The ‘living, breathing’ economy

Some time in mid-2008, mortgage defaults reached a critical mass. Wall Street went into free fall, and the US economy began to unravel. Then, like tumbling dominoes, economies around the world followed suit.

How could a few Americans defaulting on mortgages send the world economic system into a tailspin? There are probably as many answers as there are economists – maybe more. But for one school of economic thought, the more fundamental question is, why did almost no one see it coming? For these economists, the recent collapse reveals problems not just with the financial structure, but with how people conceive of and model the economy. A myopia pervades mainstream economic thinking, they charge. It fails to capture the dynamic – and somewhat chaotic – nature of what’s essentially a living system.

“We’re moving from looking at the economy in equilibrium to looking at the economy as a dynamic system that’s always changing,” says W. Brian Arthur, an external professor at the Santa Fe Institute in New Mexico. “It’s very much alive, ever-changing, and it’s never at equilibrium.”

Mr. Arthur envisions the economy as an ever-evolving ecosystem. With this as a starting assumption, it’s immediately clear that examining any part of this ecosystem in isolation, the reductionist approach that has dominated scientific inquiry since at least the Enlightenment – and which dominates economic theory now – will miss potentially game-changing interactions. That’s because self-organizing systems – the neurons that constitute your brain, the bees that make hives, and the humans that create markets – have what are called emergent properties. And it’s near impossible to predict these supremely important emergent behaviors by examining just the parts of the whole.

Consider the recent collapse. One version of its unfolding goes like this: After the dotcom boom and bust at the turn of the millennium, investors sought safe investments. Housing seemed to fit that bill. Builders got to building. Lenders lent to aspiring homeowners. Some offered the now-infamous subprime mortgages. These mortgages were bundled up – an innovation – and sold to third-party investors. Money was made at every level. That reinforced the cycle.

More houses went up, more brokers sold more loans, more mortgages were resold. Everyone made money – until the bubble popped. Then everyone began losing money.

“Everyone in that system was acting on perfectly rational decisions, even though the system as a whole was acting insane,” says John Miller, a professor of economics and social science at Carnegie Mellon University in Pittsburgh, Pa. “Everyone could follow the incentives, but those incentives led the system to an emergent behavior that was bad.”

The problem, say Mr. Miller and others, isn’t necessarily that this behavior emerged; it’s that mainstream economic models assume that economies always move toward equilibrium and can’t 
reproduce these bubbles. Our forecasting ability on this all-important aspect of real-world economies is, therefore, next to none.

In a recent essay in the journal Nature, scientists J. Doyne Farmer and Duncan Foley argue that world leaders are “flying the economy by the seat of their pants.” “Aren’t people on Wall Street using fancy mathematical models?” they write. “Yes, but for a completely different purpose: modelling the potential profit and risk of individual trades. There is no attempt to assemble the pieces and understand the behaviour of the whole economic system.”

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