Economics as a human system

I have thought more than once that someone ought to try to apply systems theory to economics in a systematic way. The application of systems theory to family therapy by Murray Bowen was a huge step forward, as was Edwin Friedman‘s work in turning Bowen’s model more broadly to congregational dynamics and leadership; Rabbi Friedman’s book Generation to Generation is one every pastor should read (and periodically re-read). Systems theory helps us to understand that problems don’t exist in isolation and can’t be addressed as if they did; we all exist within interlocking relational systems, and the problems of any given individual relate to the problems of the systems of which they are a part (and indeed, may have more to do with the health of the system than with that individual).

As a consequence, systems theory teaches us that the brute-force approach to problems, the use of compulsion and coercion, is often not the best approach, because it attacks the symptom without doing anything about the underlying issue—and indeed, will likely make the underlying issue worse. Rather, it’s necessary to address problems by changing the system. To do that, you have to identify the ways in which you are supporting the system and enabling its current dysfunction, and then change your own behavior. This changes the incentive structure within the system and shifts the stress of maintaining it off of you and on to the other members; this creates a great deal of pressure on the system which will ultimately, given sufficient time, break it, thus making real progress possible.

The same is true of our economy, which is itself a system—or perhaps one might say, a meta-system, since the “individuals” which interact are corporations, which are their own complex systems—and which is, of course, embedded in the even larger meta-system of the global economy. Problems, whether they be with companies, sectors of the economy, aspects of the economy, or whatever, don’t exist in isolation, and can’t be addressed as if they did. This means that the brute force approach, the attempt to compel the behavior one desires of a given corporation or industry through legislation and regulation, is at best highly inefficient and at worst actively counterproductive. It’s like swatting at a mobile—you put the whole thing in motion, setting it turning in ways you couldn’t have predicted, leading to results you didn’t anticipate. This is why the Law of Unintended Consequences has such force.

Rather than simply trying to regulate the economy into moral behavior, we need to recognize that it’s a complex interlocking system of human relationships, and to try to address corporate and economic issues accordingly. Obviously, this is easier said than done, as the system is far too complex to be fully comprehended by the human mind, but taking this approach at least gets us closer to understanding the real issues. For instance, don’t just look at bad behavior—whether of a rebellious teenager or a company that’s cooking the books—look at the structure of incentives within the system and see what that behavior is in response to, and what’s rewarding it.

This is not a new idea in the world of economic theory; in fact, it’s quite important in the work of the Austrian school of thought, of folks like Ludwig von Mises and F. A. Hayek. It’s one of the reasons I believe they were closer to right than other economic approaches, because they understood and emphasized that the incentive structure drives economic action—that people will tend to do what they have an incentive to do, and to avoid doing what they have no incentive to do—and that when the incentives are out of whack, it will produce behavior which will be bad for the economy. One example of this is Hayek’s Nobel Prize-winning theory of the business cycle, which makes clear that if interest rates are set such as to provide an incentive for highly speculative investments, people will speculate; the result will be an economic bubble which will eventually, inevitably, burst. Just check the housing market.

To try to rationalize the economy, then, to produce steady, sustainable growth, we need to understand (as best as possible) how our laws and regulations and the decisions of government entities like the Federal Reserve and Fannie Mae create incentives for counterproductive behavior; and then we need to work to change those incentives to reward behavior that will produce long-term health rather than short-term big profits. This means not trying to fix the economy by regulating it more—indeed, it might well mean deregulating it to some degree, not because “business can be trusted” (it can’t, but neither can government), but because deregulation simplifies the system and makes it easier to see what’s actually going on.

Hayek, by the way, though an advocate of the free market, was by no means opposed to regulation; he was enough of a realist about humanity to recognize that there is a proper role for government to play in economic matters. As such, there have been those on the Right who have criticized him for not supporting the free-market system enough. From an Austrian perspective, it seems to me, the key is that the government should only regulate cautiously and with humility, out of the expectation that it knows and understands far less than it thinks it does.

Regulation to prevent clear injustice is necessary, as are efforts to insure the free flow of information, because most people will abuse the system if you give them a clear shot and a big enough reason; but regulation to try to control outcomes is almost certain to backfire. When the government tries to pick winners and losers, you end up with crony capitalism and the disasters we’re seeing now. The best we can do is to try to keep the process as fair as possible, so that everybody’s playing by the same rules; try to keep the structure of incentives as rational as possible, so that the market isn’t tilted either towards excessive risk or excessive caution; and to remember this insight from Hayek’s 1988 book The Fatal Conceit: The Errors of Socialism (quoted at the end of the rap video “Fear the Boom and Bust”):

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

Incidentally, the odds are pretty good that you’ve seen that rap video, produced by filmmaker John Papola and economist Russ Roberts (of George Mason University and the blog Café Hayek, which I have in the sidebar), which envisions a rap duel between Hayek and John Maynard Keynes; after all, it’s now up to nearly 1.2 million views for one version of it on YouTube alone. If not, though, unless you absolutely can’t stand rap—and maybe even then—you really ought to watch it here; it’s a great piece of work. Then go read the explication of the video (which I linked above) by one of the posters on Daily Kos (yes, seriously), and Jeffrey Tucker’s piece on the website of the Ludwig von Mises Institute. You’ll be amazed how much you can learn from a rap video. (For my own part, I’m no more a Keynesian than I ever was, but I definitely have more of an appreciation for his work now than I did.)