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Complexity, modesty and economic policy

14 September 2016
by Guest author

NAECLex Hoogduin, University of Groningen and GloComNet

Societies and economies are complex systems, but the theories used to inform economic policies predominantly neglect complexity. They assume for example representative agents such as a typical consumers, and they also assume that the future is risky rather than uncertain. This assumption allows for the application of the probability calculus and a whole series of other techniques based on it.

In risk situations, all potential outcomes of a policy can be known. This is not the case in situations of uncertainty, but human beings, policy makers included, cannot escape having to take their decisions and having to act facing an uncertain future. The argument is one of logic. Human beings cannot know now what will be discovered in the future. Future discoveries may however impact and shape the consequences of their current decisions and actions. Therefore, they are unable to come up with an exhaustive list of potential outcomes of a policy decision or action.

Properly taking into account the complexity of the economy and the uncertainty of the future implies a paradigm shift in economics. That paradigm does not need to be developed from scratch. It builds on modern complexity science, neo-Austrian economics (in particular Hayek and von Mises), as well as the work of Keynes and Knight and certain strands of cognitive psychology (for example, Kahneman 2011). There is no room here to elaborate on the theory and the claim that it entails a paradigm shift. Rather, I will discuss the implications for economic policy that follow from this paradigm.

This starts with the recognition that the future cannot be predicted in detail. We should be modest about what can be achieved with economic policy. This is the “modesty principle”. Economic policy cannot deliver specific targets for economic growth, income distribution, inflation, the increase of the average temperature in four decades from now, etc. Economic policy makers would be wise to stop pretending that they can deliver what they cannot. This insight implies that many current policies should be discontinued. To mention just one example: inflation targeting by central banks does not pass the modesty test.

This principle also implies refraining from detailed economic forecasts as a basis for policy making and execution. Policies should not be made on the assumption that we know the value of certain variables which we cannot know. An example here is the income multiplier in relation to changes in fiscal policy. The modesty principle also flashes red for risk-based regulation and supervision.

What economic policy can do is contribute to the formation and evolution of a fit economic order, and avoid doing harm to such an order, what I would call the “do no harm principle”, and be as little as possible a source of uncertainty for private economic agents.

Order is a central concept in the alternative paradigm, replacing the (dis)equilibrium concept in mainstream economics. An order is the set of possible general outcomes (patterns, like growth, inflation, cyclicality, etc.) emerging from purposefully acting and interacting individuals on the basis of a set of rules in a wide sense (laws, ethics, conventions…), together called a regime. Economics can analyse the connection between changes in regime and changes in economic order. Economic policy can influence the economic order through changing the regime.

However, this knowledge is not certain. There is always the potential for surprises (positive and negative; opportunities and threats) and unintended consequences. Policy can therefore not be designed first and then just be executed as designed. Policy making and execution have to evolve in a process of constant monitoring and adaptation. This would also allow for evolutionary change. An economic order that is not allowed to evolve may lose its fitness and may suddenly collapse or enter a crisis (as described by Scheffer for critical transitions in society). This mechanism may have played a role in the Great Moderation leading up to the financial crisis of 2007/2008 and in the crisis of fully funded pension systems. It is also a warning against basing sustainability policies on precise temperature targets decades in the unknowable future.

Fitness of an order has five dimensions. The first is an order in which agents are acting as described in the previous paragraph – policymaking involves a process of constant monitoring and adaptation. In addition to that, fitness is determined by alertness of agents (the ability to detect mistakes and opportunities); their resilience (the ability to survive and recover from mistakes and negative surprises); adaptive capacity (the ability to adjust); and creative capacity (the ability to imagine and shape the future). Policies may be directed at facilitating economic agents to improve these capacities, although constrained by the “modesty” and “do no harm” principles. Note that the concept of stability does not appear in the definition of fitness. This marks a difference with current policies which put much emphasis on stability.

In its own actions the government should be transparent and predictable. The best way to do that seems to be to follow simple rules. For example in fiscal policy, balance the budget, perhaps with clearly-defined, limited room for automatic stabilisers to work.

This alternative paradigm places highlights some methods and analytical techniques, including narrative techniques), network analysis), evolutionary logic), qualitative scenario thinking, non-linear dynamics (Scheffer), historical analysis (development of complex systems is path dependent) and (reverse) stress testing.

Economic policies developed along these lines help people to live their lives as they wish. They are good policies for good lives.

Useful links

The OECD is organising a Workshop on Complexity and Policy, 29-30 September, OECD HQ, Paris, along with the European Commission and INET. Watch the webcast: 29/09 morning29/09 afternoon30/09 morning

2 Responses leave one →
  1. September 14, 2016

    “The modesty principle also flashes red for risk-based regulation and supervision.”

    Indeed, regulators when developing their risk weighted capital requirements for banks, used ex ante perceived risks and not the possible ex post risks conditioned by the ex ante perceptions of risk… and that messed up our whole bank system and caused and is causing a lot of harm.

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