Orthodox Economics Is Empirically Invalid and Theoretically Flawed. Bring on Complexity Economics.

Both economists and policy makers had been lulled into a sense of false security

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By Alan Kirman

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.

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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.

Originally published here.

2016 August 29

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  • 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.

  • X-7

    “Yet this paradigm is neither validated by empirical evidence nor does it have sound theoretical foundations.” Yes, it also happens to be non-selectable.
    Dig this work, Dr. Kirman, Thank you.

    Context for the attached: Created this AM after reading an op-ed in the NYT from Trump’s econ adviser.
    More here: Culture, Complexity & Code2:

    Partial Philosophic Framing
    Code: physics efficacious relationship infrastructure.
    Math code: distills complex relationships.
    Religious code: archaic attempt at relationship distillation.

  • SkepticalPartisan

    While not an economist, I do have a science background. The following is a comment on another site which may be relevant to this discussion…

    … economies are designed and determined by ideologues not economists. Capitalism, Keynesian economics, Marxism, Communism… all economic systems are ideologies. By adhering to a particular ‘school of economics’, economists aren’t social scientists; they do not engage in the normal rules of any science: test the predictions of your hypothesis and adjust your theory(ies) to fit. Instead, economists and their followers are indoctrinated into an economic ideology and stand firm to defend it on any and all grounds with carefully constructed questions and statistics. In the end, each ideology produces a system where a small group of powerful people make the majority of economic policies that affect the lives all everyone in their purview.

    Improving education and campaign finance reform are often mentioned as ways to reform our current political/economic system. Reform of the field of economics from an ideologically driven exercise into a data driven systems based science should be added to that list.

  • Dick Burkhart

    Beinhocker (“The Origin of Wealth”) gives a good introduction to complexity economics and how it can provide a scientifically sound basis for economics. In particular, broad “patterns” of a sort can be predicted in many cases, just not in detail (they might be “strange attractors”), And control may be easy with the right tools, based on the concept of “sensitivity to initial conditions”. Thus government armed with a broad suite of financial tools, along with sophisticated data acquisition and analysis, could do amazing things if permitted by the politics.

    Ultimately the tougher part may be the politics, which is so easily and naturally corrupted by wealth, as Piketty’s historical analysis shows. And currently even the potentially scientific part of economics is corrupted by wealth and the political ideologies which serve it. This is why, to my mind, economics never seems to reform itself, despite monumental failures.

  • There is much to agree with in this piece, but there is no reason for the strawman reference to “orthodox economics” as the hed puts it. The truth is well described in this blog post from John Cochrane last year:

  • John M Legge

    Please stop blaming Adam Smith for something that he never said. He used the metaphor of the invisible hand twice: once to point out that great landed proprietors had to share their income with their tenants and retainers or they themselves would starve; and a second time (and the only time in The Wealth of Nations) to suggest that if trading monopolies were abolished “merchants” would invest locally because of the lower risks compared to those implicit in non-monopolized trade.
    Stand by for my irate blog post on this issue.
    That comment aside, well worth reading.