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January 5, 2009

Complexity Economics, Evolution and How Change Happens

January 5, 2009

Complexity Economics and Evolution – a Truly Big Idea

January 5, 2009
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I spent much of the Christmas break sneaking off to read chapters of Eric Beinhocker’s path-breaking 2006 book ‘The Origin of Wealth: Evolution, Complexity and the Radical Remaking of Economics’. There’s probably too much to cover in one post, so I’ll follow up this overview with some more specific reflections in the days to come.

The book starts by showing that the economy fulfils the ground rules for an evolutionary system, i.e. one that meets the basic conditions of ‘differentiate, select and amplify’. This goes far beyond the evolution of biological species, constituting a general purpose algorithm for creating ‘design without a designer’, and finding ‘needles of good design in a haystack of possibility.’

Economic evolution is the result of three interlinked processes: Physical Technology;
Social Technology (e.g. the rule of law, money, venture capitalism) and business designs, which turn physical and social technologies into economic reality. In each of them ‘evolution is at work, churning through possible designs, finding and amplifying ones that work, discarding those that don’t, and thereby creating the order that we see in our technological, social and economic worlds.’

In evolutionary terms, the economy is a ‘complex adaptive system’ , where the parts of a system adapt their behaviour in response to events, (other examples include ecosystems and the internet) and produce an overall system whose behaviour is much more than the sum of its parts. Complex adaptive systems exhibit oscillations, periods of calm punctuated by sudden spikes of change and ‘power laws’ – extreme events are more frequent than predicted by classical Gaussian (or normal) distributions. The mother of all spikes is the extraordinary take off in global growth since 1750 (see graph) – an event Beinhocker puts down to the combination of the Scientific Revolution and the creation of organized markets. Science accelerated the process of exploration and innovation; markets provided rapid means to select and amplify success. 

He contrasts the fact that the economy really is an evolutionary system with the way traditional economics has used physics as metaphor, which he thinks has led it up a blind alley. Economics started off as a branch of moral philosophy (e.g. Adam Smith), but in the 19th Century underwent a bout of severe physics envy. The key figure was the Frenchman Leon Walras, who in ‘Elements of a Pure Economics’ (1872) borrowed from physics the notion and mathematics of the study of motion and energy. At its heart lay the concept of ‘equilibrium’: the economy is like a ball in a bowl, oscillating before it settles at an equilibrium point. Mainstream economics for the next century portrayed the economy as moving from equilibrium point to equilibrium point, propelled by external shocks (technology, politics etc). It was an extraordinarily powerful metaphor, which has become deeply embedded in how we think about the economy.

But it is just a metaphor, and in many respects it is misleading. To enable him to use the mathematics, Walras had to make a number of assumptions that have bedevilled economics ever since, such as zero transaction costs, a single price for any given commodity, or that economic decision makers interact only through price, and usually through an auction mechanism. ‘Walras’s willingness to make trade-offs in realism for the sake of mathematical predictability would set a pattern followed by economists over the next century’ Beinhocker concludes.

As a result, economists have had to live with the discomfort of ‘cognitive dissonance’, a gap between what they see around them, and what they believe to be true. As Alan Greenspan once noted ‘a surprising problem is that a number of economists are not able to distinguish between the economic models we construct and the real world.’ Sometimes that dissonance was extreme – when the hedge fund Long Term Capital Management collapsed in 1998, nearly taking the US financial system with it, its baffled Nobel-prize winning founder, Robert Merton, explained ‘According to our models, this just could not happen.’

Beinhocker believes that ‘Complexity Economics’ offers the new paradigm that will allow economics to reinvent itself. In contrast to the vacuities of the ‘Third Way’ propounded by Tony Blair and Bill Clinton, ‘The Complexity approach to economics offers not just a muddled middle – it is neither Neoclassicism with a few market failures, nor socialism with a few market mechanisms – but a wholly new perspective. The fundamental question isn’t Left versus Right; it is how best to evolve.’

So what? What should we be doing differently? This is where Beinhocker rather loses his way – he has some good ideas on what it means for businesses (he does after all, work for the McKinsey management consultancy), and some random, not terribly convincing, thoughts on politics and policy. To be fair, he says at the outset that his is a ‘Sunday morning’ book, i.e. big picture, rather than trying to answer the usual ‘what do I do on Monday morning?’ question. But I think working out in more detail what this all means for policy, NGOs, our understanding of change etc is really worth exploring – I’ll have a go at some of these in the next couple of days.

5 comments

  1. I’m starting graduate school in economics next year, and I think this is an absolutely fascinating area, but, like you, I think it’s hard to figure out where to go with it. I look forward to reading your thoughts over the next few days. I’ve thought about reading this book before, but saw it had mixed reviews and put it aside. I might pick it up again now…

  2. Looking forward to hearing where this thinking takes you. I agree it could be fruitful – but only if it manages to address another achilles heel of most economic thinking, namely the absence of unpaid (unmonetised?)yet utterly essential activity without which the monetised economy could not function, let alone evolve… the caring work, the reproductive work…

  3. I guess Hayek’s work seems closer to this view than most classical or neoclassical economics (mostly in his Law, Legislation and Liberty). It’s rather unfortunate that it gets mixed with much cold-war garbage.

  4. “Economic evolution is the result of three interlinked processes: Physical Technology;
    Social Technology (e.g. the rule of law, money, venture capitalism) and business designs”

    This makes a lot of sense from wondering how this translates into the economy we’ve had here in the US over the last few years since this book was written in 2006.

  5. Duncan, I completely agree with your statement that the economic equilibrium metophor is misleading – in fact I think it is completely inappropriate. As we’ve seen recently economies are a constantly changing, highly dynamic systems – interacting and responding internally and externally to factors which can not be modelled.

    @Peg (comment 4) – Indeed, we’ve seen how the banks, with lax regulation and poor risk management, have set back the world economic evolution 10 years! I doubt the economists built this into their models!

    Cheers,

    Ian

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