Why didn’t we see it coming?

By James Zuccollo 21/05/2013

A lot of things in economic models are ‘exogenous’ and outside our usual frame of investigation. Not just little, unimportant things but big things, too: innovation and technological change, recessions, bubbles in markets. On some reading of economic models each of these things is unknowable and unpredictable. Obviously that’s far from satisfactory and lots of people are working hard to change things. Via Mark Buchanan, here is an interesting perspective on why things turned out this way:

To look at the economy, or areas within the economy, from a complexity viewpoint then would mean asking how it evolves, and this means examining in detail how individual agents’ behaviors together form some outcome and how this might in turn alter their behavior as a result. Complexity in other words asks how individual behaviors might react to the pattern they together create, and how that pattern would alter itself as a result. This is often a difficult question; we are asking how a process is created from the purposed actions of multiple agents. And so economics early in its history took a simpler approach, one more amenable to mathematical analysis. It asked not how agents’ behaviors would react to the aggregate patterns these created, but what behaviors (actions, strategies, expectations) would be upheld by–would be consistent with–the aggregate patterns these caused. It asked in other words what patterns would call for no changes in micro-behavior, and would therefore be in stasis, or equilibrium. (General equilibrium theory thus asked what prices and quantities of goods produced and consumed would be consistent with—would pose no incentives for change to—the overall pattern of prices and quantities in the economy’s markets. Classical game theory asked what strategies, moves, or allocations would be consistent with—would be the best course of action for an agent (under some criterion)—given the strategies, moves, allocations his rivals might choose. And rational expectations economics asked what expectations would be consistent with—would on average be validated by—the outcomes these expectations together created.)

If we assume equilibrium we place a very strong filter on what we can see in the economy. Under equilibrium by definition there is no scope for improvement or further adjustment, no scope for exploration, no scope for creation, no scope for transitory phenomena, so anything in the economy that takes adjustment—adaptation, innovation, structural change, history itself—must be bypassed or dropped from theory.