Applying Complexity Economics Lessons To Recovery: Complexity Economics Series Part 5

Published on INFORMS Analytics Magazine (Joseph Byrum)

Author’s note: This series Seeing Economic Collapse and Recovery Through the Lens of Complexity Economics will look at the pandemic-related economic problems we currently face and how we might apply important concepts of complexity economics to better understand how to move forward. Part Four introduced 8 more complexity economics concepts that can be applied to economic recovery.

This blog has looked at 12 key concepts of complexity economics, listing them alphabetically and making recommendations for each. Now, to synthesize these 12 recommendations, let’s boil them down to four key recommendations as we pull out of the COVID-19 economic recession.

1. Pay attention to small changes – and to changes in direction 

Consider the butterfly effect: anticipate and respond to small and low probability events that have the potential to result in major harmful crises in the future. Studies of self-reinforcing, asset-price changes show that we need to look at the direction of indicators (going up, going down or experiencing unpredictable volatility). This sense of direction, more than the absolute level of these indicators, will matter most.

This small-change/directional-change principle and related concepts have the most obvious application in trading algorithms. Such an algorithm sets up rules that say when X happens, then do Y (Y being buy, sell or hold). The X in question should be programmed to anticipate the next move of the market. This can be done through candlesticks or similar technical strategies that can be sensitive to small and/or directional changes discussed above [1]. This is a way of avoiding being behind the market, and instead being ahead of it. The key lies in detecting patterns large and small, consideration of risk as a part of strategic planning, and also in company disclosures. As senior managers and boards of directors make capital allocations based on their predictions of the future their models should be on the alert for system-shaking pivot points. And when they make disclosures in proxy statements about risks (for example in management discussion and analysis) they can take these factors into account.

2. Seek balance

As we plan for recovery, we need to keep entropy in mind, understanding the power of our expectations to cause both disorder and reordering in systems. Understanding feedback loops can also help. In some cases, active intervention – by government and/or the private sector – must occur to prevent a spiraling due to positive feedback loops. The increasing returns concept helps us see the power of positive returns, but also to beware of vicious cycles. We also know from clustered volatility studies that market changes can take on a life of their own, so we should not become overconfident or underconfident. Business leaders and investors should be sure to consider a middle ground in financial decision-making and not just the extremes.

Balance and related concepts have great practical value in strategic planning, and also in company disclosures. As senior managers and boards of directors make capital allocations based on their predictions of the future, they should be on the alert for the patterns described here – large herd-like behavior that can change on a dime. During a panic, it is a good opportunity to buy [2]. For government and private sector leaders dealing with crowds of any kind (through the ballot box or social media, as well as markets) it is important to factor in the risk of large-scale change. It is important to be on the alert for system-shaking pivot points, particularly when making disclosures in proxy statements about risks (for example in management discussion and analysis).

3. Be pluralistic

Given the power of agent-based modeling, policymakers and companies should identify the key agents for recovery and support them all to the highest extent possible. The science of emergence has given businesses leaders the big picture of the world as holistically as possible. We have a planetary emergency that requires a border-free and silo-free response. As we recognize the reality of nonequilibrium systems, we must be sure to try a variety of scenarios (featuring a variety of stakeholders) before launching any given solution.

An application here lies in the choices that governments and companies make that affect multiple constituencies. A good technique here is to hold hearings (for legislatures), to make policies subject to comment periods (for agencies), and, for companies, to clearly assign the stakeholder relations role to a senior officer.

4. Stay entrepreneurial

The concept of animal spirits tells us that economies are made up of people with passions; therefore, avoid dimming the passion of entrepreneurialism when running large government programs, lest this lead to discouragement. Our study of game theory tells us that we need to prioritize investments that will trigger recoveries in other areas without being dependent on them. The concept of propagation tells us that programs can last too long. The goal of recovery is to return to self-sustaining individuals and institutions, not to encourage dependencies. Programs should have sunset clauses.

The clear application here is for the leaders of sovereign nations, provinces, states and municipalities. As these government leaders set policies to help businesses, they should not help so much that they remove the incentive to innovate and compete. For example, an interest-free or low-interest loan is preferable to a grant. Or for another example, setting a zero-interest-rate policy may not be the best for business, since it may make businesses too dependent on easy repayment; there may be an argument for some level of interest rates to show the time value of money and the effort needed to gain it.

No one knows when the world economy will recover from the devastation in human life, health and productivity caused by the COVID-19 crisis. Nonetheless, we must attempt to anticipate future developments and plan our return to economic vitality. The key concepts of complexity economics can help us forge the way ahead.

Notes & References

1. Michael Kampouridis and Fernando Esteban Barril Otero, 2017, “Evolving Trading Strategies Using Directional Changes.”
2. Bill Miller, Miller Value Partners, 2020, “Typical Recession and Recovery Economic Behavior Offers Great Stock Buying Opportunity.”