Coping with complexity

Martin Wolf says something that I'm in two minds about:

People have to understand, when they're being taught economics, how little we know, how limited our data are, and how unbelievably complex our economic and financial system is.
I think people have to begin with profound humility and know an awful lot of economic history, as I've suggested. And they have to be told every day, "What I've just told you is almost certainly wrong."

I'll join him on the barricades in saying that the economy is a complex system which is inherently unforecastable and so we must be humble about some policy recommendations such as the precise stance of fiscal or monetary policy.

However, it doesn't follow that economists must be humble. As Herbert Stein said: "Economists don't know very much; other people know even less." Sometimes, the solution to complexity is simplicity.

I reckon that we do know three general principles about coping with complexity:

1. Ensure you have the flexibility to respond to shocks. This is one under-rated virtue of markets; whereas companies can die suddenly, markets rarely do. Networks are often more flexible than hierarchies.

A key thing here is to ensure that components are substitutes rather than complements, so that the failure of one doesn't jeopardise all. Phones4U, for example, has collapsed without widespread ill-effects whereas RBS's collapse created a crisis. One reason for this is that Phones4U has many substitutes - we can get phones elsewhere - whereas RBS had complements; its failure dragged other companies down by choking off credit. As Charles Jones has pointed out, one reason why some countries are poor is that they rely too much upon complementarities, so that the failure of one component such as a port or power plant can plunge whole regions into poverty. The banking crisis reminded us that rich economies also suffer this problem. 

For me, this is one argument for Robert Shiller's macro markets. If we can't see recessions coming, we should cushion ourselves against them by using insurance markets rather than relying upon macro policy. Flexibility is better than futurology.

2. Be aware of cognitive errors. If you can't make correct decisions, at least avoid the best-known ways of being wrong.

3. Don't optimize, but satisfice. In a complex world, we often lack the data to make optimal decisions. But we can be roughly right rather than precisely wrong.

For more concreteness, let's apply these principles to financial planning - a field where economists certainly have useful things to say. They imply:

1. Always hold some cash. This protects you from correlation risk and liquidity risk, and ensures that you'll never have to be a forced seller.

2. Be aware of the common mistakes investors make, such as trading too often; being led by peer pressure into bad investments; or becoming too risk-tolerant in the spring and too risk-averse in the autumn.           

3. Don't try and chase every penny, but instead find an asset allocation that's good enough. This means holding tracker funds and avoiding actively managed ones, where you're certain to incur high fees but far (pdf) from certain to out-perform.

I suspect, therefore, that economists don't have to be that humble - at least once we recognise that the job of economists is not to give futurological advice to empty suits, but rather to help ordinary people make better choices. 

Comments

[Matt Moore]

Another great post.

You cracked it in the last paragraph. Humility is about recognising the limits of knowledge, not about bringing those limits artificially inwards.

[Luis Enrique]

"I'll join him on the barricades in saying that the economy is a complex system which is inherently unforecastable"

really? assign estimated probabilities to the following:

1. GDP halves next year
2. GDP next year is close to GDP this year

I am going for 0.1 and 99.9

if I asked you what would happen if the government introduced a minimum wage of £50 per hour, would you answer impossible to say?

[An Alien Visitor]

Isn’t the RBS Phones4u a distinction between a retailer and a bank?

“one reason why some countries are poor is that they rely too much upon complementarities”

Or put more succinctly, Africa was colonised for the stock exchange.