“If a blind man leads a blind man, both will fall into a pit,” says the Bible. Time and again there have been pits. The Asian crisis, dot com bubble, 2008 crisis, euro crisis. Some were small. The others, not so much. The crisis of 2008 was a pretty steep fall in our road to singularity. Economists and economics as a profession have come under fire for not being able to predict the crisis.
Economics, like other sciences, is tasked with observing and theorizing the world — In the words of Deirdre McCloskey, the economist is tasked with “not just brute observation, but sheer observation.” One must look for finer details. Drawing from other sciences, over time, economists found certain dynamics which guide the world — forces at play that determine the workings of the world. As cross-disciplinary studies grew, people from other fields such as philosophy, anthropology, finance brought in different perspectives on the workings of the world.
Positive and negative feedback loops
Interactions are connected through a network of feedback loops, be it positive of negative. These are self-reinforcing logics that drive free market forces in a particular direction. During the run up to the crisis, a feedback loop existed which seemed to make NINJA loans rational. Upward pressures on property prices outgrew those on interest rates. As the years passed by and property inflation outdid interest rate increases, the logic kept getting reinforced.
Popularized by George Soros, the theory of reflexivity gained attention after the 2008 crisis as people sought an explanation. Reflexivity is “imperfect views can influence the situation to which they relate through the actions of the participants” . George Soros suggests that there are two parts to the workings of the market: thinking and reality. A thinking participant performs two functions: Observing and understanding the world (cognitive function), and impacting and interacting with the world (manipulative function). When both of these are at play at the same time, neither of them are truly independent. This causes a recursive relation between the two. One’s view influences the behavior of the other and vice-versa. When applied to the market, this implies a two-way feedback loop between price and information and not a unidirectional flow from information to price.
Markets are susceptible to crises as they move away from equilibrium. Such crises give rise to regulatory reforms. But during the intermittent phase, there is continuous interaction between the two. When regulators act, markets react as part of a feedback loop. Regulators react to the acts of the market. The lines between cause and effect get blurred when they occur simultaneously. The feedback loops created are “initially self-reinforcing but eventually self-defeating”. This was seen in the case of the 2008 crisis as well as the Euro crisis.
Michael Callon put forth the idea that “economics does not describe an existing external ‘economy’, but brings that economy into being: economics performs the economy, creating the phenomena it describes”. Donald MacKenzie and other sociologists have further built upon this view.
Performative utterances refer to acts or words which “alter reality simply by being pronounced under the right conditions”. The phenomena of performativity can be seen in the case of credit rating agencies and how participants react to them. Investors across the world had started showing interest in India by 2003. They considered India investment grade and Net FII investment surged to INR 31,327 crores in 2003 from INR 3,733 crores the previous year. Despite this huge surge, it wasn’t until the credit rating agencies declared India investment grade that net investment by FIIs reached INR 75,967 crores.
Performativity also shows how flawed humans beliefs manifest and change the fundamentals of the real world.
Contagion refers to “an episode in which there are significant immediate effects in a number of countries following an event”. A more technical definition would be that given by Matt Pritisker – “Contagion occurs when a shock to one or a group of markets, countries, or institutions, spread to other markets, or countries, or institutions”. These effects are “fast and furious” and unfold over hours and days. The 2008 was a case of contagion where an event in one part of the world almost immediately triggered incidents in other parts. These act through channels such as herding, trade linkages, financial linkages, etc.
Complexity is like the word economics when it comes to definition. There are multiple ways of defining it, but it is finally determined by the specific context in which it is used. Complexity is that which emerges from the interactions among elements as opposed to the characteristics of those elements. It studies the emergent system behaviour in a system arise from its interacting parts. It looks at the system as a whole rather than a sum of its parts.
As we realize the tools we have built fail to predict and help us understand the world around us, we move into another abstract realm which helps us understand behaviour through universal behavioural patterns and underlying principles while looking at the system as a whole.
Complexity borrows upon tools of other fields of study and applies some of these concepts to derive insights into the functioning of that particular system. Economies are being looked at from the perspective of a dynamic system and the interaction among participants rather than a Newtonian system of cause and effect. MIT’s Observatory of Economic Complexity is one such effort.
While individually, we may not comprehend and know everything that is going on, at an aggregate or collective level, the system is aware and pushes on.
– Contributed by Bhargav Dhakappa
Picture Credits: vo.msecnd.net