If supply and demand equilibrium were an economic “law,” the 1929 and 2008 financial crises would have never existed. Rather than ready-made theories, economics needs the experimental background provided by systems thinking.
|This post belongs to a reading series of Doughnut Economics by Kate Raworth. For quick access to all chapters, please click here.|
Disclaimer: This chapter summary is personal work and an invitation to read the book itself for a detailed view of all the author’s ideas.
Overcoming Our Inheritance
For a long time, it was assumed that since rationality is by definition universal, there could only be one model of scientific methodology; the one notably followed by Galileo Galilei and Isaac Newton. This is how, for instance, the 19th-century economist William Stanley Jevons came to think that since physics explains the world from the atomic to the planetary level, the market should too—from the behavior of a single consumer to national and global outputs. In his own words, “Just as we measure gravity by its effects in the motion of a pendulum, so we may estimate the equality or inequality of feelings by the decisions of the human mind. The will is our pendulum, and its oscillations are minutely registered in the price lists of the markets. I know not when we shall have a perfect system of statistics, but the want of it is the only insuperable obstacle in the way of making Economics an exact science.”1
Since there is perfect regularity in how bodies in motion interact, assumed W. S. Jevons, science is set to measure action and reaction as mere quantities the exact same way in any other field of research than physics. Simply put, these other fields of research cannot be labeled as scientific ones otherwise. This narrow understanding of science made the law of equilibrium between forces reign supreme in economics. As Kate Raworth explains, “Crucially the nascent theory hinged on assuming that, for any given mix of preferences that consumers might have, there was just one price at which everyone who wanted to buy and everyone who wanted to sell would be satisfied, having bought or sold all that they wanted for that price. In other words, each market had to have one single, stable point of equilibrium, just as a pendulum has only one point of rest. And for that condition to hold, the market’s buyers and sellers all had to be ‘price-takers’—no single actor being big enough to have sway over prices—and they had to be following the law of diminishing returns.”
This is what the diagram of supply and demand illustrates. The market price is not set by suppliers’ costs nor by consumers’ utility alone, but precisely where costs and utility meet—and there lies the market equilibrium point. According to the theory, furthermore, “if those markets were comprised of fully informed, small-scale, competitive sellers and buyers, then the economy would reach a point of equilibrium that maximised total utility. In other words—in a neat echo of Smith’s invisible hand—it would, for any given income distribution, produce the best possible outcome for society as a whole.” The full mathematical model of general equilibrium was provided in the mid-1950s2 “It appeared to be a landmark proof, giving microeconomic underpinning to macroeconomic analysis, launching a seemingly unified economic theory and laying the foundations of what has been known ever since as ‘modern macro.’”
The theory of equilibrium is nevertheless a pure abstraction. Its inability to predict boom, bust, or depression effectively shows that it has no foundations to hold to in the real world. One economist, in particular, took it upon himself to enlighten the public about the issue. Not any economist. “Robert Solow, known as the father of neoclassical economic growth theory and long-time collaborator of Paul Samuelson, became an outspoken critic [of the equilibrium theory], first in his 2003 speech bluntly entitled ‘Dumb and Dumber in Macroeconomics,’ then in analyses that mocked the theory’s stringent assumptions.3 The general equilibrium model, he pointed out, in fact depends upon there being just one single, immortal consumer-worker-owner maximising their utility into an infinite future, with perfect foresight and rational expectations, all the while served by perfectly competitive firms. How on Earth did such absurd models come to be so dominant? In 2008, Solow gave his view:
‘I am left with a puzzle, or even a challenge. What accounts for the ability of ‘modern macro’ to win hearts and minds among bright and enterprising academic economists? . . . There has always been a purist streak in economics that wants everything to follow neatly from greed, rationality, and equilibrium, with no ifs, ands, or buts . . . The theory is neat, learnable, not terribly difficult, but just technical enough to feel like ‘science.’ Moreover it is practically guaranteed to give laissez-faire-type advice, which happens to fit nicely with the general turn to the political right that began in the 1970s and may or may not be coming to an end.'”4
The crux of the matter is that generations of economists have deluded themselves in thinking that scientific evidence must necessarily follow the thinking process required in exact sciences. Among many other authors who countered that narrow and, one must say, ignorant view, Warren Weaver wrote in 1948 a particularly clear article titled Science and Complexity.5 He explains that there are three main kinds of problems that science can help us understand. The argument is summarized by Kate Raworth this way: “At one extreme lie problems of simplicity, involving just one or two variables in linear causality—a rolling billiard ball, a falling apple, an orbiting planet—and Newton’s laws of classical mechanics do a great job of explaining these. At the other extreme, he wrote, are problems of disordered complexity involving the random movement of billions of variables—such as the motion of molecules in a gas—and these are best analysed using statistics and probability theory. In between these two branches of science, however, lies a vast and fascinating realm: problems of organised complexity, which involve a sizeable number of variables that are ‘interrelated in an organic whole’ to create a complex but organised system.”
