Complexity, Economics & Risk

by Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The economic crisis has thrown the inadequacies of macroeconomics into focus. This has led to the argument that the narrow conception of the macroeconomy as a system in equilibrium is problematic. Economists should abandon entrenched theories and understand the macroeconomy as a self-organizing complex system.

This is a question asked by Alan Kirman in a recent VOXEU communique (29^th Oct.)  called What is the use of economics? The author offers detailed suggestions on what alternative ideas economists can teach their future students that better reflect empirical evidence of financial markets.

The question was raised during a recent conference as to what extent has - or should - the teaching of economics be modified due to the current economic crisis? For macroeconomists, the reaction has been to suggest that modifications of existing models to take account of ‘frictions’ or ‘imperfections’ will be enough to account for the current evolution of the world economy.

However, some economists feel that we have finally reached the turning point in economics where we have to radically change the way we conceive of and model the economy and risks. The crisis is an opportunity to carefully investigate new approaches. Economists tend to inaccurately portray their work as a steady improvement of their models whereas; empirical reality is changing just as fast as their modeling. The economist’s instinct is to attempt to modify reality in order to fit a model that has been built on longstanding theory. Unfortunately, that very theory is itself based on shaky foundations.

Economics is faced with the model of the isolated optimizing individual who makes his choices within the constraints imposed by the market. Somehow, the axioms of rationality imposed on this individual are not convincing. There is equilibrium with prices that will clear all markets simultaneously and has desirable welfare properties.  Students are taught that the aggregate economy or market behaves just like the average individual they studied, but are not told that these general models perform poorly.

Macroeconomists are faced with a stark choice: either move away from the idea that we can pursue our macroeconomic analysis whilst only making assumptions about isolated individuals, ignoring interaction; or avoid all the fundamental problems by assuming that the economy is always in equilibrium, forgetting about how it ever got there.

The author suggests three ways to improve economic education: (1.) spend more time insisting on the importance of coordination as the main problem of modern economies rather than efficiency. (2.) cease to insist on the idea that the aggregation of the choices and actions of individuals who directly interact with each other can be captured by the idea of the aggregate acting as only one of these many individuals.  (3.) recognize that some of the characteristics of aggregates are caused by aggregation itself.

Does this mean that we should cease to teach ‘standard’ economic theory? For the moment, standard economics is what economists do. However, we need to point out difficulties with the structure and assumptions of our theory. Although we are still far from a paradigm shift, in the longer run the paradigm will inevitably change. We need to remember that current economic thought will one day be taught as history of economic thought.  Until we fully understand how the macroeconomy works as a complex adaptive system, risk analysis will remain a problem.

www.voxeu.org/article/what-s-use-economics