Thursday, March 12, 2009

The Future of Macroeconomics

The future of macroeconomics will continue to be a series of disastrous experiments until we come to understand macroeconomic behavior as emergent features of a complex system. Understanding the economy as a complex system that evolves -- and can evolve into a new kind of complex system -- is what is necessary. Recessions are transition states from one stable economy to another (see catastrophe theory for the proper model of this). As changes and errors accumulate in a stable economy, it becomes unstable, a shift occurs, and the economy leaps into a new stable order. This is part of Joseph Schumpeter's “creative destruction." During recessions, though, there's an emphasis on the destruction part. But this is necessary. In natural ecosystems (to which an economy can be fruitfully compared), mass extinctions are often needed to make space for new forms of life. Sure, some mass extinctions are caused by asteroids -- but that's a rare event. In the case of cambrian explosion. there was a sudden increase in number and kinds of species after a period of relative stability.

But let's look at this on the cellular-molecular level. Gould proposes that an individual species stays that species over long periods of time, and mutations accumulate over that period, until a critical number of mutations accumulate, and (a) new species emerge(s). On the cellular level, the stable system moves closer and closer to chaos, until a catastrophic collapse is reached. The system either goes extinct, having collapsed into complete chaos, or it moves into a new, typically more complex level. This is what causes the emergence of new species. At the ecological level, we have species coming and going off and on, here and there all the time. But sometimes, every so often, there will be a conjunction of species going extinct, opening up new niches, new species emerging to help those extinctions along, and other new species, later, filling in the newly opened niches. New niches may even form, with new species emerging to fill them. A species that was just barely holding on may suddenly find the environment perfect for it. This is much like what happens in a typical business cycle. Some are as spectacular as the Cambrian explosion. Others are more subtle.

Ormerod's "Butterfly Economics" sets us on the right path, but he still falls a little short, still missing the forest for the trees. His ideas need to be combined with Hayek's spontaneous order model of the economy, as well as Prigogine's dissipative structures, and Gould's punctuated equilibrium model of evolution. Indeed, the punctuated equilibrium model I think brings us much closer as to why there are business cycles in market economies. It also explains why we have so many scandals at the time of recessions -- as cheaters (those contributing to the errors accumulating in the system) are exposed. Cheaters have to be swept away for the next, healthy system to come into existence.

Some may object that things are in fact simpler than this. They could not be more wrong. All economies are nonlinear, complex, self-organizing, dissipative systems. Simple is not an option. Simple, linear thinking is what makes recessions in these cycles worse. The attempt to make such a system simple and linear -- through welfare statism or socialism -- stretches the recession out through time and at best flattens growth. What we are witnessing right now is the actions of people who see the economy as simple ,linear, and as a zero-sum game. They are wrong on all accounts. To not understand the need for systems theory in economics is like not understanding the need for it in biology. You can keep trying to apply Newtonian physics equations to cellular behavior, but you're not going to have the foggiest idea what's going on.

Macroeconomics is the attempt to understand the macrofeatures of the economy. To make an analogy, microeconomics is biochemistry, macroeconomics is cell biology. Or should be. Right now, macroeconomics is more like molecular biology in its attempt to understand the large institutions within the economy. To that extent, there is in fact almost no theory of macroeconomics proper. There needs to be a medioeconomics that deals with institutions, firms, etc. in the same way molecular biology deals with structural and informational macromolecules. Could you imagine the state biology would be in if there weren't a separation between molecular biology and cell biology? Yet, that is the state I see in economics, with macroeconomics being that sort of fusion. At best. At worst, it doesn't even admit to their being true macrofeatures. It would be like having a theory of biochemistry and molecular biology without a theory of the cell.


Winton Bates said...

I found this very interesting, Troy.

I think your analogy with evolution works best in terms of a long run analysis where equilibrium is disturbed by some fairly fundamental change in technology. That is consistent with your reference to Schumpeter.

The question in my mind is to what extent technology can be held responsible for the current recession. There is certainly a technological element involved in the extensive use of CDOs etc - the failure of which might be equivalent to an evolutionary dead end.

However, government policy has also had an important role in the move away from the equilibrium economic growth path. We have a supply-side finance sector problem (which has arisen in part because of policy failures)being aggravated by mis-guided government policies that prevent self-correcting processes in the system from working effectively.

I guess I am just agreeing with you that the system is complex - and made even more complex by government interventions.

Troy Camplin said...

Technology isn't the only way that these kinds of shifts can occur, though that was what Schumpeter had in mind. There are also innovations in the way business is conducted, etc. A change in rules and regulations can have massive effects on the economy. Take for example the President Clinton's law that restricted pay to $1 million. The first reaction to that created the conditions that led to the 2000-1 recession and the Enron scandal (and others similar to it), where compensation was increased with stock options, leading to people running up the stock price until they left the company and cashed out. Now we have the bonus structure, which is in fact working fine, except that the term "bonus" is used, which is causing all kinds of pointless talk and threats from Congress. The recent bubble was created almost exclusively by government meddling in the mortgage business, sending out false information about the real estate industry. Unfortunately, Obama thinks the solution is more of the same of what caused the problem in the first place.

Incidentally, the Fed also just printed up a trillion dollars. So now we're going to get an unhealthy dose of inflation to boot.

The government tends not to complexify the economy, but to complicate it. There is a huge difference.