The economies of fiction

The fables inherent in contemporary economics are various

August 24, 2011

In early 2010, the world economy may finally be emerging from the deepest recession since the 1930s. The blame for the recession has been put on many things, including the US housing market, complex credit derivatives, risk models, banker bonuses, and so on. However I believe that the problems run much deeper than that; for they can be traced back to a set of economic myths which have been cultivated and maintained over the last century and a half, ever since economics was invented.

These myths include the ideas that markets are stable, self-regulating, and efficient; the idea of a rational economic man; and even the idea that the economy can be described in terms of mathematical laws.

Although heterodox economists have argued against many of these for years, they are remarkably persistent and still make their presence felt in introductory textbooks, in the models used for policy decisions, and in the risk models used by banks. The only way we can get the economy on a more sustainable path, I believe, is to finally rid ourselves of these distorting fictions. So in the next few months, I will be writing on a number of these myths, starting today with one that will be rather counter-intuitive to anyone who has been awake the last couple of years, namely the myth that markets are stable.

This idea can be traced back at least to the equilibrium theory proposed by Léon Walras in the 19th century. In his 1874 book Elements of Pure Economics, he imagined a perfect competitive economy where an auctioneer acted as an intermediary between buyers and sellers. The auctioneer would start off with an initial price, then adjust it in a “groping” process – or tâtonnement, it sounds better in French – until buyers and sellers were in agreement, and the market cleared. Economists believed this price represented a stable equilibrium.

Weighing supply and demand
Of course, markets usually don’t have an auctioneer, so their invisible hand has to grope its way to equilibrium all by itself. However, a similar auctioning process is used to set the price of gold, in the ritual known as the London Gold Fix. Twice daily, at 10:30 AM and 3:00 PM, five people representing the city’s largest gold traders hold a teleconference to buy and sell gold bars. The chairman announces a starting price, and everyone says how many bars they want to buy or sell at that price. If demand exceeds supply, the chairman raises the price; otherwise he lowers it. The process continues until the buyers and sellers are in agreement.

While the resulting price may represent a temporary truce between supply and demand, it doesn’t however seem to resemble a stable equilibrium. A cursory examination of the gold price, including its rise last year to over $1,000 per ounce, reveals that it has been rather unstable ever since 1970, which was when the dollar peg was abandoned. Stability, it seems, is more the sign of government control, than the invisible hand of the markets. Other assets such as currencies or stocks also seem to have a bad case of the shakes. So what is going on?

Before giving my interpretation, I should first explain something of my background. I am not an economist, but an applied mathematician working primarily in the area of systems biology. In many ways the economy can be viewed as a biological system – at the most basic level, it imports energy and resources, transforms them in various ways, and expels

waste – and as we’ll see many techniques and insights from systems biology turn out to be directly applicable to business and finance.

Now, in biology, the only systems that are completely stable, are the ones that are dead. Since the economy is verifiably still alive (even after its near-death experience of the credit crunch), the idea of static equilibrium is something of a non-starter. Indeed, living systems operate at a state which is best described as far from equilibrium, in the sense that their components are constantly being churned around instead of sliding into stasis.

This does not mean that living systems are erratic or uncontrolled. The human body, for example, needs to maintain key parameters such as body temperature, salinity, or blood glucose levels within certain limits. It accomplishes this by using complex feedback loops which control and regulate the system. When these regulatory systems break down, the result can be ill-health.

To understand how these feedback loops work, systems biologists use techniques from the branch of applied mathematics known as nonlinear dynamics. Positive feedback has the effect of amplifying signals, and is used to provide a rapid response. Negative feedback acts to damp out the signal, and is used for control. The two types of feedback usually act in concert to give a controlled response to stimuli.

So what does all this have to do with the price of gold? Well, it too is characterised by feedback loops. Negative feedback occurs because when the price gets too high, then people may decide it is over-valued and sell their holdings. This acts to stabilise the price. However, that isn’t the whole story. For gold is of course desired, not just for its industrial applications or attractive bright colour, but for its perceived value as a financial investment. When the price of gold is going up, then to many it becomes more attractive, because this confirms the story that it is a good investment. A change in price is therefore amplified: positive feedback.

The presence of positive feedback means, from nonlinear dynamics theory, that there is no reason to expect the price of gold to have a stable equilibrium. The same kind of feedback loops are seen throughout the rest of the economy. Their most spectacular manifestation is in the form of financial bubbles and crashes. On the way up, the asset of choice (tulips in 17th century Holland, houses in 21st century America) becomes very attractive exactly because it is going up in value (and conversely on the way down).

Clear horizons spell trouble
The problem today is that our standard economic theories do not properly take into account these effects, and instead seem fixated on stability. Risk models assume that the economy is essentially stable, so that the past will resemble the future. General Equilibrium Models, used by governments and central banks to make policy decisions, assume that the economy has an inherently stable equilibrium point. Popular theories such as the efficient market hypothesis are explicitly based on the existence of equilibrium.

So no wonder we get into trouble. If we believe that the economy is inherently stable, then there’s no need to properly regulate it – which, as shown by the credit crunch, is dangerous. In future columns, we’ll look at ways that new ideas from areas like systems biology can help to bring the economy to a better state of health.