The Coming Revolution in Complexity Economics

None of that is true according to CE practitioners. SE defines a strange system that many people put special value on escaping, whether through charitable and spiritual pursuits or simply leisure and retirement.

Other participants came at SE from the other end. How can we consider a system of thought and policy to be valid if it meets any of the following conditions:

• Fails to predict major financial crises, or even upcoming recessions;
• Has led to climate change and massive environmental degradation;
• Creates massive social discontent in the face of “prosperity;”
• Allows slavery, child labor, and other forms of exploitation;
• Undermines government actions and other forms of collective decisions;
• Cannot explain the absence of inflation in the face of the policies of the last decade;
• Has no satisfactory theory of change or economic growth;
• Has no way to properly encourage or enforce long-term commitments;
• Does not deal with fear, hope, sharing, art, or many other “non-economic” influences; and
• Does not incorporate the importance of energy and entropy in economic activity.

The final area of criticism of SE comes from its closed and ideological nature. The leading SE schools educate the next generation of economists into the same theories, and provide the members for many government bodies, including the Council of Economic Advisors and the Treasury department. The Federal Reserve funds most of the research into monetary economics, funding those who explore within the accepted framework. Interdisciplinary work is not encouraged and doesn’t help with tenure. Foundational texts including The Road to Serfdom (Hayek) and Capitalism and Freedom (Friedman) use political goals to define economic thinking.

At least that’s the way those at the SFI symposium saw it.

CE is as much an approach to as a theory of economics. It sees the economy as an “order-creating system,” a collection of arrangements, made up of verbs more than numbers, an ecology, not a machine, a system that is neither rational nor in equilibrium. The practice often involves observing or creating a set of actors with imperfect knowledge, skills, and motivations, and turning them loose to see what happens. There is great diversity among the actors in the system, and many have non-economic objectives, being purpose-driven and valuing empowerment over financial wealth.

The symposium took place over two days in October 2019, just as, unknown to all, the first cases of what became COVID-19 were appearing in China. On the first day, Eric Beinhocker, author of The Origin of Wealth (2005), offered a vigorous critique of economics as it is taught and practiced in the U.S. Economic theory, according to Beinhocker, shapes the economy, politics, and the goals society is “allowed” to pursue, so we need an approach that is more humanistic, inclusive, cooperative, and respects a variety of values and planetary boundaries. Further, since the economy is something we create, not something that simply “exists” with unchanging rules, we collectively have the power and right to change it. Alison Stanger, a professor at Harvard and Middlebury, argued that the goal of society and economics should be maximizing human flourishing, not just profits, consumption, and the power of the elites. Later that first day, Ole Peters made a presentation on ergodicity, an important and complicated concept about the role of time in the economy described well by Michael Edesess in his March 1 Advisors Perspective article and the following discussion. Additional talks presented the role of networks, collective actions, and shared knowledge in the economy, and how they can be incorporated into CE.

Brian Arthur, the founding father of complexity economics, gave the evening keynote speech explaining why economics needs this different approach. Economics changes when the techniques of economics change. When SE was being developed, limits on the power of mathematics constrained the nature of scope of economic theory. It was necessary to look at aggregate outcomes, assume uniform and rational actors, and posit that the system is the pursuit of equilibrium and optimization. Now we not only recognize that we live in a world without equilibrium, with fundamental uncertainty, with institutions that are continually being changed by the very people using those institutions, but we have the advanced math and computational power to set things in motion and see what happens. If a system never reaches an optimal state, then there is always room for it to be gamed and manipulated in novel ways.

Sciences from psychology and medicine to biology and physics have changed their methods and pursuits radically in the last 50 years. These changes are accelerating. Only economics is still relying on theories and assumptions that pre-date the Eisenhower administration. Further, Beinhocker reviewed the indices of six leading economics university textbooks, and none had any listings for “energy,” “thermodynamics,” or “entropy.” Considering both the theoretical deficiencies and bad outcomes from SE, it is past time to modernize economics.

Four panels on the second day explored different frames for viewing economics and the economy, and how CE would operate within those frames to improve understandings. The computation panelists pointed out that we have new tools and power to study real and hypothetical agents in much greater detail than ever before, and we should ask more interesting questions about that data. The physics panel looked at the complexity of disequilibrium and predicted that the convergence of blockchain and automated trading will overthrow the current system within five to 10 years. Several speakers drew parallels with AlphaGo, the program that became the best player in the world at the game of Go, using strategies that no human player (or programmer) understands, drawn only from a statement of the rules of the game and without any examples of human play.

The biology panel looked at the economic organism, a diverse and self-evolving system. For success, it requires diversity in actors and actions – the crashes that happen when a dominant narrative collapses spill over far beyond the economy itself. Finally, the architecture panel discussed the structures, networks, institutions, and tools that provide scaffolding for the economy. Standard economics considers those as given but lacks good theories for their change or emergence. The big challenges facing us on earth are systemic, and SE is blind to them in principle.

In these discussions, the need for diversity arose frequently. Systems operate with actors (people, firms, states) with differing goals, knowledge, power, and restrictions. Systems do best when they have different kinds of outcomes. Understanding systems is best when the researchers have diverse perspectives and goals – including professional training, age, political views, demographics, and other characteristics. As Stanger proposed, we should always question inequality of outcomes, lack of diversity in any forum, and our own blind spots.

