Economic complexity beyond rational management

The economic crisis is a global crisis and although there has been much to-and-fro on the proper response one thing we all surely agree on is that a global crisis requires a global solution. Most of the attention has been given to short-term responses such as relaxed monetary and fiscal policies. These responses seem to be appropriate, although the focus here is on long-term solutions. For Australia the economic crisis has once again brought to relief a perennial structural defect in the economy, which neoliberal reforms were supposed to eliminate.

An interesting sub-text in all of this is the status of economics as a rigorous intellectual discipline.

Much of the neoliberal reforms were justified on the basis that economic theory amounted to an empirically well grounded physical science. It is revealing that the leading critic of Australia's debt fuelled binge, Steve Keen, just so happened to also write a book puncturing the scientific pretensions of standard economic theory.

In order to develop solutions like any good doctor we need to understand why the crisis first arose. We may divide this into two components, namely at the global level and the specifically Australian aspects. Let us start with the crucial global component.

When Sir Nicholas Stern delivered his major report on the economics of global warming he pointed out that the global ecological crisis was the most severe instance of market failure in human history. This observation on Stern's part is a fact of great moment. This is because the economic crisis itself is a vast example of market failure of exactly the same type: what economists would call market failure due to negative externalities.

That most economists did not see that this type of market failure was coming seriously dents their status as objective observers of economic processes. Deregulated markets are prone to failure, a conclusion that is not made clear from the efficient markets hypothesis which is only now the subject of much critique.

In pointing this all out we should be mindful of the observation of the political economist Karl Polanyi, in his classic The Great Transformation, that "the idea of a self-adjusting market implied a stark utopia. Such an institution could not exist for any length of time without annihilating the human and natural substance of society; it would have physically destroyed man and transformed his surroundings into a wilderness."

Negative externalities arise when the social costs of economic activity are not reflected in market prices. In the case of the financial system the price can be measured in terms of risk. The reason why financial corporations such as Lehman Brothers engaged in such reckless conduct was because liberalised financial markets under-priced risk. The risk to finance companies when they engaged in complex mortgage-backed securities trading was less than the risk that such trading would lead to systemic collapse. Because systemic risk is something external to the company reckless behaviour becomes rational.

The crisis is more than just a grand failure of markets. It is also a form of institutional and political failure. Corporations, which dominate our basic social categories, are profit maximising entities. Ours is a system that has profits right at the core. The way in which the corporate form has evolved means that it is short-term profits that matter.

A result of finance liberalisation has been the rise of what is called the "dual constituency conundrum" whereby governments became accountable, or perhaps more accountable, to financial markets in addition to the electorate given the possibility of large capital strikes. This has led to finance corporations attaining great political power which they have parlayed into compelling the state to deregulate financial markets, enabling short-term, systemically risky, profit making.

When highly risky and potentially truly catastrophic actions turn into a form of perverse rationality disaster is all but inevitable.

A very important feature of the crisis can also be found in the science of complexity. The theoretical biologist Stuart Kauffman put complexity on the map through his ground breaking work on complexity and evolution, which promises to enrich our understanding of evolution in ways that go beyond adaptation and natural selection. The industrial sociologist Charles Perrow has shown that complex technological systems are prone to systemic failure, what he called "normal accidents". Perrow demonstrated, convincingly, that complex systems are prone to failure of a type that engulfs the entire system. In fact such failures are inevitable hence "normal".

Complex systems may be characterised by tight-coupling and linear interactions. A small perturbation in such systems can cascade through the entire architecture precisely because these systems are so tightly coupled. We are starting to understand that large-scale social systems can also be complex in the above terms. This was first really developed in a major way by Joseph Tainter who, in a path-breaking study, argued that the collapse of ancient societies occurred because they became too complex. These collapses were normal accidents.

Because of financial liberalisation the global financial system became particularly complex and it began to take on a high degree of tight-coupling because liberalisation led to financial globalisation. It only took the downturn in the US real estate market to reverberate its way in a dimly understood fashion through the coupled global system to bring the entire edifice towards the cusp of systemic collapse, that is, a normal accident. The property market dip acted in much the same fashion that failure in an electricity sub-station leads to massive systemic blackouts.

One feature of economic complexity is that it has led to financial crises of ever increasing frequency and scale. This makes the system poorly disposed towards rational management. The intriguing bit about that is that it seemingly turns Friedrich Hayek’s arguments, a noted free market philosopher, on their head. Hayek wrote at the same time as Polanyi.

