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The promises and the challenges of the research aimed at changing the economic paradigm

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Paolo Magrassi

www.magrassi.net

Excerpt from a paper currently under peer-review for publication in the proceedings of an international com-

puter science conference.

One “problem” of the 21st century world, particu- ken into a sum of mutually independent sub-

larly the economic and business worlds, is the phe- problems. When, on the contrary, the various as-

nomenal and increasing number of connections and pects/components interact with each other so as to

interactions. render impossible their separation for solving the

problem step by step or in blocks, then the situation

Financial markets are strongly interconnected.

is non-linear, or “complex”.

Economies are interconnected due to globalization.

Networks, such as power grids or transport, are in- Many systems can be highly complicated (from the

terconnected. Consumers are interconnected, and Latin complico, to fold) without being complex. For

influence each others’ behaviours, via communica- example, an anatomy book describing the taxon-

tions forms of all sorts. omy of the human body is very complicated: it

takes many volumes and a long time of reading, to

unfold the system completely and master the name

and the functional role of every individual compo-

nent. Still, the whole is equal to the sum of its parts.

In anatomy, a body is a set of organs.

By contrast, physiology is, in addition to compli-

cated, complex (complector: to encircle, to com-

prise, to unite under a single thought), because it

entails the study of the influences that each and

Increasing connectivity means that markets, prices, every organ can exert on others. One thing are the

supplies, demands, consumers, companies are all components; another thing is the system, even

more and more interacting and consequently giving though it is made of those and only those compo-

raise to enormous degrees of what mathematicians nents.

call non-linearity, a.k.a. complexity.

Linearity can be a useful approximation

And complexity often brings with it unexpected

phenomena, such as chaos and emerging behaviour, The “systems” and the “problems” that are encoun-

that can become threats for the survival of eco- tered in nature are essentially non-linear.

nomic agents. However, in many situations, one can resort to line-

Complexity can explain why illustrious analysts arity as a first-order approximation: if the effects of

and the mainstream of economic research can be non-linearity can be considered negligible, a

caught by surprise when global financial markets mathematical model can be built that represents the

collapse and robust economies plunge into deep re- system as if it were linear. This approach is fecund

cessions. in many situations, from electronics to ecology,

from computers to economics.

Let us look at some of the most radical proposals

that have been advanced to fix such situation, and As an example, an audio amplifier is not linear but,

underline as well some of their limitations. within certain frequency limits (i.e., as long as the

wavelength is much smaller than the circuit’s

Complexity physical dimensions), it will behave as if it were

and this is why it is a useful hi-fi device. Conse-

In common parlance, complexity can take many quently, its description throughout the electronics

meanings, but in science it is about non-linear sys- and audio literature will always be that of a linear

tems1. A problem/system is linear if it can be bro- system, even though strictly speaking it is not.

1 Linear models are useful because, within their lin-

Here we are using the dynamic/systemic view of com-

plexity. Another one is possible, i.e. the computa-

ear range, many natural systems resemble one an-

tional/structural one. Ultimately related to Gödel incom- other: their behaviour can be described with the

pleteness theorems, the structural view is predominantly

adopted in information theory and computer science, The two views are ultimately connected, although in sub-

where it has to do with the computability of algorithms. tle and convoluted ways, via the concept of entropy.

1

Paolo Magrassi 2010 - Creative Commons Attribution-Non-Commercial-Share Alike 3.0

same equations even if the contexts are very differ- ability of preys. These, on the other hand, depend of

ent, such as mechanics, electronics, chemistry, bi- the availability of food, and eating too much of it

ology, economics, and so on. A linear oscillator is a would cause the preys population to contract, pos-

model described by the same mathematical equa- sibly beyond sustainability.

tion, whether it be a metal spring, an electric circuit

or a standalone El Niño. The preys–predators–food system is intrinsically

non-linear: none of its components may be studied

(Complex systems, on the contrary, each have their in isolation from the others. And indeed, the Lotka-

own mathematical formalization and, in many Volterra equations are a classical example of simple

cases, not even that: equations are substituted by non-linear model of an ecological situation. Pur-

numerical computer simulations.)

posely simplified, the Lotka-Volterra model may

lead to the formulation of the so-called logistic

Non-linearity map:

Huge scientific and technological advances have xn+1 = r xn (1 - xn)

been made using simplifying linearity assumptions,

before computers started allowing to venture into with x0 representing the initial condition, i.e. the

non-linear territory, giving birth to “complexity sci- initial population at discrete time interval t0.

ence”, a.k.a. “complexity theory”.

