Economic Systems are Chaotic Systems

A comment I posted to Noah Smith’s Japan and the Liquidity Trap. In the end, Noah can’t accept that Japan is experiencing an understandable phenomenon because it has simply lasted too long.

On one level, Noah is falling victim to the belief that a coin that has come up “heads” 20 times must not be a normal coin. But random events don’t accrue a “reversion to the mean” over events. They only “revert to the mean” on a random basis, over time. It is entirely possible that a fully balanced coin will just randomly come up “heads” for long sequences of flips.

But on another level, Noah is assuming that economies prefer full-employment. But this is not really the case. Full-employment and a fully “healthy” economy are a “special case.” First, just look at the number of months any national economy has maintained employment at the NAIRU (say, 4-5%-ish). It happens. But is it the norm? No. Economies are chaotic systems populated by actors that are constantly developing new strategies based on whatever the current conditions are. They are not fundamentally predictable and no model can reliably predict how they will definitely behave over time. The type of model that will be “most accurate” in describing a complex system like an economy will be similar to a Quantum Mechanics’ descriptions of matter. That model will describe the realm of possibilities and the corresponding likelihood of various outcomes – but the further in the future one tries to predict, the more the probable accuracy of the prediction will fall to zero. Just like the weather. Just like the trajectory of the next photon to pass through a double-slit.

So here’s my actual (posted) comment…:

I think it’s awkward to talk about how long a recession lasts (with or without a liquidity trap). I think you are confusing yourself by thinking of it that way. Here’s why.

An economy is just a big capital flow “system”. Some mid-20th century economist (Phillips?) actually created a refrigerator sized economy simulator via water flowing through transparent tanks and regulators. The video’s out there if you can find it – it’s awesome – his system actually demonstrates long-term cycles that take 10-20 decades to develop in real-life, but 5-15 minutes on the machine.

This is not to say we humans are quite so mechanistic as water molecules (or are we? read: Free Will is an illusion….)

….However, it matters what the cause of a recession is – where did the shock occur? What kind of problem is it? And how big is the problem? Is it a problem that is implicitly fixed (such as a turbulent flow problem? eg: flow instability due to uncertainty in stock markets due to, say, imminent fascist invasion)? Or is it an institutional collapse that has to be repaired? (eg: terrorists nuked the central bank and all the gold reserves?) Or was it a mass “teleportation”/”disintegration” event where the medium of flow (capital/wealth vs water) disappeared or was moved.

The latter describes the shock we had in the Lesser Depression. People and businesses thought they had a certain amount of more or less reliably increasing wealth in real-estate assets, and they leveraged against those assets just like everyone always does. Only in this case, fairly suddenly, that wealth disappeared. It’s like a significant chunk of the water in the “consumer assets” tank just disappeared – or, at least, was “teleported” to a “questionable assets” tank and was suddenly out-of-circulation.

That missing medium (ie capital/fluid) means that all the downstream recipients of the flow suddenly experience a massive decrease in flow – and that disruption is slowly propagated through the entire economy. In some cases, the propagation seems instantaneous since humans can see that there’s a problem in the suppliers of their suppliers, etc, and they start to take immediate steps (cutbacks) even though the disruption hasn’t necessarily hit them yet. But that type of action increases the propagation rate of the flow disruption (and is analogous to a “supersonic shock” – but that doesn’t matter).

What’s important is that all of these flow-effects have a significant amount of uncertainty. The initial uncertainty is implicit from the nature of that “asset-value uncertainty tank” the water got teleported to. But by the time the flow disruption (ie: price signal) propogates through the economy, that initial uncertainty causes the margin of uncertainty in almost every other “asset” value to fall into doubt. Even intangible assets. For instance, how safe is Noah Smith’s job / income stream? That’s a kind of asset whose value-certainty was at least somewhat damaged as the Lesser Depression flow disruption reverberated through the economy. Your income is still coming in, though, but for many others – their income fell to zero, or near-zero. And, unfortunately, each of *those* events acts like yet another (little) shockwave that must reverberate through the economy. When there are millions of these shockwaves reverberating through the economic system, they take the form of a “macro”(economic) shock – and cause the value of everything else to take on much more uncertainty – until the reverberation finally dies down *AND* the capital/fluid flow returns to some kind of predictable flow. And, even then, you won’t be back to “normal” until a weighted quantity of people have transitioned back to the liquidity-preference-level that existed before the shock *and* the net value of all “assets” is in the ballpark of what it was before the shock, too (adjusted, again, for liquidity).

That sounds like gobbledegook to many, I’m sure. But it’s easy to grasp when you just think of what happened to people that lived through the Great Depression. My grandparents became ultra-frugal, canned their own food, scorned the taking-on of debt, and they passed that on to their kids – and my wife will tell you that some of that got inculcated into me, too. The point is that some big shocks like this change people – permanently. They cause a marked change in the aggregate preference for debt vs consumption – a change that will only truly go away after 3+ generations via the death of the original generation. And even then, the change will only happen *IF* the economy recovers and leads to a seemingly sustainable and “safe” environment that makes increased leverage seem acceptable to a critical mass of people. (This perceived “cycle” is what leads to the “70-year debt cycle/wave” – but it isn’t actually a cycle or wave – it is a chaotic, unpredictable system, dependent on many indeterminate factors…)

In short, “recovery” is a bit of an illusion. In some respects, recovery never actually happens. But if you want to know when the economy will get to “full employment,” again – it will do so as the reverberations attenuate (which is not a predictable process – the economy is not an echo-chamber – it is more like millions of interacting – *powered* – amplifiers!) and the flow of capital eventually takes on *something like* the flow that previously existed – but (importantly) relative to the new economy. For instance, demographic change means that capital flow patterns (such as tax rates/policies, agricultural/climatic states) will most likely end up in new %-of-gdp values.

In other words, you’ll know it when you see it. But that also shows that it is a chaotic system that is not predictable with convenient “less than 5 years” *or* “10-20 year” monikers. In a chaotic system, the more you try to apply a pattern, the more the system will violate the pattern. In the case of a human economy – that violation happens in part because whatever tag you believe applies, there will be others that agree with you – and some number of them will *bank* on that. And those bets will distort the course you’d extrapolated – forcing you to change your prediction. And this doesn’t converge into a final, predictable value. Human economies are divergent systems, not convergent systems – because they are always comprised of players whose goal is to exploit the trends, not comply with them. That is the nature of the predictability of chaotic systems.

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About stormculture

In pursuit of reality.
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One Response to Economic Systems are Chaotic Systems

  1. Pingback: Do Economies Inherently Recover? | Stormculture’s Weblog

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