Looking at the World with One Eye Closed
Neil Irwin, in The Economy That Wasn’t Supposed to Happen: Booming Jobs, Low Inflation, uncovers the mistake that economists made in 2018's projections: the world has changed, but our economics haven't.
In particular, it now appears that recession fears that emerged at the end of 2018 were misguided — especially once the Fed backed off its campaign of rate increases at the start of 2019.
But beyond the assigning of credit or blame, there’s a bigger lesson in the job market’s remarkably strong performance: about the limits of knowledge when it comes to something as complex as the $20 trillion U.S. economy.
The last few years have made it clear that the Phillips curve — the relationship between unemployment and inflation — has either changed shape or become irrelevant.
The breakdown of the old guidelines suggests that policymakers need to avoid overreliance on them, and to stay broad-minded to the full range of economic possibilities. Maybe using data from a few decades in the middle of the 20th century to set policy in the 21st isn’t actually a good idea.
And to make explicit the point Irwin is hinting at, the decades that these guidelines are based on predated the hyper-interconnected world economy of the 21st century. He leaves unanswered what sorts of tea leaves the economists are supposed to read to make their projections. Certainly, we need an economics based on premises suitable to a world dominated by increasing complexity and the uncertainty, volatility, and ambiguity that arises. Notably, Irwin never mentions complexity economics, which has failed to register in the contemporary discussion of the economy, despite being around since the '90s.
Neoclassical economics has failed to predict this unexpected boom because many of its premises are wrong, or at least, overly generalized. Specifically, the notion of homo economicus as a deeply non-social actor who merely attempts to 'maximize his utility,' as Neva Goodwin pointed out in The human element in the new economics: a 60-year refresh for economic thinking and teaching.
Economics will need to be recast to include what we have learned about the biases in human reasoning, our deep social and societal connections, and to move past overly simple linear models. As the world has grown more connected we've passed a tipping point where those approaches fail to shed light on what is happening and what will happen.
We need a new understanding of economics that is grounded in knowing that complex systems are not necessarily in equilibrium, that there is no underlying steady state that the systems return to after perturbations occur.
As W. Brian Arthur wrote,
Complex systems are ones with multiple elements adapting or reacting to the pattern these elements create. The elements might be individual cars reacting to cars in front or behind them, to the "traffic" patterns they form. In complexity, individual elements adapt to the world—the aggregate pattern—they co-create. With the economy, agents — whether they are banks, consumers, firms, or investors — continually adjust their market moves, buying decisions, prices, and forecasts to the situation these moves or decisions or prices or forecasts together create. So complexity is a natural way to look at the economy. In a way this viewpoint isn't new. Adam Smith pointed out that aggregate patterns form from individual behavior and individual behavior responds to those aggregate patterns. This is really an economics of things coming into being and it focuses on patterns forming, structures changing, and the consequences of permanent disruption.
In complexity economics we ask how agents react to the aggregate pattern they create. That's the natural question, but it's complicated. So to seek analytical solutions, economics historically asked instead what agents’ behavior might be consistent with the aggregate pattern it creates—would be in equilibrium with the outcome it creates. General equilibrium theory asks: What prices and quantities of goods produced and consumed are consistent with—would pose no incentives for change to—the overall pattern of prices and quantities in the economy’s markets? Classical game theory asks: What strategies, moves, or allocations are consistent with—would be the best course of action for an agent (under some criterion)—given the strategies, moves, allocations his rivals might choose? Complexity economics by contrast asks how actions, strategies, or expectations might endogenously change with the patterns they create. It is a nonequilibrium approach.
Arthur makes an argument that may in part answer to the question Irwin almost-but-not-quite poses: what is being left out of the thinking about the economy that allows such bad forecasts? He has a theory that there are two great questions in economics:
One is allocation within the economy: how quantities of goods and services and their prices are determined within and across markets. This is represented by the great theories of general equilibrium, international trade, and game-theoretic analysis.
This is why economics, historically, has been commonly defined in terms of the study of scarcity.
Arthur goes on:
The other is formation within the economy: how an economy emerges in the first place, and grows and changes structurally over time. This is represented by ideas about innovation, economic development, structural change, and the role of history, institutions, and governance in the economy.
The allocation problem is well understood and highly mathematized, the formation one less well understood and barely mathematized.
Complexity economics looks at structures forming in the economy, so it's just as much concerned with formation as with allocation.
So I will offer one observation to the discussion that Irwin wants to have: economists have failed to develop new guidelines that are based on the new structures that have formed in the economy in the past decade or two, such as the rapid and pervasive emergence of platform ecosystems, and the enormous impact they have had. (Just consider the differences between linear supply chains and non-linear ecosystems.)
There was nothing remotely like Amazon or Alibaba thirty years ago. There was no parallel to the global spread of smartphones and their app stores. And likewise, the impact of web and mobile advertising by Google, Facebook, and others on the media landscape has no precedent. None of these ecosystemic phenomena are included in the long-established and now outmoded economic models, like the Phillips Curve.
Applying Arthur's two-great-questions insight, we could say that economists have been viewing the world with one eye closed. They've focused so much on allocation that they have missed the formation of new structures in the economy, the rise of new 'institutions' (or something like them), and the patterns that are rippling through a changed world. We'll have to have a new generation of economists asking a different set of questions — with both eyes open — if we are ever going to find those patterns and understand the new foundations from where they arise.
Sign up for On The Horizon's free weekly newsletter to keep informed on new writing, related thinking, events, and other activities.