Markets are stable, investors are rational and the earth is flat. David Orrell, a fascinating mathematician who works in systems biology has published a book dedicated to exposing what he considers the great flaws of neoclassical economic theory. Adam Smith’s invisible hand “has a bad case of the shakes,” he says. In Economyths, he argues that the global economy functions like other organic systems, in a state known as “far from equilibrium.” And that as long as we labour under the false assumptions of mainstream economics, we’ll continue to fall prey to crises. He and I spoke on Tuesday.
What does your field teach us about the economy?
Isaac Newton showed that physical objects obey very simple mechanical laws. Using this approach, you break the system down to its individual components, work out the mathematical laws that govern each of the components, and translate those into mathematical equations. Then you can build a model and predict into the future. That’s worked really well in physics or chemistry, but the problem is that in a system – the kind of thing that we really want to predict, like the economy – the approach just breaks down. These systems are governed by what we call emergent properties: properties that cannot be reduced to some sort of simple mechanistic explanation. They just are. So in economics, there’s always this search for economic laws which are similar to the laws of physics. From a complex systems point of view, there are no such laws.
Is economics a science?
The conclusion that I came to is that economic theory is a sort of a mathematical model of human society. The problem that I have as a mathematical modeler is that the most important thing in a mathematical model is the assumptions that you put into the model. The thing about economics is that the key assumptions that we make about the economy do seem very strange to an outsider like me.
You reject the notion of stable markets.
The idea that the market is stable is based on Adam Smith’s idea of the invisible hand. There is this regulating principle: when prices get too high, more suppliers will come into the market and that will drive prices down to some kind of long-term equilibrium. In systems biology, you usually see systems that operate in a state that’s called “far from equilibrium,” in the sense that the contents of the system are constantly being churned around by the natural life processes. From that point of view, the idea that the economy should be at equilibrium just seems to be very strange. And indeed if you look at the behaviour of just about anything in the economy, it’s never stable for long. Everything is in a constant state of flux. The idea that markets are stable, that investors behave rationally and that therefore you can mathematically prove that markets are efficient; these are very strong assumptions.
Do any economists agree with you?
Yes, definitely. There’s a real change going on at the moment. Ever since neoclassical economics got started, there have been people who have been saying that people don’t always behave rationally when they make decisions, or the market isn’t stable or the market isn’t efficient. The so-called heterodox economists have argued this for a long time. But the thing is they’ve always sort of been on the fringes. They’ve never really made their way into the mainstream. Mainstream economics has been dominated by ideas such as efficient market theory and rational expectations. Rational expectations assumes not only that people behave rationally, but that they also have a perfect model in their head of what the economy as a whole is doing. Their judgment is sort of superb on every level: the individual level and the global level.
You’ve written about gold prices to illustrate your point.
It’s funny that gold is valued in part because it’s seen as a stable metal. It’s seen as kind of an anchor to the world economy. And of course it was until the early 1970s under Bretton Woods when currencies were fixed against the price of gold. But as soon as that was relaxed by [U.S. President Richard] Nixon, the price of gold has gone up and down. Now of course it’s soaring to extreme high levels. If you look at it from the outsider point of view, it seems to be a highly unstable system. The only time when it was stable was when it was actually fixed by government control. So if the invisible hand is controlling the price of gold, then it clearly has a bad case of the shakes. This is something that doesn’t make sense, really under standard economic theory. But if you think of the economy as being at a state that’s far from equilibrium, it can have actually chaotic dynamics where something like the price of gold can vary within a huge band without any particular rhyme or reason. That’s almost what you would expect. One reason this kind of thing goes on in the economy but not in the human body for example – you don’t get huge variations in body temperature and blood pressure – is that these are closely regulated by the body. There’s a comparison there with the economy because one sort of stabilizing influence on markets is a degree of regulation. When it’s relaxed, it tends to increase volatility.
Why didn’t more forecasters see the credit crisis coming?
Obviously some forecasters did, but there weren’t very many and they were definitely outside the mainstream. And they caught a lot of flak for doing so. I think one contributing factor to our general lack of foresight here was reliance on mathematical models. Most people who are working in economics think that markets tend toward equilibrium. They also think that a good measure of risk is fluctuations around that equilibrium. So if you have an asset that in the past hasn’t fluctuated very much, then according to the theory it’s not very risky. U.S. houses, real estate, fit that to a T because house prices had been rising on a national basis for decades. There wasn’t really any volatility that would indicate that there was a risk growing. But from another modeling point of view, which took into account the mounting debt, the mounting leverage and so on, then there would have been much more evidence that we were heading for trouble.
You see a potential bubble here in Canada.
Interest rates are being kept at very low levels to keep the crisis at bay so to speak, and they’re probably going to keep them low for a bit. When I was in Vancouver about four years ago, I thought house prices were extremely high at that time. They’ve come down a bit, but not really that much.
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