Wednesday, 12 December 2012

Finding a New Framework for Economics

from Geoff Davies
November 28, 2012

Real-World Economics Review Blog

The challenge, and reactions to it
Many economists, and more non-economists, agree that economics needs new ideas, given the comprehensive failure of the mainstream to foresee the Global Financial Crisis and its continuing failure to lift the US and Europe out of deep recession or depression.
Few in the mainstream seem to have any idea where to start. Many non-mainstream economists offer ideas, and many of those ideas are important, but not the whole story. Many of the non-mainstream proposals reach back to older ideas (Keynes, the Austrians, etc., often with valuable but incomplete insight) rather than reaching forward to new and more comprehensive approaches. There seems to be little agreement on which things to change, nor on how much the subject needs to change.
Some react against the excessive, and useless, mathematics of neoclassical economics to reject the possibility of using mathematics at all. Others reject the possibility that economics could ever be a science, no doubt meaning a reductive, Cartesian, clockwork kind of science. I can only agree with the inadequacy of reductionist science, but there is now also holistic systems science, and this should not be rejected out of hand. To me, an experienced Earth scientist, science is the invention and testing of stories. Mathematics is a tool that is useful in the testing stage. Sometimes a simple calculation [1] or a rough estimate can yield important insight into what a story (theory) implies. Sometimes more elaborate mathematics is justified [2], but not if the relevant observations are incomplete or inaccurate. The problem is not mathematics itself, but the inappropriate use of mathematics, especially when it is used to put pseudo-scientific wrapping around non-scientific mumbo-jumbo.
When proposals do appear that might begin to address fundamental problems, many economists seem to recoil, and others seem simply to fail to recognise that the proposals have any relevance. This raises the question of whether many economists would recognise an important new approach if they saw it.
A comprehensive reconception required
Coming from outside the profession, and having spent nearly fifteen years exploring economies and economics, my own assessment is that there are multiple, independent, fundamental problems. The mainstream theory of markets is pre-scientific, and its application is pseudo-science (see more below). Economic accounting, via the GDP, is misguided, misleading, and seriously distorts economies. The special nature of land is ignored (as Henry George argued). The endogenous creation of debt is ignored (as Steve Keen argues). The feedback between credit and land prices, which regularly creates booms and busts, is therefore overlooked. The many possible forms of ownership, and their potentially profound influence on the economy, are hardly noticed, except in the extreme forms of absolute private ownership versus socialist government ownership. Even the nature of money, as a social contract, is widely misunderstood, witness regular calls for a return to the so-called gold standard.
The neoclassical theory of markets is based on such absurd assumptions (no economies of scale, rationality, similar preferences, no social interactions, ability to predict future probabilities, etc.), and its central prediction of equilibrium is so obviously violated, that it can only be called pre-scientific. Ptolemy’s theory of planetary motions gives passable predictions of where planets will be, as did the more ancient systems from which it was refined. Neoclassical theory cannot begin to predict the major economic events, nor even allow that they are possible, and is therefore a useless distraction. Dressing it up in mathematics merely presents it as pseudo-science.
This is a harsh assessment, but one I think is straightforwardly justified. Having sketched out how comprehensive and fundamental the remake of economics must be, we still need to figure out how to proceed. I have argued here in the past that economies can be recognised as complex systems, and that recognition provides a framework within which a proper science of economics can be developed.
What this is, and is not
Some seem to have interpreted this as though I am proposing to establish a new school of thought, rather as one might start a new art movement or religion. Perhaps because it is not their preferred school of thought they are not interested. Others see complexity mentioned and refer me to the people who are using complexity concepts and models to understand various aspects of market behaviour (for example). That is excellent work but I am not doing that either. I am inferring a comprehensive framework for understanding economies and societies, and drawing immediate fundamental conclusions.
So here, in as concise a form as I can put it, is how I think economies can be recognised as complex self-organising systems, using well-established and commonplace observations of their behaviour. This is only a brief summary to highlight the line of the argument. It does not provide much supportive detail, which can be found in my book.
Inferring the new framework
I argue that a broad framework for a new theory of market economies can be arrived at rather readily by combining modern ideas of systems with well-known observations of modern economies. Briefly, there are some readily identifiable sources of instability that are at work all of the time, not just during market crashes when their presence ought to be undeniable. (Examples are given at the end.) There are also stabilising forces, of the kind described by the invisible hand metaphor, though they are far from dominant. Thus the economy has both invisible hands (stabilising) and invisible feet (destabilising) driving its behaviour from the inside.
