The unstable economy and the delusion of ‘the Great Moderation’

economyths-cover“Economists are taught that the economy is intrinsically stable – price changes are small and random, so perturbations are rapidly damped out by the ‘invisible hand’ of market forces. This assumption would be fine, except that it is contradicted by all of financial history. Booms and busts aren’t exceptions, they are the standard course of things…the assumption of stability has been a feature of scientific modelling of natural systems since the time of the ancient Greeks…we need to better account for the dynamic, unpredictable, and reflexive nature of the economy.

…A property of complex systems like the economy is that they can often appear relatively stable for long periods of time. However, the apparent stability is actually a truce between strong opposing forces – those positive and negative feedback loops. When change happens, it often happens suddenly – as in earthquakes, or financial crashes.”

David Orrell (2010), Economyths – How the science of complex systems is transforming economic thought

The above quote is from another book on Complexity Economics. This one is much shorter than The Origin of Wealth, which I discussed last week, and it is livelier and more accessible, so I can highly recommend it as an introduction to these kinds of ideas.

The evidence for the idea that the economy can appear stable for a while, then suddenly shift into a crisis, can be seen in the complacency of claims for ‘The Great Moderation’ in economic performance made by former chairman of the Federal Reserve Ben Bernanke and other economists working there in the mid-2000s. They claimed that independent central banks, freer from political influence, along with new technology and greater flexibility in the workplace, had helped to reduce the volatility of GDP, while inflation and unemployment stayed relatively low. In fact, the whole system was on the brink of the greatest meltdown since the Great Depression of the 1930s.

Economists such as the late Hyman Minsky and Wynne Godley of the Levy Institute, and other heterodox (non-mainstream) figures such as Steve Keen and Anwar Shaikh, had predicted a major recession some years before it hit. Minksy, who died in 1996, had put forward his Financial Instability Hypothesis in the 1960s and 70s. This held that financial stability tends to encourage increasingly risky behaviour by borrowers, which then makes the system more fragile and sets it up for a crisis.

In the absence of financial regulation, which needs to evolve with the complexity of the financial system itself, and the ‘automatic stabilizers’ of the government’s fiscal policy, such a crisis could be severe. And so it proved. The non-linear analysis of Complexity Economics seems to be much more helpful than many mainstream models. These only account for crises as random exogenous (from outside) shocks to the system. Complexity and other heterodox models treat crises as endogenous (arising from within the system itself). This is a much more fruitful line of thinking.

While prediction may still be a tricky business with regards to the economy, these kinds of models can be used to produce a wider range of economic scenarios that might occur in the future. Governments can then plan for such eventualities and have appropriate tools that can be used more effectively, rather than simply desperately making it up on the hoof when a crisis hits.

Having said all that, some humility by policymakers is in order: as Marx observed long ago, crises will always be with us under capitalism, and even the best policies cannot prevent them entirely.

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