New Perspectives

In Economics and Finance

Complexity and Economic Analyses

Henning Schwardt, author of The Path to a Modern Economics, writes about why conventional economic wisdom needs to be challenged. 

Our world is complex. For making sense of this complexity, conventional wisdom provides the backdrop for the interpretation of information, as the foundation for a fair share of analysts. Conventional economic wisdom rests on a specific theoretical foundation. To stray (too far) from this framework, will cost credibility.

Conventional economic wisdom embraces one core assumption: there is a way for the economic system to function that produces optimal results, and we define this as the outcome of a ‘normal’ functioning of the economic sphere. Any divergence means distortions, by private or public agents, or signals ‘market failures’, the result of conditions hindering the normal functioning of markets.

But current conventional wisdom is not all we can rely on for economic analyses. In fact, we can divide economics’ analytical frameworks, roughly, into two groups. The theoretical foundations for the frameworks in the first group, assume certain characteristics of the economic system at the outset. Namely, global, unique, and stable attractors. These attractors serve as reference points in analyses, and for policy recommendations.

In these analyses, and for these recommendations, conventional economic wisdom can draw on economic laws that tell us what reaction to expect from economic agents and in the economic system following which measures. Note that outside an equilibrium framework, we cannot identify these laws. Outside a tightly constrained economic system, the reactions that follow changes will typically depend on the context in which these changes are enacted.

In the second, somewhat diverse group, we find approaches that ask how agents interact and what system we might expect to emerge from these interactions. This does not mean that there could not be stability in the system, or patterns in its dynamics. In fact, the chaos that would result for individuals without these would likely lead to a rapid change in economic systems. More technically, in the adaptive system ‘economy’, its individual components create a stable environment.

This stability is not an inherent characteristic of the system itself, though, imposed on and constraining individual agents, while showing specific (desirable) traits. Rather, it can represent a temporary state that may change as individual behaviors change, and as individual behaviors affect the overall economic environment. It is a resting point, then, and by now means it is guaranteed that it would represent a particularly good, much less optimal, outcome. It works well enough for enough people with a voice in it.

Economic crises, manifested in unemployment, or problematic development in subsystems of an economy (say, financial markets) are a normal part of modern economic activity in these bottom-up frameworks. They thus reflect a long-standing point of interest in the social sciences, namely, a conflict between individual and group level, and the potential for even individually reasonable actions to produce disadvantageous results at higher levels of aggregation. On the other hand, where the individual rules supreme, assumptions about the economic environment itself have to be made to guarantee good results. Without these assumptions about the system, even perfectly rational agents driven only by economic motivations would produce emergent effects, turbulence, and potentially undesirable outcomes. Such situations, however, would interfere with the neat cause-and-effect patterns that are sought after, as economic laws. Where the conflict between individual and group finds space in an analytical framework, immediately, the dynamic of analyses changes; and, in fact, dynamics can be introduced into the framework. (While conventional wisdom in economics relies on dynamics, or competition, in its rhetoric, it defines these terms very differently from a systems dynamics theorist, in the former case, or a business woman, in the latter; and in ways that do not share any substantial overlap with these disciplinary definitions, or common usage of the terms, for that matter.)

The bottom-up framework cannot afford much patience for an antagonistic view on private and public sectors, nor is there scope for concepts such as a true price, or a given value, of goods and resources. Prices still offer information, and more than any other single economic indicator, but they do now anchor economic activity to a certain equilibrium outcome.

Information we gather from prices depends on its context. Price movements are part and parcel of economic activity, because the movements themselves offer information about others’ evaluations of future potential. That does not mean that, say, a long-run average could not serve as an anchor for expectations, and divergences could not be interpreted accordingly.

So, if we do not force assumptions on the economic system before we even start our analyses, we often arrive at markedly different perspectives on this system. In fact, depending on how we approach the complexity of the (economic) world, our view of it changes. Problems we identify and solutions we (can) propose change with the perspectives we adopt.

To bend a model into an ex-post description is one thing – and not a particularly difficult one, given that standard economic models come with a curious mix of tight constraints, at the systemic level, and vast degrees of freedom to bring about a set of results at the individual level. An understanding of the economic sphere is a different matter. Here, the characteristics of a complex system, are crucial. These characteristics are abstracted from in conventional economic theorizing; and the policy prescriptions that flow from there.

Nevertheless, increasing experience with economies hones economists’ senses. Given the pronounced freedoms in model formulation, they can offer a story of events in the accepted communication structures of the discipline. They cannot rely on those communication structures to foresee developments, though. Here, their experience comes into play. A recognition that economies are complex systems thus seems implicitly included. But you need to know the proper communication structure – ‘this situation is comparable to model subcase x, as formulated by economist z who recognized the importance of the following distortions for economic performance’ – to be heard. The analytical structure itself is so open that it can offer support for any position. However, with the embrace of the position of a normally functioning economic sphere producing good results, the focus is not on crises, and their development. This influences where attention is directed, and which stories are more likely to gain traction.

Analytical frameworks focusing on an understanding of the complex system ‘economy’, ‘sector’, or ‘market’, may ‘only’ be able to identify potential for problems – and thus ‘identify nine of the last five crises’ – but they offer that possibility. Crises are part and parcel of modern economies. The possibility for their emergence is more present in the minds of researchers relying on bottom-up frameworks that normally include their potential in their work. Given the reality of economic crises, their contributions are lightly discarded at our own peril.

Henning Schwardt is Visiting Teaching Assistant Professor in the Department of Economics at the University of Denver, USA. His research has focused on institutional economics and development economics, as well as complexity economics.  

The Path to a Modern Economics