Complexity Economics

Economic Governance, Science and Policy

Olivér Kovács

• Publisher: Routledge
• Year: 2022
• ISBN:
  9781000610246
• Edition: 1
• Topic: Economía
• Subtopic: Teoría económica

Our socio–economic innovation ecosystem is riddled with ever-increasing complexity, as we are faced with more frequent and intense shocks, such as COVID-19. Unfortunately, addressing complexity requires a different kind of economic governance. There is increasing pressure on economics to not only going beyond its traditional mainstream boundaries but also to tackle real-world problems, such as fostering structural change, enhancing sustained growth, promoting inclusive development in the era of the digital economy, and boosting green growth, while addressing the divide between the financial sector and the real economy.

This book demonstrates how to apply complexity science to economics in an effective and instructive way, in the interest of life-enhancing policies. The book revolves around the non-negligible problem of why economics, to date, seems to be inadequate in guiding economic governance to navigate through real and ever-intensifying complex socio–economic and environmental challenges. With its interdisciplinary approach, the book scans the nuanced nexus between complexity and economics by incorporating, as well as transcending, the state-of-the-art literature. It identifies ways to trigger opportunities for behavioural change in the economic profession with respect to how and what to teach, introducing and developing further complexity economics taking into account the configuration of its main principles and outlining the silhouette of next-generation economic governance.

The book deciphers recommendations for economic theory, practice, education and economic governance. It will be of interest to students, scholars, academics, think-tank researchers and economic policy practitioners at the national and/or supranational levels.

1 Complacency Economics: Tectonic Fault Lines

DOI: 10.4324/9781003288398-2

1.1 Nullified Reality and the Build-Up of Dangerous Complacency

Here, I put forward with conviction that when we formulate statements about the current state of economics, it is not an outburst, not a declaration of war against the representatives of mostly American mainstream economists.¹ My goal is just what one of the famous contemporary Hungarian philosophers, Mihaly Vajda, used to say: let us question the ingrained evidence by asking: is everything as good as it could be? In other words, we are tempted to see things differently from the way the famous Heideggerian das Man interprets them.

Let us go back a bit to just before the 2007–2008 financial and economic crisis period, to the year of 2006. That was a time when some eminent Federal economists in the United States made an in-depth analysis of what would happen to the US economy if house prices plummeted by 20%. They deployed their state-of-the-art macro model, calibrated and ran it. The result was soothing: well, not so much. Growth could be a little sluggish, there could be a slight recession, but eventually nothing could happen that some interest rate cuts would not fix effectively. Importantly, the model did exactly what it was designed for. It assumed that everyone would behave rationally, markets would work efficiently and hence the system would correct back to a balance with full employment. As became clear later, this was absolutely not the case. Thus, something is wrong; there may be profound hidden problems with our ingrained evidence.

It also happened in 2006 that a group of archaeologists found a 20-metre-high, 150-metre-wide, roughly 1,200-year-old hidden Aztec pyramid in Mexico. The piquancy of the discovery was that the site had been home to Christian rituals since the 1800s; participants in those events had not realised that, beneath the ground, lay a pyramid glorifying the gods of earth, wind and rain. During the ceremonies, believers trampled and moved the ground with their feet, until, all of a sudden, a major collapse occurred and the top of the pyramid became recognisable.

Now, imagine dropping grains of sand on a table from a certain height, one after the other. Sooner or later, a mound starts to form. Then, there will be a grain of sand that, when dropped, suddenly and unexpectedly triggers an avalanche on the surface of the sand pyramid which is forming, fundamentally reshaping it. How can this happen? Because critical instability has been invisibly encoded over time inside the sand pyramid, and the addition of a grain of sand, which had previously seemed to be no problem, creates a radical phase transition. When translating this example into economics, the question arising is: do crises only come when volatility and uncertainties are high, as common sense (or ingrained practice) would dictate? The answer is no. It seems more demonstrable that the experience of the past 200 years on emerging great collapses suggests that they typically occurred after a period of low volatility. Which means that crises are mostly developing quietly and latently by affecting people’s psyche and thus their economic behaviour (e.g., their willingness to take risks). For instance, a period with moderate volatility may drive higher risk-taking mentality to soar. It can be confirmed by looking at credit card issuance and usage statistics. In a time considered by the masses as “good”, i.e., a low-volatility period with respect for key economic indicators, people tend to file for and use credit cards in a more vigorous way. It implies that they will already be in debt when the recession hits. In other words, the boom period is even bigger than the optimal, whereas the bust period will also be even deeper than its inevitable level. In short, this implies that a peaceful or perhaps boring period is more likely to encourage complacency, manifesting in arrogance and irrelevance, so that critical instability is developing.

