One of the great lessons of science is that complexity and complication are not the same thing.
Complexity Doesn’t Mean Complicated
As noted in The Rational Frame for Economics, planetary motion appears complicated when viewed through a geocentric frame. Viewed through a heliocentric frame, much of that complexity disappears.
Evolution produces astonishing biological complexity from a remarkably simple mechanism. Likewise, some of the most complex systems we observe in nature are governed by surprisingly simple underlying principles. The challenge of science is not to explain complexity by making our theories increasingly complicated. It is to discover the simple mechanisms that generate the complexity we observe.
Consider the Earth’s oceans. Imagine humanity had somehow developed thermodynamics before discovering ocean currents. We would be able to calculate incoming solar radiation. We could estimate energy absorbed by different regions of the ocean. We could model heat gain and heat loss and derive equilibrium temperatures for different locations around the globe.
At first, the results would appear impressive – our equilibrium model would reveal undeniable ‘stylised facts’ that lend credibility to the models. The equator is warmer than the poles, and this would be a forecast outcome of an equilibrium model. Tropical waters would contain more energy than polar waters. Again, tick. Many important observations would be explained.
Yet a persistent problem would remain. The data would never quite match.
Actual ocean temperatures would drift away from the values predicted by a purely local equilibrium based model.
Researchers and theoreticians would respond in the usual way. Better data. Better measurements. More sophisticated models. Additional variables. Additional corrections. Identify the missing exogenous drivers of temperature. Use placemakers – hypothesised ‘shocks’ – to explain differences between theory and empirical results.
The forecasts might improve. But the discrepancy would remain.
Then somebody would notice something obvious.
The oceans currents move heat around the globe.
Warm water flows away from the equator. Cold water flows away from the poles. Differences in local equilibrium conditions generate dynamic flows throughout the macro-level system. This is an emergent, dynamic property of a non-equilibrium system.
The crucial insight is not be that equilibrium analysis is wrong. Local equilibrium calculations would still be useful. The problem is that the behaviour of the macro-level system cannot be understood simply by studying local equilibria in isolation.
The most important dynamics emerge because different parts of the system possess different equilibrium states. The climate is not merely a collection of equilibrium conditions. It is also a system of flows between those local equilibria.
Perhaps macroeconomics faces a similar challenge.
Equilibrium Is Local. Macroeconomics Is Not
A polar ocean and a tropical ocean each possess their own local equilibrium conditions.
If considered in isolation, each can be analysed and understood. Given enough information about solar radiation, heat transfer, evaporation and atmospheric conditions, we can estimate the equilibrium temperature toward which each region might tend under thermal equilibrium conditions.
Yet the behaviour of the global climate cannot be understood simply by studying these local equilibria. The assumption that the system is an equilibrium system is may be locally true, whilst also being globally incomplete.
The reason is straightforward.
The equilibrium temperature of the tropical oceans differs from the equilibrium temperature of the polar oceans. And these differences generate flows.
Heat moves. Water moves. Energy moves. And those movements become some of the most important drivers of the global climate system.
The climate is not merely a collection of equilibrium states.
It is a system that also contains flows between, and driven by, heterogeneous local equilibria. Emergent, dynamic flows are generated, and these are non-equilibrium in nature.
Perhaps economies work in much the same way.
A lender and a borrower may each possess different equilibrium states. Lending institutions may employ analytical, strategically rational decision-making frameworks. Borrowers may instead rely upon heuristic decision-making processes shaped by evolutionary biology, bounded cognition, social influence, and incomplete information.
A manufacturer and a retailer may face different constraints, different incentives, and different competitive pressures. Each may operate within a different frame of reference when making decisions.
A low-income household and a high-income household may occupy fundamentally different equilibrium positions with respect to savings, consumption, indebtedness and risk.
A commodities producer and a professional services firm may have different equilibrium states despite both being managed by financially sophisticated actors. Their behaviour may differ because of production cycles, capital requirements, client composition, supply-chain structures, regulatory environments, or exposure to uncertainty.
Each of these actors may be understandable in isolation. Each may possess its own local equilibrium. But macroeconomics is not concerned with isolated actors. It is concerned with the behaviour of the entire system.
