It’s the Complexity Stupid

Romain/ mars 3, 2021/ Finance, Science/ 0 comments

I have received interesting questions about concepts like econophysics and self-organized criticality. As I plan to dedicate a future article to that new discipline named “econophysics”, the focus of the present post will be set on complex systems, nonlinear dynamics and instability.

Would Keynes endorse MMT?

As already explained in previous posts (see Black Holes and Revelations), Western authorities have traditionally applied Keynesian principles to deal with economic issues. From that perspective, everything seems ruled by the simple Y = C + I + G + (X – M) equation, and some postulates such as agents’ rationality or utility maximization.

However, Keynesian models imply a linear and unrealistic vision of the world, while practitioners have to deal with phenomena like nonlinearity or nonstationarity. Said differently, that theory makes everyone think that they can “have control” over the economic activity, which is highly misleading.

The disconnect between real life and intellectual frameworks that have fed economic policies for decades has even got bigger with the move of so-called “elites” towards modern monetary theory (MMT). While Keynesian economists used to recommend public interventions during recessions, post-Keynesian thinkers state that infinite government deficit and monetary expansion should be used as permanent tools to drive the economy. Note sure that John Maynard Keynes would have agreed with such extreme conclusions.

Ideology vs Science

The problem is that post-Keynesianism looks more like an ideology – that may be seen as “convenient” by authorities – rather than a pure scientific theory. And the risk is that such ultra-dovish policies create distortions which will be out of the scope of the models, and that are likely to provoke an even bigger crisis.

So far, so good? Why not, but an economy is a nonlinear framework, and growing imbalances may slowly drive the system towards critical points, and thus towards underestimated tail risks. One should remember that even small shocks can lead to large economic drawdowns.

The thing is, economics is a much more complex discipline than what people commonly think. In fact, it could (and should) be regarded as the science of complexity.

Firstly, economic activity is driven by intersubjective interactions between humans, implying metaphysical concepts which are not necessarily easy to handle. Secondly, an economy – like capital markets – is a self-organized system characterized by rigidity, heterogeneity, and by a very high number of microscopic interactions between participants that result in a macro-state which may differ from so-called economic equilibrium.

Small Shocks and Snowball Effects

Introducing the concept of self-organized criticality, Danish physicist Per Bak suggested a simple model of interactions between producers and consumers to illustrate the subtle functioning of an economy (see figure below), highlighting that “small shocks, large impacts” puzzle. Bak heavily criticized the way traditional economists work, claiming that “[they] like to deal only with models that can be solved analytically with pen and paper mathematics”, and adding that “very rarely [physicists] are able to ‘solve’ problems in the mathematical sense.”

Following Bak’s ideas, researchers Jean-Philippe Bouchaud and José Moran released a preprint paper in 2019, studying the structural instability of large economies. Considering an even more complex network of firms, where each company may be connected to the others, they found that the distribution of firm sizes develops a power tail. More interestingly, because of rigidity and heterogeneity, they showed that a large economy becomes highly unstable and vulnerable to even with small shocks.

While Bouchaud and Moran’s paper is a deep dive into random matrix theory, it is interesting to note that similar conclusions also emerged from evolutionary biology with Robert May’s works on the dynamics of animal species, which suggests that economic activity might be ruled by natural laws common to various phenomena.

The Modern Prometheus

With the rise of econophysics and other interdisciplinary endeavors in economics, curiosity and humility should become the norm among regulators and policy makers, as any attempt to “control the economy” could finally lead to catastrophic outcomes. As Dr Frankenstein would have said to central bankers: “never bet against nature.”

To conclude, risk is like energy, it cannot be eliminated, it can only be transferred. By doing “whatever it takes” to prevent an asset crisis, American and European authorities have been quietly laying the ground for even more violent economic shocks.

Bak, P. (1996) How Nature Works: The Science of Self-Organized Criticality. Copernicus, New York City.
May, R.M. (1972) Will a Large Complex System Be Stable? Nature. 238: 413-414
Moran, J., Bouchaud, J.P. (2019) May’s Instability in Large Economies. Physics and Society Papers.

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