2014.05.19 - oecd-eclac workshop_session 1_alan kirman

Economic Policy and Complexity

Alan Kirman Aix Marseille University and EHESS

presenta;on at the ECLA OECD workshop May 2014

Complex Collapse


Complex collapse

•  The Western Antarc;c Ice Sheet is now subsiding into the sea more rapidly than previously. Furthermore, this process is now irreversible, according to two ar;cles in Science (Ian Joughin et al. 2014) and Geophysical Research LeTers (Rignot et al. 2014). This will lead to a « short term » rise in sea level of over one metre and a longer term rise of much greater magnitude.

•  Anthropogenic causes are an important part of the explana;on


Complex collapse 2 •  Why is this of interest to economists? •  First, because it is claimed that human behaviour has been, in part, responsible for the changes that have led to the collapse (already forecast by John Mercer Nature (1978))

•  Secondly, because the nature of the causality is not as simple as might be thought.

•  The obvious argument is that rising air temperatures caused by increasing CO2 emissions have increased sea temperatures and that this has caused the mel;ng.


Complex collapse 3 •  In fact the mechanism is more indirect. Stronger winds have pushed warmer water which rises naturally towards the Antarc;c region. These are caused, it is claimed, by global warming.

•  This coupled with the increased Ozone hole, due in part to the emission of aerosol gases has led to the change in the ice sheet’s stability.

•  « There is no stabilising mechanism » as one of the authors said.

•  Changing the things which we can control will not help now to prevent the phenomenon but could slow it.

•  The system has self organised into an unstable state.


Lessons for economists

•  We also are faced with a complex adap;ve system over which we have very limited control.

•  Some;mes it is not always possible to reverse the consequences of well-‐inten;oned but erroneous measures.

•  The way in which the system self organises creates its own dynamics and incen;ves.


Economists and Climatologists •  The results men;oned previously are, in one paper, the result of data analysis not of computer models

•  Climatologists have usually been cri;cised for their models not for their data analysis

•  Economists have rejected cri;cism of their models usually with the argument that those who proffer the cri;cism do not understand the mathema;cal analysis.

•  Many economists have expressed an unwavering faith in our models even acer the crisis.


Two basic approaches

The standard approach •  Our models must be built on

sound microfounda;ons •  Lucas, one should only make

assump;ons about individual characteris;cs

•  Individuals should sa;sfy economists’ axioms of ra;onality

•  They should op;mise in isola;on •  They undertand the economy

they func;on in. •  Aggregate behaviour is like that

of a ra;onal « representa;ve agent »

The economy as a complex system

•  Individuals follow simple rules •  They adapt to their

environment. •  They are not irra;onal and do

not act against their own interest

•  They have limited and largely local informa;on

•  Aggregate behaviour emerges from the interac;on between individuals.


Confidence in our theory The “central problem of depression-‐preven;on has been solved,” , Robert Lucas 2003 presiden;al address to the American Economic Associa;on.

In 2004, Ben Bernanke, chairman of the Federal Reserve Board, celebrated the « Great Modera;on » in economic performance over the previous two decades, which he aTributed in part to improved economic policy making. Our models func;oned well during this period but would not any model have done so? We need models to help us understand and deal with crises


Crises as Rare Events

•  “With notably rare excep;ons (2008, for example), the global “invisible hand” has created rela;vely stable exchange rates, interest rates, prices and wage rates.”

•  Alan Greenspan, Former Chairman of the Federal Reserve Bank





•  “With notably rare excep;ons, Germany remained largely at peace with its neighbours during the 20th century.”





•  “With notably rare excep;ons, Germany remained largely at peace with its neighbours during the 20th century.”

•  “With notably rare excep;ons, Alan Greenspan has been right about everything.”

•  Comments on the blog Crooked Timber presenta;on at the ECLA OECD workshop

May 2014

The view of those responsible in the U.K

•  « But there is also a strong belief, which I share, that bad or rather over-‐simplis;c and overconfident economics helped create the crisis. There was a dominant conven;onal wisdom that markets were always ra;onal and self-‐equilibra;ng, that market comple;on by itself could ensure economic efficiency and stability, and that financial innova;on and increased trading ac;vity were therefore axioma;cally beneficial. »

Adair Turner, Head of the U.K. Financial Services Authority


So in summary your majesty, the failure to foresee the ;ming, extent and severity of the crisis …was principally the failure of the collec;ve imagina;on of many bright people to understand the risks to the systems as a whole. Reply to the queen by the BriBsh Academy


Bob Shiller

•  Of course, the problem with economics is that there are ocen as many interpreta;ons of any crisis as there are economists. An economy is a remarkably complex structure, and fathoming it depends on understanding its laws, regula;ons, business prac;ces and customs, and balance sheets, among many other details.


Bob Shiller •  Yet it is likely that one day we will know much more about

how economies work – or fail to work – by understanding beTer the physical structures that underlie brain func;oning. Those structures – networks of neurons that communicate with each other via axons and dendrites – underlie the familiar analogy of the brain to a computer – networks of transistors that communicate with each other via electric wires. The economy is the next analogy: a network of people who communicate with each other via electronic and other connec;ons.


Bob Shiller The brain, the computer, and the economy: all three are devices

whose purpose is to solve fundamental informa;on problems in coordina;ng the ac;vi;es of individual units – the neurons, the transistors, or individual people. As we improve our understanding of the problems that any one of these devices solves – and how it overcomes obstacles in doing so – we learn something valuable about all three.

hTp://www.project-‐syndicate.org/commentary/the-‐neuroeconomics-‐revolu;on#01DugqtByVO8W50F.99


Mo;va;on

•  There has been a growing dissa;sfac;on with exis;ng models of the economy

•  Many cri;cisms have come from those who have to make policy

•  They blame the unsa;sfactory nature of the models which have come to be viewed, wrongly, as an increasingly sophis;cated vision of how the economy works.


