Future Economics

The recent failure of classical economics to predict and manage the catastrophic failure of the world’s financial system has triggered a re-evaluation of the whole basis of current economic theory, which has been applied to sustain capitalism for the last 100 years. .

By the end of the 20th century traditional economics was dominated by the classical paradigm based on notions of rational consumers making rational choices in a simple supply/demand world of finite resources, with prices constrained by decreasing returns; all driving the economy to an optimal equilibrium point.

Twentieth century economists had finally realised their dream of creating a rational, rigorous and well-defined mathematical model for describing the workings of the global economy. This standard model has been applied by business leaders, finance ministers, central bankers and presidential advisers ever since.

Up until recently classical economic theory has appeared to work adequately by a process of trial and error. In stable times people are generally rational and optimistic and the theory describes reality reasonably well. But in extreme circumstances people panic and the theory fails spectacularly, including the performance of the quantitative risk algorithms beloved by hi-tech stock market traders.

Unfortunately such a clockwork model has proved over the last four decades to be seriously out of synch with reality, as global markets have been roiled by a series of disastrous credit, market, liquidity and commodity crises. The predictions of the standard model have failed to match real world outcomes, generated in succession by the Savings and Loan, Asian, Mexican, Dotcom and now toxic mortgage bubble disasters.

In this ‘mother of all’ excess greed debacles, high risk mortgage loans were repackaged many times over into opaque risk financial instruments, such as Collateralised Debt Obligations or CDOs, which ended up through the unregulated banking system in the portfolios of nearly every bank and financial institution around the world. Because of lack of regulation, members of the shadow system such as hedge funds and merchant banks borrowed scores of times their own worth in cash. When the CDOs finally failed, the losses rippled through the world economy. The banks stopped lending, leading to further business failures and investors were then forced to sell previously sound stocks causing a stock market crash.

But this crash is far more serious- perhaps even more than the Great Depression, as it cannot be contained within borders as easily or so simply solved by mass lending and job creation programs. Now we have the biggest banks, manufacturers, miners, energy suppliers and whole national economies from the US to Iceland toppling like dominoes around the world, under trillions of dollars of debt - with no end in sight.

In fact a number of interdisciplinary thinkers, starting in the seventies, began to question the credibility of the entire basis of the classical economic model, likening it to a gigantic academic exercise rather than a serious science. And it gradually began to dawn on this group that at a number of the key premises or axioms underpinning the existing model were seriously flawed.

As mentioned, the first is the assumption that humans are rational players in the great game of market roulette. They are not. Behavioural scientists have shown that while people are very good at recognising useful patterns and interpreting ambiguous or incomplete information in their decision-making, they are very poor when it comes to performing complex logical analysis, preferring to follow market leaders or flock. This can further amplify distorting trends.

The new theories of behavioural finance argue that during a bubble the rate of buying and selling can become manic, resulting in irrational decisions. Making money actually stimulates investor’s brain reward circuitry, causing them to ignore risk and making it difficult to value stocks accurately.

But perhaps the most critically flawed assumption is that an economic system always reaches an ideal point equilibrium of its own accord. In other words, the market is capable of self-regulation- automatically allocating resources and controlling excesses in an optimum way, with minimum outside interference.

Since the nineteenth century the fundamental principle underpinning economics has been based on the idea that the economy is an equilibrium system- a system that moves from one equilibrium point to another, driven by shocks from external disruptions - technological, political, cultural etc- but always coming to rest in a natural equilibrium state.

The new emerging evolutionary paradigm however postulates that economies and markets, as well as the internet, enterprises and the brain, are all forms of complex adaptive systems in which agents dynamically interact, process information and adapt their behaviour to a constantly changing environment- but never reach a final equilibrium or goal.

In biological evolution, the natural environment selects those systems that are able to best adapt to its infinite variation. In economic evolution, the market is a combination of financial, production, trading, cultural, organisational and regulatory elements which adapt to and influence a constantly changing ecological, social and business environment.

In essence, economic and financial systems have been fundamentally misclassified. They are not perfect self-regulating systems. They are enormously complex adaptive networks, made up of individual agents which interact dynamically in response to changes in their environment- not merely through simple price setting mechanisms, tax or interest rate cuts, liquidity injections or job creation programs. They must be understood and managed at a far deeper level.

Modern evolutionary theorists believe that evolution is a universal phenomena
and that both economic and biological systems are subclasses of a more general and universal class of evolutionary systems. And if economics is truly an evolutionary system and general laws for evolutionary systems exist, then it follows there are also general laws of economics which must be harnessed. This contradicts much of the standard theory in economics developed over the past one hundred years.

The economic ecosystem is now fed by trillions of transactions, interactions and non-linear feedback loops daily. It may in fact have become too complex and interdependent for economists and governments to control or even understand. It may therefore, as several eminent complexity theorists have recently stated, be on the verge of chaos. Too much or not enough regulation can distort the outcomes further- creating ongoing speculative pricing bubbles or supply and demand distortions.

There is now an urgent need to understand at a much deeper level the genie that modern civilisation has engineered and now let loose. This can only be done by admitting the current crumbling edifice is beyond repair and building a radical new model from ground zero; a system that incorporates the hard science of network, behavioural and complexity theory.

A new adaptive evolutionary model is not only essential- it is the only option.