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The rising complexity of the global economy

September 2, 2016

NAECSony Kapoor, Managing Director, Re-Define International Think Tank and CEO of Court Jesters Consulting

A complicated system (such as a car) can be disassembled and understood as the sum of its parts. In contrast, a complex system (such as traffic) exhibits emergent characteristics that arise out of the interaction between its constituent parts. Applying complexity theory to economic policy making requires this important recognition – that the economy is not a complicated system, but a complex one.

Historically, economic models and related policy making have treated the economy as a complicated system where simplified and stylised models, often applied to a closed economy, a specific sector or looking only at particular channels of interaction such as interest rates, seek to first simplify the real economy, then understand it and finally generalise in order to make policy.

This approach is increasingly out-dated and will produce results that simply fail to capture the rising complexity of the modern economy. Any policy decisions based on this notion of a complicated system that is the sum of its parts can be dangerously inaccurate and inappropriate. What are the forces driving this increasing complexity in the global economy? What, if anything, can be done about this?

A complex system can be roughly understood as network of nodes, where the nodes themselves are interconnected to various degrees through single or multiple channels. This means that whatever happens in one node is transmitted through the network and is likely to impact other nodes to various degrees. The behaviour of the system as a whole thus depends on the nodes, as well as the nature of the inter-linkages between them. The complexity of the system, in this instance the global economy, is influenced by a number of factors. These include first, the number of nodes; second, the number of inter-linkages; third, the nature of inter-linkages; and fourth, the speed at which a stimulus or shock propagates to other nodes. Let us now apply each of these factors to the global economy.

The global economy has seen a rapid increase in the number of nodes. One way of understanding this is to look at countries that are active participants in the global economy. The growth of China and other emerging markets, as well as their increasing integration into the world trading and more recently global financial systems, is a good proxy to track the rise in the number of nodes. The relative size and importance of these nodes has also risen with China, by some measures already the world’s largest economy.

Simultaneously, the number of inter-linkages between nodes has risen even more rapidly. The number of possible connections between nodes increases non-linearly with the increase in the number of nodes, so the global economy now has a greater number of financial, economic, trade, information, policy, institutional, technology, military, travel and human links between nodes than ever before. The increasing complexity of supply chains in trade and manufacturing, ever greater outsourcing of services, rising military collaborations, the global nature of new technological advances, increasing migration and travel, as well the rise and rise of the internet and telecommunications traffic across the world have all greatly increased the number of connections across the nodes.

It is not just that the number of interconnections between nodes has risen almost exponentially. The scope and nature of these inter-linkages has broadened significantly. The most notable broadening has come in the form of the rapid rise of complex manufacturing supply chains; financial links that result directly from the gradual dismantling of capital controls; and the rise of cross-border communication and spread of information through the internet. These ever-broadening connections between different nodes fundamentally change the behaviour of the system and how the global economy will react to any stimulus, change or shock in one or more of nodes in ways that becomes ever harder to model or predict.

Last but not the least, it is not just the number and intensity of links between the nodes that has risen, but also how quickly information, technology, knowledge, shocks, finance or pathogens move between the nodes. This results, in complexity theory parlance, in an ever more tightly coupled global economy. Such systems are more efficient, and the quest for efficiency has given rise to just-in-time supply chains and the rising speed of financial trading and other developments. But this efficiency comes at the cost of rising fragility. Evidence that financial, economic, pathogenic, security and other shocks are spreading more rapidly through the world is mounting.

To sum up, the Dynamic Stochastic General Equilibrium (DSGE) models and other traditional approaches to modelling the global economy are increasingly inadequate and inaccurate in capturing the rising complexity of the global economy. This complexity is being driven both by the rising number of nodes (countries) now integrated into the global economy, as well as the number and nature of the interconnections between these, which are intensifying at an even faster pace.

This calls for a new approach to policymaking that incorporates lessons from complexity theory by using a system-wide approach to modelling, changes institutional design to reduce the fragility of the system and deepens international and cross-sector policy making and policy coordination.

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 Models used in the OECD Economics Department Dave Turner, Head of the Macroeconomic Analysis Division in the OECD’s Economics Department, on Insights

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