For an economist, the year 2006 was part and parcel of the period 1992–2007, which was not particularly eventful. The era of the so-called Great Moderation was in full swing,² as it seemed that economic planners had achieved a combination of steady growth and low inflation, whereas deregulation had resulted in an escalating financial sector, providing an unprecedented level of resources to the real economy, and Nobel Prize-winning economist Robert Lucas (2003) took a position that we finally have all the necessary empirical and theoretical backing, together with the policy tools, to prevent any crisis.³ And if that were not enough, as a sign of complacency, economics began to move away from relevance towards irrelevance by partially replacing in-depth analyses of real socio-economic problems with less important and more abstract studies during the Great Moderation. It further heightened the tendency towards decreasing public policy relevance in published scientific economic writings. For striking examples, it is enough to crosscheck how leading mainstream economic journals were flooded by irrelevance back in 2006.⁴ Let us take, for example, the following five mainstream journals. An article published in the American Economic Review in 2006 was about Why Beauty Matters (Mobius et al. 2006) by arguing that the more beautiful people are usually more confident as well. We researchers are often very uncertain (i.e., make more and more cautious and indecisive statements about socio-economic phenomena), so in principle we should be ugly. For another example, the Journal of Economic Perspectives accepted and published a paper on What’s in a Surname? The Effects of Surname Initials on Academic Success by Einav and Yariv (2006), despite the fact that even the authors admitted that the correlation was extremely weak (if at all). Moreover, later studies also showed that there was no evidence whatsoever that alphabetically earlier surnames gained advantage in academic success;⁵ there is therefore no gainsaying the fact that such analysis does not carry any valuable policy implications in any respect. If one takes a mere glimpse at the Quarterly Journal of Economics, considered to be one of the most influential journals according to the usual impact factor ranking, it published an article about How Do Friendships Form? by Marmaros and Sacerdote (2006), which illustrated the self-evident fact that people typically interact with those friends promising greater benefits. We are just saying that no serious econometric study is needed to realise on the basis of common sense that friendships (and deeper relationships) increase the level of life satisfaction.⁶ It is also telling that the article published in another equally important mainstream periodical, the Journal of Political Economy, by Fama and MacBeth (1973), entitled Risk, Return, and Equilibrium: Empirical Tests, in which basic assumptions over the efficient markets have failed the test of time, has been being the most cited paper. Considering recent papers, one can find studies in eminent journals like The Economic Journal where the content conveys neither new-fangled insights nor policy implications. Consider, for instance, the paper by Cacciatore and Ravenna (2021), Uncertainty, Wages, and the Business Cycle, in which the authors show that a lack of wage elasticity increases uncertainty during economic downturns, thereby contributing to a deepening recession. The paper also emphasised that measured uncertainty rises in a period of recession through non-linear local projections and vector autoregression estimates. It would be extremely difficult for us to regard these results to be scientific and especially to be novel, principally because the study concludes without a single, valuable policy lesson. To avoid the accusation of superficial conjectures and cheap generalisation stemming from arbitrariness based on the journal articles mentioned above, let us recall what Kim et al. (2006) found when systematically compiling a list of articles which received more than 500 citations up until 2006, published in 41 major peer-reviewed economics journals over the past 35 years. The authors found inter alia that, based on JEL code analysis, a predominant share of the papers used econometric methods, but not necessarily with the primary goal of addressing real-world problems for the convenience of economic governance. Again, by 2006, the economics profession had reached the phase of complacency, promising better governance, and hence improved socio-economic conditions, practically for all.

One year later, the promise of this world was shattered. The financial system had expanded beyond the real economy, and the credit pyramid had collapsed. It had been proven that our belief in the durability of models simplifying the world had spectacularly cracked, and it had been proven that mainstream economics existed in an echo bubble (i.e., it had become a repository of results confirming its own worldview): it had not questioned the ingrained evidence. Believing in someone who is talking about simplicity is just as misguided as putting faith in the astronomical knowledge of the cannibal tribes of the islands of the Azores and the Islets of Langerhans. The reality is that, after the era of Great Moderation, the period of Great Recession arrived, after which the economics profession thought that, despite the twists and turns in crisis management, entailing negative consequences, the recovery period begins, whereas the near-death experience of global capitalism becomes a distant memory, and mainstream economics will again be able to explain the processes of the world economy. It did not happen that way.

In addition to a perceptible general loss of confidence in the effectiveness of economic policy, there is a pervasive digitalisation fuelling the existential fear of many. As for the former, after 2008, the Great Recession came up with the near-death experience of capitalism, which was followed by a weakening social trust in governance and institutions. Furthermore, productivity dynamics have been deteriorating for decades despite the unprecedented levels of digitalisation. One possible reason behind it was the fact that the financial sector had been liberated wholeheartedly, thereby it had started not to serve the real economy.⁷ Additionally, wealth and income inequalities had become large and chronic, with this trend being exacerbated by automation as well as by robotics and, of course, accelerated by the Great Pandemic; according to estimates, coronavirus increased the number of people living in extreme poverty worldwide by 150 million by 2021, losing so many of the jobs that had been created since 2008. As far as the existential threat is concerned due to digitalisation, extensive digitalisation (automation, robotisation, etc.) undermines the job-creating growth paradigm relying on wage-based competitiveness, whereby frightening those who are afraid of losing their job. By the same token, more and more people believe that the state has been unable to achieve growth that benefits all.

