Thursday, July 02, 2009

Popular Economics and understanding markets

When I was younger I was entranced by the magazine called Popular Mechanics because it had all these cool projects where you could make mechanical and electrical things. Having the attention span of a gnat, and eight thumbs and two fingers I never did any of them though.

But you could almost run one now called Popular Economics wit the number of books that are addressing some big economic issues in a both academic and poluar way. A couple that fall into that vain are The Origins of Wealth and The Company of Strangers. These two in particular are books with an intened audience outside the academic economics community that both deal with the idea of economic progress as an evolutionary process - and hence the term evolutionary economics.

It is an interesting juncture for the intellectual move this way, given that Darwin got some of the evolution ideas from reading the economist Malthus. There are many i the evolutionary club who will date formal evolutionary views to Alfred Marshall who is more generally seen as the father of the marginalist school that created the familiar mathematical model of equilibrium.

Anyhow, my purpose in this brief post is to try to bring together a number of strands of heterodox economics. By definition heterodox economists are defined by what they are not rather than what they are. What they are not is orthodox - where orthodoxy is defined as the machinary of economics built on the framework of equilibrium between demand and supply.

As a consequence there are many strands of heterodox economics, including the Marxist and the feminists. There are also the variants suc as the New eynseian economists - though there disagreements may be more within the orthodox club than outside it.

There are four elements I want to discuss here, they are institutional, behavioural, evolutionary and complexity. Going through them in order the institutionalists argue that there are many things going on in an economy other than markets and that a proper understanding requires an understanding of these other things - which can be thought of as various unwritten rules. The behavioural have their gripe in the observation that real economic decision makers (consumers) aren't the rational calculators of theory and that they deviate in a number of significant ways. Key among these are that they actually favour fairness, that they value something they have more than something they may get (the endowment effect) and that they value something they can get now more than just the time preference of money more than getting it in the future.

The evolutionary view is built on the idea that the economy isn't just static, nor that it is just trying to find its equilibrium but that it continues to change over time. The term evolutionary is used to refer to the idea that the change occurs through small amounts of continual changes, some of which get reinforced because they work and others die out because they don't. The twop books referred to above focus on this evolutionary process. The first mentioned talks about evolution in both physical technology and social technology. The second book talks about it more ostensibly as institutions, the social rules and norms as well as characteristics like money and banking.

Finally complexity economics says that even if you did have the kind of forces back to an equilibrium described in orthodox theory the actual dynamics of the mathematics indicate that the macro effects of all those forces could be as complex as weather patterns on which the Lorenz equations and butterfly effects are based.

There are a couple of points I wanted to emphasise here. The first is the close relationship between evolutionary and institutional economics. This is because what is evolving is the institutions or social technology.

The second observation to make is that if individuals did behave the way that the orthodox economists believed then this evolution wouldn't have occurred. The Company of Strangers book points out that humans are the only animals that rely upon non-relatives for obtaining our food. For the social institutions that enable that to hapen to evolve out of earliest man we actualy had to have the altruism and trust genes.

Put another way, if individuals only acted in immediate self interest and were ambivalent betwee today and tomorrow there would not have occurred a framework in which sufficient trust could evolve to make exchange happen, and nor would an environment arisen where what we think of as "the accumulation of capital" could have occurred. (Note capitalism in some definitions is identified more by the accumulatuion of capital than by the reliance on markets).

This leads me into a related but different discussion - the idea of a market and what they are good for. In the process I will defend Hayek.

In the conception of the market of both Hayek and Adam Smith the market "works" because the market provides a way for the transmission of massive amounts of information about preferences and production costs, far more than could be handled in a command economy.

This varies dramatically from the actual assumptions of the neoclassical analysis which is based on he assumption that the market works BECAUSE consumers and producers are fully informed.

The interesting point is that these are not in conflict in a stable environment. They are not in conflict because they work together, in an evolutionary way. At teach point the market is informed from the market trades before, each set of market trades provides the information for the next. In very simple dynamic models these get mapped as cobweb diagrams.

What we learn though is that in the face of "discontinuous" change markets WILL fail. They will fail because the market is trading on the old information. Of course, the definition of "dicontinuous" may be circular - we know it was discontinuous because the market failed.

The recent examples are the boom and bust and the sub-prime crisis. The discontinuous changes were the advent of the internet and the advent of new capital adequacy rules incorporated in the change from Basel I to Basel II.

What is the significance of all this? it means that from a public policy standpoint we need to take particular care over what will be the market consequences of big changes. Most importantly we need to be prepred to use every means abvailable to dampen exuberance following a change because it is most likely a consequence of a positive feedback loop in the twin role of the market described above.

Finally a comment. When I was thinking of this earlier and the Company of Strangers book I was thinking that specialisation of labour was the "dual" of a market. You can't get a market without specialisation and there is no point in specialisation without a market. But it isn't the case, because you can also have specialisation in a hierarchy. But it does highlight again why Williamson named his book Markets and Hierarchies and why I need to go get a copy.

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