“Weaver’s examples, adds the author, came close to asking the very questions that Newton’s apple failed to prompt. ‘What makes an evening primrose open when it does? Why does salt water fail to satisfy thirst? . . . Is a virus a living organism?’ He noted that economic questions came into this realm, too. ‘On what does the price of wheat depend? . . . To what extent is it safe to depend on the free interplay of such economic forces as supply and demand? . . . To what extent must systems of economic control be employed to prevent the wide swings from prosperity to depression?’ Indeed, Weaver recognised that most of humanity’s biological, ecological, economic, social and political challenges were questions of organised complexity, the realm that was least understood.”
Studying how relationships between the many parts of a system shape the behavior of the whole is how we can overcome our inheritance in the field of economics. This study became a science in the 1970s.
The Dance of Complexity
“At the heart of systems thinking lie three deceptively simple concepts: stocks and flows, feedback loops, and delay. They sound straightforward enough, but the mind-boggling business begins when they start to interact.” Their synergy offers a far more relevant picture of how the real world evolves than any conventional economics dogma ever could.
“Stocks and flows are the basic elements of any system: things that can get built up or run down—just like water in a bath, fish in the sea, people on the planet, trust in a community, or money in the bank. A stock’s levels change over time due to the balance between its inflows and outflows.”
“If stocks and flows are a system’s core elements, then feedback loops are their interconnections, and in every system, there are two kinds: reinforcing (or ‘positive’) feedback loops and balancing (or ‘negative’) ones. With reinforcing feedback loops, the more you have, the more you get. They amplify what is happening, creating vicious or virtuous circles that will, if unchecked, lead either to explosive growth or to collapse. . . . If reinforcing feedbacks are what make a system move, then balancing feedbacks are what stop it from exploding or imploding. They counter and offset what is happening and, so, tend to regulate systems. Our bodies use balancing feedbacks to maintain a healthy temperature: get too hot and your skin will start sweating in order to cool you down; get too cold and your body will start shivering in an attempt to warm itself up.”
Lastly, delays between inflows and outflows “are common in systems and can have big effects. Sometimes they bring useful stability to a system, allowing stocks to build up and act as buffers or shock absorbers: think energy stored in a battery, food in the cupboard or savings in the bank. But stock–flow delays can produce system stubbornness too: no matter how much effort gets put in, it takes time to, say, reforest a hillside, build trust in a community, or improve a school’s exam grades. And delay can generate big oscillations when systems are slow to respond—as anyone knows who has been scalded then frozen then scalded again while trying to master the taps on an unfamiliar shower.”
“It is out of these interactions of stocks, flows, feedbacks and delays that complex adaptive systems arise: complex due to their unpredictable emergent behaviour, and adaptive because they keep evolving over time. . . . it soon becomes clear just how powerful systems thinking can be for understanding our ever-evolving world, from the rise of corporate empires to the collapse of ecosystems.”
Complexity in Economics
Here is for systems thinking in a nutshell.6 Let’s consider the shortcomings of the equilibrium theory in that light.