Mo;va;on •  My basic claim is that the basic problem lies with the passage from the microeconomic analysis which we purvey, to the aggregate behaviour of the economy.

•  Aggregate behaviour is not the sum of nor the average of individual’s behaviour.

•  As is widely recognised in other disciplines such as physics, biology and sociology the behaviour of a complex system of interac;ng agents is intrinsically different from that of its individual components.


Mo;va;on

•  What we have to be able to reproduce is the sudden, endogenous changes that occur at the aggregate level without having recourse to exogenous shocks.

•  Our models of ra;onal individuals do not allow us to achieve this.

•  Op;misa;on at both the individual and collec;ve level is illusory, what should concern us is not so much efficiency but rather coordina;on.


Economists and Models “And the first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask “how come?” – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what acer the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing”.

Speech by Mario Draghi, President of the European Central Bank at the Global Investment Conference in London 26 July 2012


Economists and Models

•  We are so wedded to our models that when they do not correspond to empirical reality, we wonder what the problem with the evidence is


The Ex Governor of the European Central Bank •  When the crisis came, the serious limita;ons of exis;ng

economic and financial models immediately became apparent. Arbitrage broke down in many market segments, as markets froze and market par;cipants were gripped by panic. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. As a policy-‐maker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conven;onal tools. In the absence of clear guidance from exis;ng analy;cal frameworks, policy-‐makers had to place par;cular reliance on our experience. Judgement and experience inevitably played a key role. Trichet (2010)


Economists’ Recommenda;ons

•  Undertake structural reforms (a.k.a reduce unit wage costs and make labour market more flexible)

•  All of this is on the basis of what theory? •  We are faced with a combina;on of policy measures based on ideology rather than on analysis


Tough Medicine


Alterna;ves

•  Macro modellers have added imperfec;ons and fric;ons to their models to beTer account for observed data but these are as ad hoc as the alterna;ves they cri;cise.

•  Alterna;ves have been proposed from ABM to more Behaviourally oriented models, to sta;s;cal physical models, to more inclusion of networks. None of these is a complete and comprehensive answer but almost any would seem to be preferable to the current models.


Analysis? •  Two things have awakened public scep;cism about the value of

economists’ analysis •  The IMF’s mistake on the fiscal mul;plier •  The famous Reinhart Rogoff 90% threshold •  Both mistakes have been used to jus;fy austerity measures. •  We should use some of the army of economists employed by the

central banks, the EU and the OECD for example to check on the theore;cal validity or the empirical accuracy of the analysis

•  Our basic problem is that our recommenda;ons are s;ll predicated on the idea that the current economic system is s;ll essen;ally self-‐organising and achieves efficiency with the minimum of interference.

•  We need models which explicitly produce endogenous crises


Quiet Withdrawal


Income and Wealth Distribu;on


Income v Wealth Inequality


What people want and think


What we should do

•  We should use surveys and « Big Data » to find out what people think rather than insist on « ra;onal expecta;ons »

•  Compare the facts and opinions about immigra;on.


•  « A very natural next step for economics is to maintain expecta;ons in the strategic posi;on they have come to occupy, but to build an empirically validated theory of how aTen;on is in fact directed within a social system, and how expecta;ons are, in fact, formed. Taking that next step, requires that empirical work in economics take a new direc;on, the direc;on of micro-‐level inves;ga;on proposed by Behavioralism. »

•  Herb Simon (1984)


Our basic assump;ons: Trichet again

•  First, we have to think about how to characterise the homo economicus at the heart of any model. The atomis;c, op;mising agents underlying exis;ng models do not capture behaviour during a crisis period. We need to deal beTer with heterogeneity across agents and the interac;on among those heterogeneous agents. We need to entertain alterna;ve mo;va;ons for economic choices. Behavioural economics draws on psychology to explain decisions made in crisis circumstances. Agent-‐based modelling dispenses with the op;misa;on assump;on and allows for more complex interac;ons between agents. Such approaches are worthy of our aTen;on.


Conven;onal Recommenda;ons

•  What have been the recommenda;ons to get out of the crisis?

•  Austerity •  We must reduce our debts and deficits •  You know the numbers but Europe has to get back to 3%

•  A meaningless number. Why not Π or e??? •  Wri;ng numbers into trea;es does not make sense.


The perversity of austerity •  Austerity diminishes growth •  But if growth slows the debt becomes even more important •  Why worry about the debt? •  Because the markets will not lend to countries with high debt. •  France has never borrowed at such low rates. •  Markets self organise but when they do so we only look at them if

they comfort our beliefs. •  Why not look at the facts rather than speculate on the basis of our

theories and our ideology? •  There is some no;on of morality here which is inappropriate.


How should we stabilise the system? •  The view that we can set up a new more sophis;cated set of rules and then everything will be under control is illusory.

•  It is based on the idea that there is a « correct » model and that, and if only we can find it we can establish the right rules and leave markets to sort things out.

•  But, in reality there is no reason to believe that self organisa;on is a stable process and furthermore the economy is constantly evolving and and therefore so must the rules.


Overall Conclusions •  We have to accept that unlike in our models, in markets,

informa;on is dispersed across individuals and is not transmiTed through some central signals

•  How things come to be coordinated is what we need to explain •  We should treat macro phenomena as emerging from the intricate

interac;ons between individuals. •  We will never become a “science” in the sense that Walras wanted. •  We have to spend more ;me observing the real evolu;on of the

economy and less ;me”improving” our exis;ng models. •  Policy should be concentrated on influencing the evolu;on of the

economy not on determining it


2014.05.19 - oecd-eclac workshop_session 1_alan kirman

Economy & Finance

inone paper