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Tuesday, January 16, 2007

An Edifice of Sand?

Martin Wolf looks at "complexity economics" and the evolution of economic systems:

Standard economics and the 'evolution' thesis can coexist, by Martin Wolf, Commentary, Financial Times: Is the discipline of economics built on sand? Most economists would answer with a resounding "no". But most must also know that the economy is not characterised by perfect foresight and equilibrium...

This gap between how economists think and what economies are is evident... But hitherto nobody has closed the gap... This, argues McKinsey's Eric Beinhocker in a brilliant, thought-provoking and wide-ranging book ... is about to change. Welcome, he argues, to the world of "complexity economics", computer-based simulations and more realistic assumptions. ...

"The economy is a marvel of complexity," he states. "Yet no one designed it and no one runs it." How can such a system have been created? Why has complexity increased over time? Why has so much of the rise in wealth and complexity been so sudden? The answer to these questions can be found, suggests Mr Beinhocker, in understanding that the economy is "a complex adaptive system", which works under the same logic as biological evolution - differentiate, select and amplify.

Conventional economics cannot explain such an evolutionary process, because the science that has provided most of its ideas is not biology, but physics. ... As Mr Beinhocker puts it: "The economy is ultimately a genetic replication strategy. It is yet another evolutionary Good Trick . . . built on the complex Good Trick of big brains, nimble tool-making hands, co-operative instincts, language and culture." So successful is the economy that much of humanity no longer has to focus on staying alive. ...

How has today's economy evolved? The answer is: through the interaction of three processes. The first is the evolution of physical technology, which spurted after the scientific revolution of the 17th century. The second is the evolution of social technologies, such as money, markets, the rule of law, the corporation and democracy. The third is the evolution of businesses, the entities that live, die and replicate in the economy.

Economic evolution and biological evolution are different: the fact that human beings can plan and adapt makes economic evolution faster and more purposive than biological evolution. But it is still evolution. ...

As Mr Beinhocker puts it: "Markets win over command and control, not because of their efficiency at resource allocation in equilibrium, but because of their effectiveness at innovation in disequilibrium." Markets are a hugely powerful evolutionary mechanism: they are innovation machines.

Is this thesis true? Is it useful? Does it replace standard economic analysis? The answers to these questions, I believe, are: yes; yes; and no.

First, today's economy has indeed evolved. ... Second, this way of thinking is extremely useful. The book explains, for example, why most companies fail to sustain competitiveness. ... As Mr Beinhocker notes: "Companies don't innovate; markets do." So businesses should think in terms of evolutionary adaptability. But they find this difficult, because they are far better at executing plans than adapting to unforeseen circumstances. That is the price they pay for hierarchy.

Finally, what does "complexity economics" mean for economics? Much less than Mr Beinhocker imagines, I believe. Even such great evolutionary theorists as William Hamilton and Maynard Smith also used equilibrium models. Similarly, the economist's simplification of human motivation is often the only way to make a complex problem tractable. The implications of the ad hoc, computer-based simulations Mr Beinhocker recommends are often difficult to understand. Above all, traditional economics often works: look at the success of inflation targeting or at the benefits of trade. ...

If you are interested in more along these lines, see What Economists Can Learn from Evolutionary Theorists.

    Posted by on Tuesday, January 16, 2007 at 06:30 PM in Economics, Methodology | Permalink  TrackBack (0)  Comments (10)


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