Rethinking Economics Using Complexity Theory

Abstract

In this paper we argue that if we want to find a more satisfactory approach to tackling the major socio-economic problems we are facing, we need to thoroughly rethink the basic assumptions of macroeconomics and financial theory. Making minor modifications to the standard models to remove “imperfections” is not enough, the whole framework needs to be revisited. Let us here enumerate some of the standard assumptions and postulates of economic theory. 1. An economy is an equilibrium system. In other words, it is a system in which all markets systematically clear at each point of time, but where the equilibrium may be perturbed, from time to time by exogenous shocks. 2. Selfish or greedy behaviour of individuals yields a result that is beneficial to society – a modern, widespread, but inaccurate reformulation of the principle of the “invisible hand”. 3. Individuals and companies decide rationally. By this it is meant that individuals optimize under the constraints they are facing and that their choices satisfy some standard consistency axioms. 4. The behaviour of all the agents together can be treated as corresponding to that of an average or representative individual. 5. When the financial sector is analysed, it is assumed that financial markets are efficient. Efficiency here means that all the relevant information concerning an asset is reflected in the price of that asset. 6. For financial markets it is assumed that they function better if their liquidity is greater. 7. In financial markets, the more connected the network of individuals and institutions the more it reduces risks and the more stable and robust is the system. Below, we discuss the fundamental problems with these assumptions and outline some of the policy implications of improved assumptions.