Investing and the application of complexity economics was the subject of the final panel, which featured Bill Miller of the Miller Value Trust and a long-time major supporter of the Santa Fe Institute, Katherine Collins, head of sustainability investing at Putnam, Paul Davies of the Wall Street Journal, Michael Mauboussin, who described himself as a fundamental investor, and Dario Villani, a quant hedge fund manager. While, unsurprisingly, no unified new theory of investing emerged, many valuable, interesting, and amusing points were made:

Miller listed three insights he received at SFI over the years that made him a lot of money. When he understood the value of lock-in and path dependence, he bought a lot of leading tech stocks in 1995. An appreciation of innovation led him to buy Google at its IPO (and use the profits to fund a major gift to the SFI). An introduction to the revolutionary nature of blockchain led him to buy bitcoin at $200.

Collins talked about our “triple blinders” as investors: We only measure outcomes in dollars, we base our analysis on equilibrium, history, and “return to the norm,” and we focus on short-term periods rather than decades. We pursue cleverness, not wisdom. We focus on allocation and pricing, not wealth formation where the real money is made. When we are afraid, we don’t entertain new ideas and become brittle.

In 2013, the Nobel Prize in Economics was shared by Fama and Shiller, despite their having opposite and contradictory views on securities valuation. Mauboussin said they are both right, but not at the same time. SE gets asset pricing right 98% of the time, but the money is made in the other 2%.

Villani explained that finance is the only area where market knowledge changes the market itself. Everybody sees the same factors, so trades become crowded. With low interest rates, future cash flow and earnings become a larger factor in determining valuations, but future cash flows are very uncertain, so investing becomes more of a gamble. The proper time scale to use in valuations is the most important question he must answer every day. You need to be agile and adaptive, but not erratic.

To Miller, free cash flow (FCF) is much more important than earnings, in part because FCF is much harder to manipulate. Over the last four decades, top decile stocks by FCF have vastly outperformed the market. It is hard to beat the market in the short term, but not in the long term, if that is your plan. Don’t forget Shubik’s law: “The function of markets is to take money away from stupid people who don’t deserve to have it.”

CE has yet to prove itself useful outside of finance. This is not surprising given the newness of its tools and analysis and the lack of curiosity about it from academic economists. In other areas of science, it has taken decades for fundamental insights to change mainstream thinking. As physicist Max Plank put it, “science advances one funeral at a time.” CE may emerge from the commercial world that is willing to support it.

There may be more support than appears, however, to challenging some of the economic fundamentals. Early actions by the Biden administration have included direct cash payments to individuals, cash grants to families, raising the fight against climate change and the promotion of gender and racial equity as goals equal to economic growth. The last three American presidents embraced massive deficit spending. We seem to be running a test on alternatives to conventional economic thinking.

CE is not the only challenge to SE. Modern monetary theory has received much press (but not acceptance in “the academy”). In the coming months I plan to present similar analyses in reviewing books about biophysical economics and de-growth economics.

Coda – Complexity thoughts about whether we are on the edge of a crash

Complexity thinking offers a useful perspective on market activity. I am writing this in late March 2021, and it will be read in a future I cannot predict. Many of the most-read articles in the Advisors Perspective newsletter attempt to show that equity market prices are dangerously high and a crash is imminent, or attempt to prove the opposite.

The chart below shows the so-called Buffett indicator, the ratio of the value of all traded equities to the overall economy from 1952 to the end of 2020. What stands out for me is the two different ranges presented. From 1952 to 1996, the values ranged from 32% to 87%. In December 1996 Fed Chair Alan Greenspan gave his famous speech warning about “irrational exuberance” in the markets, as values reached record highs.

In the subsequent 24 years, there have been only seven quarterly readings of this indicator that were lower than at the end of 1996. The market moved into a new range, with lows around 80% and highs around 160%. Why that happened is not clear, and it certainly was not clear at the time. Perhaps it was a shift of market leadership to a new kind of company (although the top firms in 1997 were mostly traditional firms), or day trading, or something else, but prices moved into a new zone and largely stayed there.

Now we are above the top of that zone. By traditional valuation measures of price-to-almost anything, values are extreme and still going up. If you draw a trend line on the graph, the ratio has clearly been going up for 70 years, but is there an economic reason for that rise, or any reason to expect the rise to continue indefinitely? It is possible that, for reasons not yet clear, we could be entering yet another range of valuations that will shape the next few decades. Perhaps the development of more sophisticated trading programs analogous to AlphaGo, and the example of the recent flurry in GameStop, driven in part by commission-free trading and on-line message boards, and the difficulty of applying valuations to an uncertain environment in a zero-interest-rate world, and the emergence of “non-fungible tokens” as a “thing” are all signs of a new world untethered to the real economy of firms and resources.

Or not. The hidden clock may still strike midnight, Cinderella’s carriage will become a pumpkin again, the bubbles will burst, and the old rules will reign. The economic ravages of COVID-19 a year ago almost crashed the markets, but they didn’t. If that wasn’t enough, what will be?

¹ The Santa Fe Institute is an independent research institution created in the mid-1980s to study complex adaptive systems, chaos theory, and related concepts in complexity science. Its goal is to create new ways of approaching a wide range of subjects from the so-called hard sciences to economics, history, psychology, and sociology. Multi-disciplinary work has been key to its success, and many of its ideas have become mainstream. Two good introductions to the science and the SFI are Chaos by James Gleick and Complexity by Malcolm Waldrop. Some of the work by those authors is very accessible, and some is very technical and advanced.

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