Saturday, November 22, 2008

The Darwinian Evolution of Financial Crises

In response to the current financial crisis, many people assume that this shows a lack of proper planning and regulation by government, and they demand that political leaders should resolve the crisis and create new plans and regulations to prevent future crises. This intelligent design theory of political economy assumes that political and economic leaders have the knowledge and virtue to plan out and regulate the future of the global economy to avoid economic disasters.

I reject this as a foolishly utopian view of human knowledge and virtue in managing the future. Against this intelligent design theory of economics, I would offer a Darwinian evolutionary theory. Much of modern economic theory is based on formal, mathematical modeling comparable to the physical sciences. The idea of economic "equilibrium," for example, is borrowed from physics. But this ignores the historicity and contingency of human social behavior. If the social sciences are sciences, they are historical sciences like evolutionary biology rather than ahistorical sciences like physics. Economics is an evolutionary science, and economic history is an evolutionary process in which the future is unpredictable and unplanned because it always brings novel events that no human being could have anticipated. The best that we can do is to allow for economic survival of the fittest.

This evolutionary theory of economics has a long tradition. Adam Smith and other philosophers of economics in the Scottish Enlightenment saw the history of economic institutions as an evolutionary history that emerged by human action but not by human design. Darwin's theories of organic evolution (in The Origin of Species) and moral evolution (in The Descent of Man) were inspired by the ideas of the Scottish Enlightenment. Later, economists like Joseph Schumpeter (in the Austrian School tradition of economics) showed how capitalism could be understood as an evolutionary process in which novel developments in economic life bring about "creative destruction"--firms adapted to the new circumstances succeed, while those that are maladaptive fail. Just as most biological species have gone extinct, most firms vanish because they cannot survive in their competitive environments.

Historian Niall Ferguson applies this evolutionary approach to economics in his new book--The Ascent of Money: A Financial History of the World (Penguin Press, 2008). He shows that the current financial crisis is only the latest development in a five-thousand-year evolutionary history of money and finance regularly punctuated by financial disasters.

Against the common assumption that we should be able to avoid economic crises if only we had the right planning and regulation, Ferguson argues that there are three reasons why economic catastrophes are inevitable.

First, the future is always uncertain. This is not the measurable uncertainty that we associate with risk but the unmeasurable uncertainty that cannot be reduced to any calculable probability. "To put it simply, much of what happens in life isn't like a game of dice." We can calculate probabilities for the rolling of dice. But we can't do that for our economic future, because we cannot predict future economic history at all. That's one reason why all those fancy economic forecasting models used by the Wall Street bankers failed to predict our current financial collapse.

The second reason for the instability of financial systems is the imperfection of human knowledge and behavior. As psychologists like Daniel Kahneman and Amos Tversky have shown, human beings do not make their decisions based on a purely rational calculation of probable costs and benefits. In fact, human beings are very bad at calculating probabilities, because their judgments are shaped by innate biases of the human mind as shaped by evolutionary history.

The third reason for the unpredictability of financial history is that it really is like Darwinian evolution. In the financial world, business practices are inherited through cultural evolution. Innovations in such practices constitute mutations that compete with customary practices. By competition, some practices are more productive than others, and some go extinct. What we are seeing today in the global financial crisis could turn out to be a mass extinction event, in which many business practices and firms will disappear as new ones emerge triumphant. This is what Schumpeter called "creative destruction."

The problem, however, is that political leaders feel pressured to intervene to stop such destruction. Surely, some firms are "too big to fail." That's the thinking that has led us to the governmental bailouts favored by Bush, McCain, and Obama. It's hard to accept the harsh truth that economic failure and bankruptcy is a normal part of economic innovation. So we are tempted to assume that Wall Street bankers like Henry Paulson must know how to plan out our economic future so that we can avoid the painful consequences of economic dislocations. But that assumes more knowledge and virtue than we can realistically expect from human beings.


mtraven said...

I agree, let's make the markets more Darwinian! A big part of the problem seems to stem from financiers having no downside to taking insane risks with other people's money. So, let's remedy that by decreeing that Wall Street types who manage to make billions of dollars of real value disappear while enriching themselves in the process should be summarily executed, thus removing their genes from the pool.

bill greene said...

The present financial crisis is not the result of "a lack of proper planning and regulation by government," but is the direct result of too much planning, manipulation, and regulation.

It was Fannie Mae and other Congressional legislative encouragement of risky loans that did the harm. The House Banking Committee was the prime source of this anti-free market regulation--they supported the government subsidized issuamce of sub-prime loans.

It may be that economic history cannot predict the future. And it may be even truer that the abstract macro-economic theories of the academics will more often than not lead us astray. But an unbiased knowledge of economic history can at least prevent our repeating some of the worst blunders of past political leaders.

My historical review of national success stories over the last 3,000 years shows that success was obtained in locales where the ordinary people were free to enter the marketplace without either excess regulation or subsidy. "Common Genius" recaps how progress emerged in the very few free markets that dotted our progress from ancient times.

As compared to complex mathematical models, simple common sense underlies all successful economies. Common sense accepts the fact that human beings are creative and unpredictable. But one constant--a recurring lesson of history-- is that you reward their bad behavior at your peril. The recent financial meltdown came from violating that simple precept.

Economic history does, therefore, allow us to predict the future to some extent: subsidies will encourage behavior contrary to normal risk-reward considerations, and sheltering individuals from their bad behavior will encourage more of the same.

Neither of these two "sins" come from a free marketplace--they both come from meddlesome central authority. Too simple for the would-be central planners to want to accept. It would leave them unemployed!

Martin Hewson said...

Prof Arnhart, having just recently discovered this blog, I have to say it is fascinating.

But I think in this post the dichotomy of "intelligent design" vs "unplanned evolution" does not quite apply.

The credit crisis is due in part to un-intelligent design -- ie poor regulation and policy, or (in short) imprudence. (In the US mainly an unintended result of the longstanding effort to promote homeownership.)

Better regulation can prevent such crises as is show by the fact that some countries (eg Spain and Canada) have not had banking crises whereas others have (Iceland, the USA, and UK).

The conservative, prudent, character of Canadian banking has saved it.

Thus, your analogy of financial history to a Darwinian natural history of selection seems to me to neglect such factors as agency, learning, and prudent foresight; factors that a conservative (Darwinian or otherwise) would tend to accentuate.

I would like to see you comment further on the Darwinian analogy of "social selection." One can be a good Darwinist (as I am) without accepting it. (Have you commented in this blog or elsewhere on Joseph Bryant's critique of evolutionary social science in Philosophy of the Social Sciences 2004?)