Bill's Notebook

As the first decade of the 21st Century ends, I hope that the economic events of the last thirty-five years finally loosen the hold that neoclassical economics has on public policy.  It is widely recognized that the accepted economic models that governments use to shape policy are just not empirically valid.  Today’s economies are vastly different from the industrial revolution economies that shaped neoclassical economic theory.  Yet, these theories are the basis for setting interest rates, regulating the stock market, determining the level of environmental protection, almost every aspect of government regulation (Smith 2010, p. 65).  It is time to modernize the economic theories that are used to guide government and economic policies.

The case against neoclassical economics has been growing in recent years.  As Yves Smith (2010) details in her book:
1)  Economics is not a real science because it is difficult to do the empirical evidence to validate the models economist develop from their assumptions (pp. 20-21).
2)  Many of the core assumptions of neoclassicism (people are totally rational, have complete information, only act to maximize utility, etc.) have been disproved by experiments in behavioral economics (pp. 94-97).
3)  Despite the fact that they are working with faulty assumptions, economists claim that the implications derived from the assumptions are still valid because they are good approximations of reality (p. 41 and pp. 47-48).
4)  Hard sciences also use simplified models to explain phenomena but the crucial difference is that economists add unrealistic properties to validate their models.  For example, economists add the property of perfect information to make supply and demand models work (pp. 48-49).

Some economists counter by admitting that neoclassical economics has these problems but the cure is to do more empirical research.  But with more empirical research, the neoclassical assumptions are giving way to a new economic theory – complexity economics.

Eric Beinhocker (2007) surveys the rise of complexity economics in which researchers apply complexity and network theory concepts to economic activities.  The main advantage of complexity economics is that its assumptions can be empirically validated and that its findings apply to modern economic phenomena.  Thus, this is a better basis upon which to base policy decisions.

Beinhocker’s  (2007) core argument is easy to understand.  Businesses use a mixture (business plan) of physical technologies and social technologies to compete with other businesses.  The businesses that have more fit business plans out-compete businesses with less-fit business plans.  Based on this model Beinhocker details several implications for policy makers:
1)  The role of markets is to process the immense amount of information from buyers and sellers into the most coordinated and effective manner while also determining how fit a business is.  Thus free and open markets must be maintained by regulations that do not impede the flow of information available to all parties (p. 423).
2)  Government’s role is to provide and preserve the vast array of social technologies that make it possible for businesses and markets to exist.  Social technologies such as contract law, antitrust enforcement, and securities regulation (p. 425).  Therefore, government plays an important role in shaping the fitness determination role of markets (pp. 426-427).
3)  Behavioral economics indicates what kind of social programs will be more readily accepted and politically-supported.  People will support aid programs that have strong reciprocity – programs designed to help people become functionally independent (pp. 418-421).
4)  Countries that score higher on measures of societal trust also have higher economic performance than countries with lower societal trust scores (pp. 432-433).  Thus, an important role for American government is to build up social capital in the U.S. (pp. 439-440).

As the above demonstrates, government has a vital role in preserving and strengthening the U.S. economy.  The argument of neoclassical economics that government should have little or no role in market economies is a false one and has led to extreme reactions from the Left and the Right.  With a clearer understanding of government’s actual role in the U.S. economy policy makers can craft effective policies that preserve the best features of the market system while building up the necessary social capital to strengthen the economy and serve the U.S. people.  We just need to move beyond the false answers given by neoclassical economics to the insights of complexity economics.

References:
Beinhocker, E.D. (2007). The origin of wealth: The radical remaking of economics and what it means for business and society. Boston, MA: Harvard Business Press.

Smith, Y. (2010). Econned: How unenlightened self interest undermined democracy and corrupted capitialism. New York: Palgrave MacMillan.

Further Reading:
Berreby, D. (2005). Us & Them: The science of identity. Chicago: The University of Chicago Press.

Cassidy, J. (2009). How markets fail: The logic of economic calamities. New York: Farrar, Straus, and Giroux.

Lehrer, J. (2009). How we decide. Boston: Houghton Mifflin Harcourt

Pfaff, D.W. (2007). The neuroscience of fair play: Why we usually follow the golden rule. New York: Dana Press.

Schelling, T.C. (2006). Micromotives and macrobehaviors. New York: W.W. Norton & Company.

Shermer, M. (2008). The mind of the market: Compassionate apes, competitive humans, and other tales from evolutionary economics. New York: Times Books.

Stiglitz, J.E. (2010). Freefall: America, free markets, and the sinking of the world economy. New York: W.W. Norton & Company.

Thaler, R.H., & Sunstein, C.R. (2009). Nudge: Improving decisions about health, wealth, and happiness. New York: Penguin Books.

Ubel, P.A. (2009). Free-market madness: Why human nature is at odds with economics – and why it matters. Boston, MA: Harvard Business Press.