Hayek, justly in my view, famously developed an epistemic argument against central planning as exhibited in the Communist bloc. He argued that no central planning agency could possibly allocate resources efficiently because such a task assumes impossible amounts of knowledge on the part of the central planner. Yet we observe that financial liberalisation has led to a system that is so complex that it is beyond rational management.

If we are to deal with the prospect of systemic risk it would require the fashioning of a system that is less complex and thereby more prone to rational management. Clearly, this requires putting financial liberalisation in reverse gear. In this sense Hayek's epistemic argument can be, sort of, applied in the other direction. One makes this point especially for those who appreciate irony. This is doubly ironic given that Hayek was the intellectual godfather of Alan Greenspan.

The global solution to the current crisis will require co-ordination by governments the world over to fashion a new regulatory regime that helps to internalise systemic risk, thereby obviating the problem of negative externalities, and to develop a financial system less complex and globally integrated. That means reversing the trend towards the greater liberalisation of finance capital. Greater regulation and control over the movement of finance capital will also constrain the institutional and political power of financial corporations.

At the beginning of last year a lot of emphasis was placed on what was called "de-coupling". It was argued that there appeared a measure of de-coupling between the growth rates of the emerging economies of Asia, especially China, and the United States.

The Chinese economy has begun to cool off. However, de-coupling, in fact, is worse because the US economy is in deep recession. It is indeed true that China's economy is now no longer growing at supercharged levels but nonetheless the growth rate differential is actually bigger and may increase.

We mention this because we may depend on this de-coupling to help get ourselves out of the mess we currently find ourselves in. What China is not de-coupled from is a highly liberalised and integrated global financial system. This would be the causal link accounting for the observed correlation between the decrease in Chinese growth and the September 2008 financial meltdown.

This again brings to relief the issue of complexity. We may have to rely on the relatively de-coupled aspect of the global economic system to help kick-start the global economy. If the real economy was as tightly coupled as the financial economy then we would now be in a deeper global economic recession that would be very difficult to get out of. As it is the core economies of the European Union, the US and Japan are in simultaneous downturns. This has not been seen since 1945.

This demonstrates the folly of globalisation. It is crucial that we understand that a degree of de-coupling in our economic and financial architecture is vital and we must impose limits to globalisation.

We mention China for it is a natural place to bring Australia into the picture. The relative downturn in China has resulted in large falls in commodity prices. In Japan, our leading trading partner, GDP growth is declining at significant levels and industrial production is declining at a whopping 20 per cent. If these trends continue Japan could be heading for something similar to the Soviet and Russian crises of the 1980s and 1990s.

We have been told that the main rationale of the past few decades of economic reform was to structurally change the Australian economy so that it was not so reliant upon our primary resources. Yet the previous period of economic growth was largely attributable to a debt-fuelled housing bubble and the resources boom. We are now on the cusp of a recession precisely because of the fall in commodity prices, and the bursting of the housing bubble.

Paul Kelly in The Australian had informed us that "prosperity abounds" yet now household wealth is declining with the declining real estate market. One hesitates to use a phrase adopted by the Nazi's during the Weimar Republic, but any measure of household wealth that is largely based on an asset price bubble is a form of "sham prosperity".

The resources boom, as revealed by a Reserve Bank study, was fuelled by a form of demand push commodity price inflation. It was not a case of our resource companies increasing the volume of exports through greater capital investment and exploration. Chip Goodyear, when CEO of BHP-Billiton, reckoned that the resources boom was a long-term prospect. Boy was he wrong.

Australia still, to a large degree, is at the mercy of the commodity price cycle much like a third world economy.

The long-term response to the economic crisis is clear. We need to re-structure the economy towards more value added industries, especially through the development of what has been called "the knowledge economy". A knowledge economy does not arise upon the basis of free-markets. Knowledge economies depend upon a dynamic public sector.

This is because of externalities, in this case positive externalities. If we in Australia fail to develop a knowledge economy then we might call this a form of market failure.

We also need to achieve a measure of de-coupling to develop a buffer against exogenous shocks. Both the knowledge economy and de-coupling can be achieved by instituting publicly supported strategic industry policies. This means overcoming the free-trade mantra and developing a more fuel efficient car industry, investing in the development of alternative energy systems, providing support for biotechnology and greatly increasing investment in science, innovation and the tertiary education sector.

The extinction of Homo sapiens may well turn out to be the greatest market failure of all time. The economic crisis will engender great human suffering and misery but we would do well as a species if we at least manage to see the crisis as almost a divinely inspired warning and reverse our three decade-old mania for what has amounted to something very much akin to Polanyi's stark utopia.