One of them is that this theory forces downplaying the instability that may result from economic dynamics. Taking the financial crisis of 2008 as an example, Kate Raworth reminds us that “In the decade running up to the crash, and oblivious to the build-up of systemic risk, the UK’s chancellor, Gordon Brown, hailed the end of boom and bust,7 while Ben Bernanke, Governor of the Federal Reserve Board welcomed what he called ‘the Great Moderation.’8After 2008, when the boom went very bust, Gordon Brown explicitly admitted “we created a monitoring system that was looking at individual institutions. That was the big mistake. We didn’t understand how risk was spread across the system, we didn’t understand the entanglements of different institutions with each other, and we didn’t understand—even though we talked about it—just how global things were.”9
Another thing that the equilibrium theory downplays is the fostering of inequality. “Given that markets are efficient at rewarding people, goes the theory, then those with broadly similar talents, preferences and initial endowments will end up equally rewarded: any remaining differences must be due to differences in effort, and that provides a spur for innovation and hard work. But in the disequilibrium world that we inhabit—where powerful reinforcing feedbacks are in play—virtuous cycles of wealth and vicious cycles of poverty can send otherwise similar people spiralling to opposite ends of the income-distribution spectrum.”
But the main practical lesson is that by ignoring the interplay of stocks and flows, feedback loops, and delay mechanisms, the equilibrium theory has been an important intellectual driver in bringing the world to the verge of collapse. In 1972 the study Limits to Growth10 was published by a team of authors based at MIT, who had created one of the first dynamic computer models of the global economy, known as World 3, in order to explore a range of economic scenarios up to 2100. Five factors were chosen as determining—and ultimately limiting—output growth: population, agricultural production, natural resources, industrial production, and pollution. The economic scenario of business-as-usual turned out to be alarming. Unfortunately, the modelization has, since then, proved to be accurate.11
As one could have expected, “Mainstream economists were quick to deride the model’s design on the basis that it underplayed the balancing feedback of the price mechanism in markets. If non-renewable resources became scarce, they argued, their prices would rise, triggering greater efficiency in their use, the wider use of substitutes and exploration for new sources.” In theory. In practice, indefinite growth still does not make sense on a finite planet. Not only does Earth hold a finite quantity of resources but it also has a finite capacity to recycle our waste. The externalities of pollution and environmental degradation typically carry no price, generating no direct market feedback, even though they are real. “Such negative externalities, remarks the ecological economist Herman Daly, are those things that ‘we classify as “external” costs for no better reason than because we have made no provision for them in our economic theories.’”12 By taking into account the limits of the planet we should genuinely consider our home, system thinking proves to be definitely more accurate than a fake economic science creating its own abstract truths out of thin air.
Goodbye Wrench, Hello Pruners
How can the dynamics of stocks and flows, feedback loops, and delays be applied to forge a sustainable economy? To answer this question, Kate Raworth first sets the terms of the debate.
“Today’s economy is divisive and degenerative by default. Tomorrow’s economy must be distributive and regenerative by design. An economy that is distributive by design is one whose dynamics tend to disperse and circulate value as it is created, rather than concentrating it in ever-fewer hands. An economy that is regenerative by design is one in which people become full participants in regenerating Earth’s life-giving cycles so that we thrive within planetary boundaries.”
The author goes on, “In their book The Gardens of Democracy, Eric Lui and Nick Hanauer argue that moving from ‘machinebrain’ to ‘gardenbrain’ thinking calls for a simultaneous shift away from believing that things will self-regulate to realising that things need stewarding. ‘To be a gardener is not to let nature take its course; it is to tend,’ they write. ‘Gardeners don’t make plants grow but they do create conditions where plants can thrive and they do make judgments about what should and shouldn’t be in the garden.’”13
“This is our generational design challenge,” says Kate Raworth. How can system-thinking achieve it? “One approach to economic gardening is to embrace evolution. Rather than aiming to predict and control the economy’s behaviour, says Eric Beinhocker (a leading thinker in this field), economists should ‘think of policy as an adapting portfolio of experiments that helps shape the evolution of the economy and society over time.’ It’s an approach that aims to mimic the process of natural selection, often summed up as ‘diversify–select–amplify.’ Set up small-scale policy experiments to test out a variety of interventions, put a stop to the ones that don’t work well, and scale up those that do.”14
The economy could consequently be geared toward stewarding the planet. That might not be as clear-cut as equations applied to the equilibrium theory, but three criteria of any effective system serve as guidelines: healthy hierarchy, self-organization, and resilience.
