools to recognise such patterns and to react to them. But these patterns arise from the interaction of individuals who are in many ways simpler than homo economicus, and it is the interaction between these relatively simple individuals who react to what is going on, rather than optimise in isolation that produces the major upheavals that characterise our systems.

Finally, in trying to stabilise such systems it is an error to focus on one variable either to control the system or to inform us about its evolution. Single variables such as the interest rate do not permit sufficient flexibility for policy actions and single performance measures such as the unemployment rate or GDP convey too little information about the state of the economy.

Useful links

OECD-EC-INET Oxford Workshop on Complexity and Policy, 29-30 September, OECD HQ, Paris: Click here to register

New Approaches to Economic Challenges – Complexity of the Economy (October 2015 OECD Workshop)

Economic outlook, analysis and forecasts at the OECD

4 Comments leave one →
  1. Sandwichman permalink
    August 29, 2016 21:47

    If Hayek argued that there are no economic laws, why have so many of his followers missed the memo?

    Hypothesis: the imperviousness of economists to non-linear dynamic systems is an atavistic “return of the repressed” to 19th century “laws of political economy” that confused the scientific and legislative senses of law.

    “…it is often said that to regulate the hours of labour, or to introduce differential import duties, is to break economic law.” — Palgrave’s Dictionary of Political Economy, 1894

    A question for economists for Labor Day, 2016:

    Do you agree that regulating the hours of labor is a violation of economic law?

    I have a post scheduled for Labor Day on EconoSpeak that examines the etiology of economists’ neurotic compulsion to repeat the discredited 19th confusion about “breaking” economic laws.

    • September 15, 2016 03:18

      Economics is a pseudoscience, we haven’t sufficient methodology to establish a law like Newtonian physics. Human “science” isn’t 100% predictable.

  2. September 1, 2016 12:21

    Complexity economics too simplistic – human psychology neglected

    I disagree with the claim that humans (in the context of economic interactions and decisions) ‘are in many ways much simpler than homo economicus’. There is truth in that humans engage in other-regarding behaviour and thus follow the examples and opinions of ‘fellow humans’, that they do what they or even their elders and ancestors did in the past, that they react to simple (or complex) stimuli that have been developped during the evolutionary history of mankind.

    However, Kirman’s view seems to be based on ‘the’ oftentimes rather *simplistic* complexity perspective rather human (social) psychology. The complexity perspective tries to explain and reproduce complex patterns on the basis of simple rules of interaction – which is fine as one avenue of research, but only goes so far. Furthermore, it should not be mixed up with reality (as economists allegedly do with their models). As such his view seems to be influenced rather by Kirman’s professional activities than empirical research. One may be critical towards behavioral economics, but the number of framing, interpretation and decisions biases speaks for a pretty complex pucture of human psychology relevant for economics.

    Note I am referring to this section:

    “While some might take the complex systems approach as an admission of our incapacity to control or even influence economic outcomes, this need not be the case. Hayek once argued that there are no economic “laws” just “patterns”. The development of “big data” and the techniques for its analysis may provide us with the tools to recognise such patterns and to react to them. But these patterns arise from the interaction of individuals who are in many ways simpler than homo economicus, and it is the interaction between these relatively simple individuals who react to what is going on, rather than optimise in isolation that produces the major upheavals that characterise our systems.”

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