Breakthrough economics from writer and mathematician David Orrell. Appeared in our winter 2012 edition, The F*cked Issue. Illustration by Ralph Steadman.
Fuckonomics by David Orrell
In keeping with the theme of this issue, one feature of today’s world that most people agree is totally screwed is the global economy. We are constantly buffeted by financial storms, which seem as beyond our control as a meteor shower from outer space. Money has departed from its original function as a means of exchange to take on a crazed, computer-driven life of its own, surging through financial networks at the speed of light, building up huge walls of fictitious debt – which then suddenly collapse, creating mayhem in the lives of millions. We have reverted to the state of primitives, in awe of external forces, desperately searching for some way to find stability and predict the future.
Ironically, though, it is our very attempts to predict and control the economy that have turned it into the unrestrained beast it has become. Our sophisticated mathematical models have become part of the problem, not the solution. As I told an audience at the Breakthrough Capitalism Forum in London earlier this summer: in order to break through to a new kind of system, we need to rethink the way we do economics.
Order and symmetry
Economics can be viewed as a mathematical model of the world. Such models are interesting because they encode a kind of story about reality. The models – and especially the assumptions on which they are based – tell a lot about the way we see the world and the way we see ourselves.
A good example of this was one of the older mathematical models, the Greek model of the cosmos.
This model was based on two main assumptions. The first was that everything moved in circles, which were considered the most perfect and symmetrical of forms. The other was that everything moved around the Earth. In Aristotle’s scheme, the planets and stars were thought to be encased in crystalline spheres which moved at different speeds around us.
Of course, as we now know, both of these assumptions were wrong. But that didn’t seem to matter, for the model persisted for well over a thousand years, until it was finally overturned in the Renaissance. How did it manage to last for such a long time?
One reason relates to the fact that, as Aristotle put it, man is a political animal. The Greeks believed that there was a strong parallel between what was going on in the cosmos and what was going on in human life. As with the model of the cosmos, Greek society was structured as a series of concentric rings, with slaves at the base, followed in ascending order by ex-slaves, foreigners, artisans, and finally the land-owning, non-working upper class. These men alone could be citizens, and oversaw everything from above, like the stars in the firmament (women did not take part in political life and took their social class from their male partner).
A model of the universe that suggested that each object, and each class, has its natural place in the cosmic scheme therefore supported the status quo, and would certainly have appealed to the male leisure class that ruled ancient Athens.
Perhaps a more important reason for the success of the Greek model of the cosmos, though, was that it could make accurate predictions of things like solar eclipses. In a time when human affairs were believed to be influenced by the movements of the celestial bodies, this was an impressive demonstration of the power of mathematics.
Breaking the spheres
As mentioned, the model lasted for well over a thousand years. In 1543, though, Copernicus argued that the Earth went around the Sun, rather than vice versa. In 1572, the Danish astronomer Tycho Brahe observed a comet that passed between the planets, so if Aristotle’s crystalline spheres had actually existed, it would have broken through them. Finally, in 1687, Isaac Newton combined Kepler’s theory of planetary motion with Galileo’s study of the motion of falling objects to derive his three laws of motion and the law of gravity. The Greek circles were replaced with dynamical equations.
Newton believed that matter was made up of ‘solid, massy, hard, impenetrable, movable particles’ governed by physical laws – i.e. atoms. His work laid out a template that scientists have continued to follow until the present day. To understand and predict a system, you break it down into its constituent parts, find the mathematical equations that govern their behaviour, and solve.
This approach has been very successful in areas such as chemistry and physics. Newton was less confident that it would apply to other fields. After losing most of his fortune in the collapse of the South Sea bubble, he warned that ‘I can calculate the motions of heavenly bodies, but not the madness of people’. In the nineteenth century, though, economists decided to forge ahead anyway. The result, known as neoclassical economics, was directly inspired by Newton’s ‘rational mechanics.’ As a mathematical model, it may have had as great an effect on society as the Greek model did in centuries past.
In order to mathematicise the economy, economists of course had to make a lot of assumptions. No one thinks these assumptions are completely true, but, as we will see, they have been amazingly influential.
The theory assumed that individuals and firms, who were the atoms of the economy, acted independently and rationally to maximize their own utility. This led to the famous caricature of rational economic man. The ‘invisible hand’ (usually attributed to Adam Smith, though the idea predates him) then drives the economy to a stable equilibrium. The result of all this was supposed to be maximal societal happiness.
