Patterns in the Dark: Understanding Risk and Financial Crisis with Complexity Theory
by Edgar E. Peters (New York: John Wiley & Sons, 1999); 222 pages; $39.95.
In the 1920s, 1930s, and 1940s, the Austrian school of economics was considered one of the leading contributors to both economic theory and economic policy. The Austrian economists challenged the premises and arguments of the socialists, interventionists, and inflationists of their day. They offered an insightful conception of the free-market economy as a dynamic competitive process that coordinated the actions and activities of multitudes of individuals without central direction. They emphasized the role and importance of the entrepreneur for bringing the forces of supply and demand into balance and generating creativity and innovation throughout the market. And they refined Adam Smith’s “invisible hand” argument that a market economy, securely based on individual freedom, private property, voluntary agreement, and rule of law, had the ability to create a self-generating “spontaneous order” without any political command or control.
During the 25 years after the Second World War, the Austrian contributions were in eclipse owing to the rise and domination of Keynesian economics and of a neoclassical, mainstream economics steeped in the idea of mathematical models for determining the general equilibrium solutions to a complex economic system. The Austrian eclipse was reinforced by the ideological triumph of those who hoped to discover the quantitative methods for planning and manipulating an economy into desired directions through mathematical and statistical techniques.
Beginning in the 1970s, the theoretical and factual premises of Keynesian economics were increasingly challenged by a growing number of economists. And mathematical economics has slowly come to be seen as a dead end that neither significantly adds to our knowledge about the workings of an interdependent, complex economic order nor offers a key for predicting future changes in the market.
The revival of Austrian economics has received support from unexpected directions in recent years. One of these has come from what is known as “complexity theory.” For example, William A. Sherden, in his book The Fortune Sellers: The Big Business of Buying and Selling Prediction (1998), says,
“Complexity refers to the phenomenon of order emerging from the complex interactions among the components of a system influenced by one or more simple guiding principles. Structures such as an economy emerge out of what would otherwise be anarchy by a process of “self-organization.” Complex systems organize themselves without some form of internal control…. The discovery of self-organization could be attributed to eighteenth-century British economist Adam Smith. Smith reasoned that this “complex stew” of interactions among individuals and businesses pursuing their self-interest would create a functioning economy all by itself, with no one in charge.”
Investment strategist Edgar E. Peters makes the subject of complexity theory, Austrian economics, and the market process the central theme of his new book, Patterns in the Dark. As Peters points out, “The Austrians believe that individuals working in their own self-interest will spontaneously self-organize when there is an overlap in goals and knowledge. There is, in fact, a direct correspondence between many concepts developed by the Austrians and those of complexity theory.”
Peters goes on to explain.
“What makes a social system complex is a loose coupling between individual participants and an increase in the number of possible paths of development…. Complex systems are characterized by global structure and local randomness. The global structure maintains the strength of the whole. The local randomness creates innovation and resilience. In free-market economies, competition is the source of local randomness, and regulation maintains the global structure.”
What does Peters mean by “regulation”? He generally means the institutional “rules of the game” within which individuals freely interact and compete with each other: private property, rule of law, enforcement and respect for contract, and individual rights as a basis for freedom.
And what makes a complex social system and a free-market order “unpredictable,” he argues, is that there is no way to know all the possible ways individuals will adapt to changing circumstances and how entrepreneurs will creatively imagine new and original ways to react to their competitors or initiate new methods and lines of production. Without such real and radical uncertainty, not open to probabilistic risk analysis, the market economy would not have its large degree of adjustability and adaptability to minor and major shifts in opportunities and conditions. Therefore, a market economy evolves and changes through time in ways that makes its future development fundamentally unpredictable. Peters says,
“A free-market economy promotes the trade of goods and services among participants who seek to increase their wealth. The goal of a complex system is not a static “equilibrium.” It is, instead, a dynamic and evolving state that is ever changing, ever creative, but ever stable. The details as to how it achieves this state are never constant. Because a complex system does not need a specific sequence of events to achieve its goal of a stable state, it is resilient despite unexpected changes in its environment, and its creativity adapts.”