“First, healthy hierarchy is achieved when nested systems serve the greater whole of which they are a part. Liver cells serve the liver, which in turn serves the human body; if those cells start to multiply rapidly, they become a cancer, no longer serving but destroying the body on which they depend. In economic terms, healthy hierarchy means, for example, ensuring that the financial sector is in service to the productive economy, which in turn is in service to life.”15
“Second, self-organisation is born out of a system’s capacity to make its own structures more complex, such as a dividing cell, a growing social movement or an expanding city. In the economy, much self-organising goes on in the marketplace through the price mechanism (that was Adam Smith’s insight), but it also takes place in the commons and in the household too (the insight of Elinor Ostrom and generations of feminist economists). All three of these realms of provisioning can self-organise effectively to meet people’s wants and needs, and the state should support all three in doing so.”
“Lastly, resilience emerges out of a system’s ability to endure and bounce back from stress, like a jelly that wobbles on a plate without losing its form or a spider’s web that survives a storm. Equilibrium economics became fixated on maximising efficiency and so overlooked the vulnerability that it can bring, as we will see in the next chapter. Building diversity and redundancy into economic structures enhances the economy’s resilience, making it far more effective in adapting to future shocks and pressures.”
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- Jevons, W.S. (1871) The Theory of Political Economy (1.17)
- “In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an overall general equilibrium. . . . The theory reached its modern form with the work of Lionel W. McKenzie (Walrasian theory), Kenneth Arrow and Gérard Debreu (Hicksian theory) in the 1950s.” (Wikipedia)
- Solow, R. (2003) Dumb and dumber in macroeconomics. Speech given in honour of Joseph Stiglitz’s 60th birthday.
- Solow, R. (2008) The state of macroeconomics, Journal of Economic Perspectives 22: 1, pp. 243–249.
- Classical Papers – Science and complexity E:CO Vol. 6 No. 3 2004 pp. 65-74
- For a complete view, see Donella H. Meadows, Thinking in Systems – A Primer
- Brown, G. (1999) Speech to the Labour Party Conference, 27 September 1999. http://news.bbc.co.uk/1/hi/uk_politics/458871.stm
- Bernanke, B. (2004) The great moderation. Remarks at the meeting of the Eastern Economic Association, Washington, DC, 20 February 2004. http://www.federalreserve.gov/boarddocs/speeches/2004/20040220/
- Brown, G. (2011) Speech made at the Institute for New Economic Thinking, Bretton Woods, New Hampshire, 11 April 2011. http://www.bbc.co.uk/news/business-13032013
- A Synopsis: Limits to Growth: The 30-Year Update
- See Is Global Collapse Imminent? by Dr. Graham Turner, Melbourne Sustainable Society Institute, 01 Aug 2014. See also Update to limits to growth, Comparing the World3 model with empirical data by Gaya Herrington for KPMG LLP, Los Angeles, California, July 2021, and Dennis Meadows on the 50th anniversary of the publication of The Limits to Growth
- See Herman E. Daly, Steady-State Economics.
- Liu, E. and Hanauer, N. (2011) The Gardens of Democracy.
- See Beinhocker, E. (2012) New economics, policy and politics, in Dolphin, T. and Nash, D. (eds), Complex New World. London: Institute for Public Policy Research, pp. 142–144.
- See Lovins, H. (2015) An Economy in Service to Life.