Social trust in governments and in the economic profession also began to decline significantly. This trajectory can be captured on many grounds by starting from the movement of Occupy the Wall, or the movement shouting the famous sentence ‘Keep the government out of my Medicare!’, the fact that Donald J. Trump was able to become the President of the United States, through the emerging global trade war between the United States and China and the Siege of the Capitol in Washington, to the gilet jaune movement in France, or to the U-turn of Hungary⁸ and that of Poland by moving more and more away from the basic European and democratic values, or up to the disintegrative trends in the European integration process (i.e., the realised Brexit scenario), etc. As for the economic profession, the pattern of public trust in experts has also changed significantly. According to the survey carried out by YouGov (2017), nurses (84%) and doctors (82%) were the experts in which more than two-thirds of the respondents trusted the most. By a striking contrast, people tended to believe more in weather forecasters (51%) or even in nutritionists (39%) (!) than in economists (25%). Even the premium of politicians has been going through a non-negligible decline (5%). A whole series of emerging phenomena confirmed that tendency by towering before us like a huge pyramid. Without being exhaustive, we just mention a few, demonstrating the critical instability in the system: the spread of fake news,⁹ the rise of illiberalism, populism, post-factual mindset, political tribality, cognitive crisis, denial of science, plebiscitarian state attitude, anti-inclusiveness and doxocracy as opinion-based policymaking in more and more authoritarian regimes (even in the European Union, EU).¹⁰ As a corollary, the time when the public listened to experts, as well as policymakers, and acted upon what they said is over. The public no longer takes what they say for granted with the same enthusiasm. Paradoxically, since more and more people feel that they are left behind in such a configuration of processes, the general public (i.e., voters) expects results and real solutions from the government.

1.2 The Echo Bubble of Economics

Of course, the ability of economic governance to act is largely determined by what economic knowledge it can build on. Demanding real answers also presupposes the bursting of the echo bubble of economics within which the mainstream only hears about its own reality (confirming ingrained evidence); alternative thoughts on reality cannot really get in there. In this section, we first contemplate the reality of the mainstream reflected in two classic textbooks, sometimes being complemented by others, by deciphering some tectonic fault lines on its reality concept. In so doing, we also cogitate on what kind of fresh air (alternative, more complexity-oriented views and understanding over socio-economic reality) is out there waiting to be incorporated.

In an effort to give a brief overview about the rose-tinted echo bubble of the mainstream, we devote special attention to tectonic fault lines as ingrained evidence still being proposed in key textbooks of economics, namely Macroeconomics and Principles of Economics written by N. Gregory Mankiw and Economics by the famous author couple, Paul A. Samuelson and William D. Nordhaus.¹¹ These have been the leading textbooks of international intermediate macroeconomics and economics courses since their first editions.¹²

In this section, at least seven tectonic fault lines are going to be juxtaposed, with the aim of contrasting the reality of the mainstream with the reality of complexity. Beyond the fact that the number seven is of mythical significance (e.g., seven sages, seven hills of Rome, seven dwarves, seven-headed dragons, the number seven in the Bible often represents completeness, etc.¹³), our purpose was just to introduce the reader to the ingrained evidence with which the echo bubble of the mainstream is filled.

1.2.1 Tectonic Fault Line No. 1:The Ingrained Evidence on Inequality and Growth

Let us first make it clear that the standard economics textbooks have a predilection to ignore the issue of inequalities by looking at the topic only as a kind of “afterthought”. However, this particular ingrained evidence says that, if economic policy seeks to increase equality, it can be done only at the expense of the “cake” to be used for redistribution: in other words, the economy will shrink. In this respect, Mankiw (2015, p. 429) argues that a more unequal distribution of income leads to greater economic performance because it encourages workers to work harder; a contrario, a fully equal society would exclude the fundamental motif of people to innovate, so progress must then be interpreted in a completely different philosophical framework. This also implies that harder work cultivates business dynamism, through the impacts on productivity of more intensive innovation as well as of smarter adaptation, by leading to a competitive environment forcing relatively less-productive firms to shrink and leave the market, giving way to more productive competitors (e.g., Acemoglu et al. 2018; Akcigit and Kerr 2018; Aghion et al. 2020). This is the mainstream’s reality, which is not in agreement with how the socio-economic system behaves. All in all, Mankiw’s line of reasoning has not changed a lot ov...