There had been, in fact, several explorations of non-

linear territory made by scholars since the 19th cen-

tury. As an example, French mathematician and

physicist Henri Poincaré was the first to discover

how an apparently simple system subject to deter-

ministic laws, such as that composed of three orbit-

ing celestial bodies (e.g., Sun, Earth and Moon),

can exhibit a complex (chaotic) behaviour. Other

scholars, including, e.g., Alexander Bogdanov,

Norbert Wiener and Warren Weaver, made ad-

vances and contributed creating complex system

thinking in the first half of the 20th century.

Figure 1: The logistic map

However, the field has acquired new lymph only

with the advent of electronic computers, as they al- By varying the parameter r, a number of weird

low to simulate whenever mathematics does not do things happen (see Figure 1), particularly for r

the job because equations are unknown. equal or greater than 3.57, when periodic oscilla-

tions (corresponding to the increases and decreases

Fundamental, in this respect, was the work of of a population depending on ecological conditions)

mathematician and climatologist Edward Lorenz. start being replaced by pure chaos.

Lorenz made apparent (Lorenz 1963) and formal-

ized the problem that Poincaré touched upon in his Thus, a “toy” ecological problem can, like Poin-

three-body system: When observing the evolution caré’s three bodies, end in chaos. In addition to sen-

of a complex system, finite variations may originate sitivity to the initial conditions, a second (and re-

from infinitesimal variations in the initial condi- lated) property of complex systems is indeed de-

tions. terministic chaos: the underlying laws (physical,

biological, etc.) may be orderly and even determi-

In other words, even two infinitely similar begin- nistic, yet chaotic behaviour is possible.

nings will look different in the future, because the

evolution of the system will differ substantially in Complex systems can surprise

the two cases, with a divergence ever-larger in time.

Making long-term forecasts becomes impossible in A third essential property of complexity is emerg-

principle. ing behaviour: even when the laws governing its

components are well-known, a complex system

Examples of complexity may show a behaviour that cannot be explained on

those grounds.

A striking exemplification of the above is to be

found in another small system such as the one com- Popular-science literature on complexity tends to

posed of a population of predator animals, a popu- furnish us with examples from the living world or

lation of preys and the food available to the latter. other high-level natural systems (flocks of birds and

A linear model turns out simplistic and inadequate colonies of ants behave in ways inexplicable based

for the situation: the population of preys is a func- on what we know of the capabilities of the indi-

tion of the predators’ population but, in turn, the viduals), however emerging behaviour has been

latter will expand and contract based on the avail- known to physicists since Phil Anderson showed it

2

Paolo Magrassi 2010 - Creative Commons Attribution-Non-Commercial-Share Alike 3.0

in the case of groups of electrons in a semiconduc- These are obviously simplifications of reality, a

tor (Anderson 1972). (This observation, along with fact well-known to economists (Scarf 1960) (Son-

the chaotic behaviour seen in very small determi- nenschein 1972) (Stiglitz 1975) (Anderson 1988).

nistic systems, shows how intimately the natural

It is a known fact that the price of an equity or

world is permeated with complexity).

commodity may influence the price of another one;

It is important to realize that what makes a system that economic agents do not behave rationally (a

complex are the interactions between the compo- Nobel price was awarded in 2001 to Daniel Kah-

nents –the ultimate cause of non-linearity (Bridg- neman for this realization); that markets are per-

man 1927)–, not the number of components them- fectly efficient only under very rare circumstances

selves. What makes it hard to tackle is that, in addi- (Nobel to Joe Stiglitz in 2002 for this proof); and

tion to the laws governing the components, we need that they can occasionally crash abruptedly, going

to study the system’s overall behaviour: the analytic long distances far from “equilibrium”.

approach must be complemented with the holistic

These realizations notwithstanding, economic the-

one.

ory and practices continue to be based on those lin-

Clearly, though, an increasing number of interact- ear simplifications. Models are adjusted here and

ing components will give raise to increasing com- there occasionally, but the perverse effects of non-

plexity, possibly exponentially: complex and com- linearity continue to be considered negligible or not

plicated makes things worse. sufficient to call for a radical overhaul of the para-

digm.

Linear economy

Is the economy becoming non-linear?

That is why, in today’s economic world, we are

more and more often confronted with complexity: it Yet, nearly catastrophic crises seem to occur even

is caused by the number of interactions within (and more frequently. These can be sudden and deep

between) the systems that surround us (Lo 2009), perturbations of global finance or of the “real”

which are complex and complicated at the same economy; or they can take the form of shocks

time. Sources of complexity include: propagating through business’ supply and demand

chains, which are no longer sequential but network-

• global financial systems;

shaped.

• networks (such as the Internet, power grids or

These shocks can have unpredictable repercussions

transport networks);

and affect sectors which appear totally unrelated to

• enterprises, as these are increasingly intercon- those where the crisis burst, and they are a cause for

nected in supply and demand chains, ecosys- concern not just for national and supranational in-

tems, and “clouds”; stitutions and the financial companies, but for en-

terprises in general.