The crucial question is therefore not whether equilibrium exists. The crucial question for macroeconomics is what happens when many different equilibria interact simultaneously.
Macroeconomic behaviour emerges through these interactions: different actors, following different decision-making rules, operating under different constraints, and responding to different local conditions.
The economy is not merely a collection of equilibrium states. It is a network of flows between them.
Just as ocean currents emerge from differences in temperature, salinity and pressure, macroeconomic dynamics may emerge from differences in incentives, resources, behavioural rules, market structures, and local equilibrium conditions.
Viewed in this way, some of the most important features of macroeconomic behaviour may be driven less by equilibrium itself than by the dynamic flows generated when heterogeneous agents interact from their respective equilibrium positions.
Are We Looking for Shocks Because We Cannot See the Flows?
The equatorial ocean is cooler than a purely local equilibrium analysis would predict. The poles are warmer.
If we knew nothing of ocean currents, we might hypothesise additional exogenous shocks: invisible cooling mechanisms operating near the equator and hidden heat sources operating near the poles.
But that would miss something fundamental. The discrepancy is not caused by mysterious exogenous influences. It arises because heat flows through predictable endogenous ocean currents.
Warm water moves away from the equator. Cold water moves away from the poles. Energy is continually transferred between regions with different equilibrium conditions.
The temperatures we observe are not the result of local equilibrium states operating in isolation. Local ‘thermal market’ equilibrium is part of the story. But the dynamic flows generated by differences between those states are essential to a full understanding.
Any model based purely on the assumption of equilibrium will be incomplete, and will drift from empirical reality.
Most importantly, these flows are not temporary disturbances. They are not anomalies. They are not exogenous shocks. They are a permanent feature of the system itself.
Ocean currents are not deviations from the behaviour of the climate system.
They are an intrinsic part of the behaviour of the climate system.
Macroeconomics may face a similar challenge.
Much of modern macroeconomic theory begins with an assumption that the economy tends toward some form of general equilibrium. Observed economic fluctuations are then explained through a series of exogenous shocks: productivity shocks, preference shocks, policy shocks, technology shocks, confidence shocks, and countless other hypothesised exogenous ‘place holder’ names for unexplained differences in empirical data.
Each hypothesised ‘shock’ is merely a name we give to our ignorance.
The assumption is deeply embedded in the framework. If the economy departs from equilibrium, something must have pushed it away. If observed behaviour differs from predicted behaviour, some shock must have occurred. But what if this logic reflects a flawed assumption about the nature of the system, rather than a missing shock?
What if the assumption of general equilibrium is itself what’s missing?
What if the economy is not a system tending toward a general equilibrium, and regularly and disturbed from that tendency?
What if the macroeconomy is a system whose natural state is continual motion?
A system of borrowers and lenders. Producers and consumers. Retailers and manufacturers. High-income and low-income households.
Different markets, different constraints, different behavioural rules, and different local equilibria.
In such a system, ongoing flows of wealth, credit, information, labour, risk and resources may emerge naturally and continuously from the differences that exist throughout the economy.
No external disturbance is required. The flows themselves explain the ongoing macroeconomic motion and change.
If we keep looking only for exogenous shock, and never for endogenous flows, we will fail to model the system as it exists.
Under this view, the economy may resemble the climate more than it resembles a mechanical system returning to rest.
Its most important dynamics arise not because equilibrium is repeatedly disturbed, but because heterogeneity continuously generates movement.
The existence of lenders implies borrowing. The existence of producers implies consumption. The existence of income differences implies expenditure flows. The existence of different local equilibria implies adjustment flows between them.
Viewed in this way, it is entirely possible that no meaningful system-wide equilibrium exists at all.
The permanent state of the macroeconomy may be continual adaptation and motion generated by interactions between heterogeneous regions of the system.
A theory of global ocean temperatures that ignored ocean currents would inevitably search for invisible heat sources and unexplained cooling effects.
A macroeconomic theory that ignores emergent flows may find itself searching for an ever-expanding catalogue of exogenous shocks.
The problem may not be that the catalogue of shocks is incomplete. The problem may be that we have ignored the emergent, dyamic flows.