As with the Greek models of the cosmos, the aim of the models was to make accurate predictions; however, in this case the models did not work quite as well. Predictions of things like gross domestic product are famously unreliable, and are not much better than random guessing even today .
In the 1960s the ‘efficient market hypothesis’ was floated as an explanation for the inaccuracy of economic forecasts. This was a physics-inspired theory which assumed that markets magically attain a stable and optimal equilibrium, and any changes are random perturbations that inherently cannot be predicted. However, it should be possible to calculate risk based on statistical methods such as the normal distribution (bell curve), or variants thererof.
This theory was used to create risk management techniques with names like the Black-Scholes formula and Value at Risk – all of which completely failed during the recent financial crisis, and indeed helped cause it by creating a feeling of false confidence. So why is it that economic storms still come as a surprise? Let’s look at some of the assumptions in a bit more detail.
The Divine love of the universe
The theory assumes that the ‘invisible hand’ drives the economy to a stable equilibrium. But if you look at something like the price of gold, it is very unstable. The reason is that we buy an asset like gold because we hope it will go up in value. Therefore when it is going up in value, we get excited and buy more. This positive feedback drives the price up further. The same thing happens in reverse on the way down, resulting in an unpredictable series of booms followed by busts. The same effect is seen in other things like oil, housing, currencies, and so on.
Now, this kind of unpredictability is superficially consistent with efficiency. However, the theory also assumes that price variations are small, random and independent, and therefore normally distributed. But as we know markets are susceptible to sudden, catastrophic crashes. Their statistics are not ‘normal’, but are similar to those of earthquakes. Most price changes are small (just as the Earth is constantly experiencing small tremors) but there is the ever-present possibility of extreme events.
Another key assumption is that people act independently and make rational decisions to optimize their own utility (the proof of market equilibrium actually assumed infinite computational capacity, and the ability to plan into the future). But emotions such as trust and fear play a vital role in markets.
Finally, the original idea of neoclassical theory was to optimise happiness, and achieve what Francis Edgeworth called in 1881 ‘the maximum energy of pleasure, the Divine love of the universe’. But while the economy has grown enormously in recent decades, reported happiness levels have remained static or even declined slightly.
One reason for this is the saturation effect: once you have a certain amount of money it doesn’t help that much to make more. But perhaps another reason is that we have internalised these values of rationality, independence, and utility optimisation; psychologists (or most human beings) can tell you that the things that make you happy have more to do with connectivity, communication with other people, and community. This theory of ours could be making us unhappy.
A new economics
To summarise: our orthodox theory is based on ideas of stability and elegance that go back to the ancient Greeks. It is Aristotlean, but not in a good way.
We model people as if they were rational and can look into the future. We model the economy as if it obeyed the harmony of the spheres. Like the Greeks, we are imposing our ideas of rationality, order and logic onto the universe. But there is one important difference: the Greek model could make fairly accurate predictions. Our models don’t have that degree of empirical validity.
As I argue in my book Economyths: How the Science of Complex Systems is Transforming Economic Thought, there is an alternative. A new theory is being forged, which is part of a larger shift in science from seeing the world as a Newtonian machine to seeing it as a living system.
Complex organic systems, from a living cell to the economy, to the Earth’s atmosphere, are characterised by emergent properties that emerge from local effects and cannot be reduced to simple equations. They operate at a state that is far from equilibrium, far from stable. They exhibit power-law statistics, like earthquakes, as opposed to ‘normal’ statistics. They are based on network dynamics, as opposed to atomistic dynamics. Opposing positive and negative feedback loops create internal dynamic tension. Together, these factors result in an inherent uncertainty. This, rather than anything to do with efficiency, is the real reason we can’t predict the future.
So why has the neoclassical model persisted for so long? In this case the answer has nothing to do with prediction. That leaves politics and the status quo. The idea that the system is stable, rational, optimal and efficient is clearly one that is favoured by the tiny elite – the sub-one percent – which derives the most benefit from the current arrangement.
Once again, it is time to break through to a new way of seeing, smash the metaphorical crystalline spheres, and build a new model of the world. Otherwise, we really are in trouble.
David Orrell is a writer and mathematician. His books include Economyths: How the Science of Complex Systems is Transforming Economic Thought, and the forthcoming Perfect Model: Science and the Quest for Order, published by Yale University Press. www.postpythagorean.com.
Copyright David Orrell 2012
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