• consumers, since their behaviours are mutually

influencing due to connections of all sorts (TV, The question may thus be raised (Bouchaud 2008):

mobile communications, Web, social networks, are those five assumptions still fair and realistic, in

email). 2010? Are their distortions still of negligible mag-

nitude?

At the heart of the current economic doctrine stand

some crucial linearity assumptions, such as: Think of Einstein’s Relativity. In most of everyday

situations, including some highly sophisticated

1. Markets are almost always at equilibrium or

technologies, we are not concerned about the ef-

slightly around it;

fects of Relativity, because the objects we deal with

2. Markets are efficient, cannot be “fooled”, and do not usually move at speeds close to light’s or

smooth out all imperfections in the large num- travel intergalactic distances. The relativistic effects

bers; are negligible.

3. Buyers and sellers behave rationally; However, GPS systems in our cars and smart

phones would not work unless their hardware and

4. Buyers and sellers take all available informa-

firmware took Einstein’s Relativity into account.

tion into account in forming expectations of fu-

There goes an example where the approximation

ture prices;

«this theory does not matter in practice» was cor-

5. Prices are independent of one another, and each rect 25 years ago but is wrong today: our “models”

moves stochastically in the neighbourhood of have had to be enriched to take into consideration

its expected value (the one in 4), with a Gaus- its practical effects.

sian distribution whose standard deviation is

Similarly, we ought to be careful not to underesti-

the measure of “risk”.

mate the appearance, in the economic world, of

facts that may render obsolete and wrong the linear

3

Paolo Magrassi 2010 - Creative Commons Attribution-Non-Commercial-Share Alike 3.0

approximations underlying the dominating eco- Another one, and considered more promising by

nomic paradigm, which is one of Rational Expecta- many, is heterogeneous mean-field approximation,

tions and Efficient Markets. And a new fact in that where the problem of N interacting particles is

sense is the quantity of interconnections between treated as that of a single particle immersed in a

economic agents, both at the macro and the micro chosen field of forces.

level. (A steep change in quantity can sometimes

Yet another model takes a thermodynamics of non

imply a qualitative change: take 1 gram of paraceta-

equilibrium approach to show the analogy between

mol and your headache will go away; take 100

Prigogine’s dissipative structures and financial

grams, and your life will be in jeopardy).

markets.

Indeed, according to an increasing number of

A vast class of models are agent-based models:

scholars, markets of the 21st century global world

here, the domain under investigation is explored via

can no longer be modelled as linear systems. The

computer-based simulation, a technique much more

linearity assumption will be showing more and

accepted in physics (and chemistry and biology)

more of its flaws as interconnections increase, be-

than in economic research, where, according to

cause interconnectedness is the main source of non-

many, it should be pursued more actively. Numeri-

linearity: its growth beyond a certain threshold is

cal investigation of a model does not prove any-

the fact that makes the linear approximation unreal-

thing, yet provides a formidable tool, a «telescope

istic.

of the mind multiplying human powers of analysis

and insight just as a telescope does our powers of

Econophysics vision», as Mark Buchanan wrote a few years ago

Radical new views of economics are being at- on the New York Times.

tempted in econophysics, a discipline born in the In the case of econophysics studies, simulations of-

mid-1990’s that is trying to a) import more ele- ten consist in defining economic agents (people,

ments of empirical research in economics (a disci- firms, banks, regulators, …) and the rules of the

pline currently resembling more mathematics than game, then letting the game run to study the possi-

physics) and b) have economics research adopt ble outcomes.

some of the methods devised in the natural sciences

for describing complex systems2. Agent-based simulations, sometimes also referred

to as complex adaptive systems or cellular auto-

Non-linearity, systems operating far from equilib- mata, were inaugurated by John H. Conway (Gard-

rium, and “organized disorder” (deterministic ner 1970) and first formalized by John Holland

chaos, emerging behaviour) are the tools of the (Holland 1975). It is impressive to notice how,

trade in econophysics today: just about the opposite given extremely simple “organisms” or “agents”

of what happens in the REH/EMH paradigm, where and a few governing rules (1 organism and 4 simple

markets have no internal dynamics (no interconnec- rules in Conway’s Game Of Life), rich and complex

tions between individual agents and choices) and forms of “life” can evolve over time.

chaos may only be stochastic, i.e., the “disorgan-

ized complexity” (Weaver 1948) of Brownian mo- Econophysics simulations of this sort often lead to

tion and equilibrium thermodynamics. situations very different from the perpetual quasi-

equilibrium of efficient markets. For example,

Some physicists and a few maverick economists are catastrophic meltdowns can take place abruptedly,

increasingly recognizing in complex models of the something that in EMH models may happen only

physical world (especially, although not only, con- with infinitely low probabilities (contrary to em-

densed matter) situations that resemble economic pirical evidence). Examples of this kind of simula-

or financial contexts. tions are to be found in, e.g., (Thurner 2010),

(Westerhoff 2004) or (Macal 2004).