These characteristics describe a self-organising system, and one that is not close to equilibrium. It is reasonable to argue further that the system is in fact far from equilibrium all of the time. In that case the system is either in a state of deterministic chaos or in a state called complexity. Although the system is sometimes very erratic, mostly it displays recognisable patterns of behaviour, though with continuous fluctuations and occasional large shifts. Such behaviour is characteristic of complexity rather than chaos. By this logic, modern economies can be identified as complex self-organising systems, or complex systems for short.
Implications of the new framework
Fundamental conclusions follow immediately.
A complex system has many possible states that cannot be readily ranked by efficiency or any other criterion, rather than the single global optimum of the near-equilibrium neoclassical theory. This means there is not just one best way to organise an economy. There are many more acceptable ways than there are societies and cultures. It is for each society to organise its economic system to support the kind of society it chooses to be. Thus economies are relegated to their proper place, which is to support the society of which they are a part. Thus also economic and cultural diversity can thrive again.
Living systems are also complex systems. Therefore there is no fundamental reason an economy cannot be made compatible with living systems, so that the natural living world can thrive around it. In contrast, the present system is incompatible with living systems at a fundamental level.
Without a global equilibrium there is no basis for the claim that free markets are the optimal way to organise an economy. The global optimum predicted by neoclassical theory is an unrealistic abstraction. Markets are clearly powerful, but if they cannot be relied on to deliver a useful result then they need to be managed.
To manage a market economy we need to understand it. The guiding principle in seeking such understanding is the same as is used in dealing with living things. Although the moment-to-moment behaviour of a dog or a horse cannot be predicted with certainty, a good trainer works with the character of the animal to manage its behaviour. At present our economies are more like wild horses. They need to be tamed, and harnessed to the urgent demands of humanity’s current precarious situation. Thus we arrive at a vision of markets managed, through incentives, to deliver the things we want.
The framework thus outlined can accommodate many of the issues addressed by the less doctrinaire economists, such as our so-called non-rational behaviour, the herding behaviour and “reflexivity” evident in financial markets, social behaviours like fashion-following, the roles of institutions and social conventions, and so on. Cooperation, which is fundamental to human behaviour and to much of the living world, can stand with competition as being an essential feature of our societies and economies. The economy can encourage compassion and love, rather than crushing them.
Some pre-existing parts of economics will presumably carry over into this framework, but some will not. The neoclassical notion of equilibrium, and its associated free-market optimality, must be abandoned. Neither is the Marxist conception of a managed non-market economy compatible with how a complex system works.
There are other important and fundamental misconceptions or malfunctioning aspects of modern economies that also need to be addressed. For example, the GDP is not a measure of material well being, it is only a measure of activity involving money. The obsession with ever-increasing GDP needs to be abandoned. The banking system, in conjunction with financial markets, currently generates grossly excessive levels of debt, and these are fundamental to the so-called business cycle and its excesses, in the form of crashes and depressions. More stable banking systems are possible.
To properly address the deficiencies of modern economics and economic management we must be willing to address such fundamental issues. But perhaps the central issue, psychologically, is the notion that the economy is never far from equilibrium and can be relied upon to sedately restore itself if perchance any small disturbance should ever come along. This belief underlies the widespread faith in free markets, but it is ideology, not science.
If economists, or some economists, or some people who want to define a new economics, are willing to contemplate such possibilities, then we can begin a constructive debate.
Examples of instabilities in modern economies:
Increasing returns to scale are pervasive, and they allow large firms to grow at the expense of smaller firms, leading to widespread monopoly or oligopoly.
Financial markets are prone to herd behaviour that amplifies trends, often dramatically.
During the 1987 market crash, valuations changed by 30-40% in one day, though there was no change in the physical world: 30% of factories had not been bombed overnight. The change was internal to the markets, an obvious instability.
Wealth tends to aggregate to the already wealthy, an instability in the distribution of wealth. At least seven mechanisms can be identified that promote this instability.
1. Davies, G.F. (2011) The value of simple models, with examples of economic dynamics. Real-world Economics Review, , 106-114,
2. Keen, S., A monetary Minsky model of the Great Moderation and the Great Recession. Journal of Economic Behavior & Organization, 2012: p. in press.

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