Great story on how network analysis can explain the 2008 collapse.  Look at the four network diagrams in the middle of the article.  You can see the various sectors of the economy gradually merge together.  The most alarming trend is how real estate went from an almost isolated sector to being the center of the combined networks.  Graphic proof of how the growing interdependence between the sectors fueled by increasingly exotic investment instruments short-circuited the regulatory safeguards of  the economy.

A book that I constantly recommend is Beinhocker’s The Origin of Wealth for two reasons. First, Beinhocker demonstrates how traditional economics is inadequate for explaining today’s economic systems. Second, he introduces complexity economics which is still developing but does a much better job in describing how real-world economies work and how people behave economically. To illustrate, let me give a simplified description of his core theory.

You start with a business plan. A business plan is a description of how you will meld physical technologies and social technologies to create a business that competes in an economy. Physical technologies (PT) are “methods and designs for transforming matter, energy, and information from one state into another in pursuit of a goal or goals.” Social technologies (ST) are the “methods and designs for organizing people in pursuit of a goal or goals.” Your business then competes with other businesses on the economic fitness landscape.

The best way to think of a fitness landscape is to imagine a square piece of land with hills and valleys. Businesses want to climb as high as they can on the highest hills because the higher you are up on a fitness landscape the more successful you are. Conversely, if you are in a deep valley you are failing in being fit on that landscape. Various factors determine fitness such as profitability, customer relations, and so on.

So, what does this have to do with Gov 2.0 or government in general? Replace business plan with plan and business with either project or program. You still have PT and ST but instead of building a business to compete on an economic fitness landscape, you are building a project or program to compete in government agency fitness landscape or policy area fitness landscape. This may seem rather abstract but this new perspective helps to consider fundamental questions about your Gov 2.0 project.

1. What are the factors that determine fitness in your landscape? Is it citizen engagement, cost-efficiency, and ease of implementation? Or is it increased collaboration and knowledge generation? Understanding what constitutes success will help to determine what the goal or goals should be for your Gov 2.0 project.
2. What PT an ST will the project need? How will these technologies blend together? Are there barriers to a good blending? Will the proposed blend fulfill the fitness factors more effectively than other blends?
3. How do I know if the Gov 2.0 project is climbing hills in the fitness landscape? How do I find the highest peaks in the fitness landscape and keep the Gov 2.0 project from being stranded on a smaller peak? How do I keep the Gov 2.0 project out of the valleys?
4. What do I do if the fitness landscape shifts? How do I determine when the fitness landscape shifts and what can I do to move the Gov 2.0 project so it stays on the peaks?

Another concept from Beinhocker that is also useful to government agencies is the idea of social architecture. Social architecture determines how adaptable an organization is and is composed of three factors:
1. Behaviors of individuals in the organization (Mental Models)
2. Structures and processes that align people and resources in pursuit of the organization’s goals.
3. The emergent culture that arises from people’s interactions with each other and their environment.
A robust social architecture gives the organization better abilities to determine the shifts in the fitness landscape and to better adapt to the shifts.

The advantages of the fitness landscape perspective is that it starts the dialogue on what the goals of the the Gov 2.0 project are and how the current environment will help or hinder reaching those goals. It also requires an honest assessment of the agency’s abilities to understand their current environment and to adapt when the environment changes. Beinhocker’s book is dense with ideas but he writes in a approachable style and his last chapter is especially vital in understanding government’s role in complexity economics.

Reference:

Beinhocker, E.D. (2006). The origin of wealth: The radical remaking of economics and what it means for business and society. Boston: Harvard Business Press.

In my previous blog, I wrote several posts praising Eric Beinhocker’s The Origin of Wealth.  It is a brilliant application of complexity theory to economics that demonstrates the failure of classical economic theory.  As Beinhocker explains, early economists attempted to make economics more scientific by grafting classical physic theories onto the field.  The most pervasive concept was “equilibrium” which has guided economic thought since the 1800s.  It was this central concept that has divorced economic theory from economic reality as Beinhocker successfully demonstrates in Part One of his book.  A better explanation of what really happens in economic systems is the interaction of autonomous agents acting in a complex and evolving fitness landscape.

I was reminded of Beinhocker’s book when I read John Cassidy’s How Markets Fail: The Logic of Economic Calamities.  Cassidy recounts the economic history of the last hundred years to explain the market failures of 2008 and 2009.    Like Beinhocker, Cassidy also blames the emphasis on equilibrium in classical economics to blinding economists like Greenspan to the realities of how economic systems actually work (as Greenspan himself admits in the book’s introduction).  Even though Cassidy calls his conclusions “reality economics,” his descriptions of subprime mortage market and the near-failure of the market giants are great examples of complexity economics.   In fact, it is hard not to read Part Three of How Markets Fail without thinking of how complexity economics (Part Two of The Origin of Wealth) can much better explain the events of 2008 and 2009 better than traditional economic theories.

How Markets Fail is an important book and another great argument on rethinking economic theory.  Why this is important to government is that efforts to fix the economy are based on outmoded theories which only go to make the situation worse.  By adopting complexity economics, governments can better treat economic issues and help sustain the market system.