New economic models being proposed

One such model is that of spin glasses, a domain Caution is appropriate

characterized by an extreme fragility with respect to Given the increasing complexity of economy, it is

small changes in parameters and the de facto ab- plausible that a radically new theoretic approach

sence of equilibrium. may be needed, to provide us with a more realistic

view of systems that we are currently treating as if

they were linear while their non-linear effects are

perhaps no longer negligible. However, one must

2

A broader, if banal, view of econophysics describes it be cautious in jumping to conlcusions.

as a discipline aimed at using in general the mathematical

methods of physics in the economy: however, this has To begin with, econophysics research needs to be

been done all the time since Leon Walras and Vilfredo strengthened by a more robust and deeper participa-

Pareto, in the 19th century. tion by economists. Its literature indicates a certain

propension to underestimate the degree of aware-

4

Paolo Magrassi 2010 - Creative Commons Attribution-Non-Commercial-Share Alike 3.0

ness that economic research has reached in many Furthermore, some econophysics seems to ignore or

sectors which are the subject of econophysics. not to care about the corrections that economists

apply over time to the simplified (linear) models.

Another occasional distortion of econophysics re-

Some others go as far as to invoke the adoption of

search consists in claiming the need for new theo-

statistical mechanics models in economics when, as

retical models without having taken the time to ac-

we already pointed out, this has been done for 150

tually confute the existing ones. Many high-level

years now.

economists, while admitting the limitations and im-

perfections of the current paradigm (REH/EMH), Finally, econophysics will suffer from the social

are not worried at all about its sustainability and limitations typically imposed on interdisciplinary

fitness. research: it is easier to win a tenure, get a PhD as-

signment or publish on top-tier journals by partici-

As an example, according to some of them the 2008

pating in a study that resonates with the dominant

financial crash was not but the efficient-market an-

paradigm and focuses on a limited domain, rather

ticipation of a to-be economic recession. In this

than by venturing in distant and subversive territo-

view, finance was the victim, not the cause, of the

ries.

economic meltdown, as Eugene Fama told J.

Cassidy in the January 11, 2010 issue of the New All these factors will substantially slow down the

Yorker. victory, if it ever takes place, of a new economic

paradigm jointly built by economists and physicists.

Anderson, P. W. (1972), “More Is Different”, Science, New Series, Vol. 177, No. 4047, pp. 393-396

Anderson, P. W., Arrow, K. and Pines, D. (1988), The Economy as an Evolving Complex System, Addison-

Wesley

Bouchaud, J. P. (2008), “Economics Needs a Scientific Revolution”, Nature, Vol. 455, p. 1181

Bridgman, P. (1927), The Logic of Modern Physics, The MacMillan Company, New York, p.26

Gardner, M. (1970), “The fantastic combinations of John Conway's new solitaire game «life»”, Scientific

American, N.223, p.120

Holland, J. (1975), Adaptation in Natural and Artificial Systems, University of Michigan Press

Lo, A. (2009), “The Feasibility of Systemic Risk Measurement”, Written testimony prepared for the U.S.

House of Representatives, Financial Services Committee, October 19, 2009

Lorenz, E. (1963), “Deterministic Nonperiodic Flow”, Journal of the Atmospheric Sciences, Vol. 20, pp.

130-141

Macal, C. M. et al. (2004), “Modeling the Restructured Illinois Electricity Market as a Complex Adaptive

System”, 24nd North American Conf. of the USAEE/IAEE Energy, Environment and Ecnomics in a New

Era, July 8-10, 2004, Washington, D.C.

Scarf, H. (1960), "Some Examples of Global Instability of the Competitive Equilibrium", IER

Sonnenschein, H. (1972), “Market Excess Demand Functions”, Econometrica, Vol. 40, pp. 549-563

Stiglitz, J, (1975), “The Theory of «Screening», Education, and the Distribution of Income”, American Eco-

nomic Association

Thurner, S., Farmer, G. D. and Geanakoplos, J. (2010), “Leverage Causes Fat Tails and Clustered Volatil-

ity”, arXiv, Quantitative Finance > Statistical Finance

Weaver, W. (1948), “Science and Complexity”, American Scientist, Vol. 36, p. 536

Westerhoff, F. (2004), “The effectiveness of Keynes-Tobin transaction taxes when heterogeneous agents

can trade in different markets: A behavioral finance approach”, Scientific Commons

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