Looking For The Flows
If macroeconomic dynamics are driven by persistent flows generated by heterogeneity, then we might expect to observe recurring patterns that conventional equilibrium-based explanations struggle to fully explain.
Several candidates come to mind.
Throughout history, observers have noted a persistent tendency toward concentration of wealth and economic power. The rich appear to become richer while the poor struggle to accumulate assets.
Traditionally, this tendency has been explained through differences in widening gaps in productivity, skills, incentives or other ‘intrinsic’ individual characteristics such as preferences.
But another possibility exists.
What if part of this phenomenon is driven by a persistent and measurable flow of wealth between different regions of the economy?
Not a shock. Not an exogenous anomaly. But a structural feature of the system itself. A flow of wealth generated by the difference in equilibria that owes nothing to preferences, shocks or even intrinsic properties of the individual agents.
Likewise, economists have long debated the phenomenon of secular stagnation in mature economies. Explanations range from demographic change to productivity slowdowns, or diminishing returns from technological innovation.
But it remains possible that a deeper dynamic process is at work.
A process that emerges naturally from the interaction of heterogeneous actors and markets, influencing innovation, productivity, and driving a difference in the cause and magnitude of growth over time.
Another longstanding puzzle concerns the apparent tendency for the marginal productivity of capital to decline more rapidly than some theoretical frameworks would predict.
Perhaps this is the economic equivalent of observing unexpected temperature patterns in the world’s oceans. The discrepancy may not arise because the underlying theory is entirely wrong. It may arise because an important dynamic process has been omitted from the model.
A scientist unaware of ocean currents might search for mysterious heat sources near the poles and hidden cooling mechanisms near the equator.
The real explanation could be simpler. Heat flows.
Likewise, some macroeconomic puzzles may ultimately prove to be symptoms of persistent flows operating within the economic system itself.
Flows that are measurable. Flows that are predictable. Flows that arise endogenously from the interaction of heterogeneous agents, markets and industries.
Flows that are not included in our current models because we haven’t looked for them.
If that possibility is correct, then the challenge facing macroeconomics is not merely to improve its understanding of equilibrium conditions.
It is to identify the dynamic laws governing motion between them.
The Future of Macroeconomics
The purpose of this article has not been to argue that equilibrium analysis is wrong.
Local equilibrium is real. Markets clear. Prices adjust. Firms optimise. Households make decisions within constraints.
The question is whether local equilibrium is sufficient to explain the behaviour of the macro-level system as a whole.
The ocean current analogy suggests caution.
A scientist who studied only local energy balances would learn many true things about the climate. Yet something essential would still be missing.
The equator is cooler than its local equilibrium would suggest. The poles are warmer.
Not because hidden cooling sources exist at the equator. Not because invisible heat generators exist at the poles. But because heat flows.
The observed state of the system depends not only on local equilibrium conditions, but on the ongoing transfer of energy between regions with different equilibrium states.
The flows are not a disturbance to the system. They are the system.
Macroeconomics may face a similar challenge.
The economy is not merely a collection of markets. It is not merely a collection of equilibria.
It is a system of flows between heterogeneous agents, industries, institutions and communities.
Those flows may be moving wealth. They may be moving information. They may be shifting productivity. They may be influencing the opportunities available, and the incentives to invest in different parts of the macro-economy.
And they may be doing so continuously.
If our models begin with an assumption of generalized equilibrium, we may be excluding from analysis some of the very forces that drive the economy.
Just as a climate model that ignores ocean currents will struggle to explain observed temperatures, a macroeconomic model that ignores emergent flows may find itself relying upon an ever-expanding catalogue of hypothesised exogenous shocks to explain empirical data.
The result is a world that appears increasingly complicated. Yet complexity need not necessarily mean complication.
Sometimes apparent complexity is simply a sign that our theory is incomplete. That we have failed to account for simple, predictable endogenous dynamics.
My own research has increasingly pointed toward the existence of several persistent endogenous flows that appear capable of explaining a number of longstanding macroeconomic puzzles. The details will be presented in a forthcoming series of academic papers.
For now, the broader point is simpler.
The economy may not be a system occasionally disturbed by shocks.
It may be a system continuously shaped by flows.
Perhaps the most important forces in the macroeconomy are not the shocks we cannot observe. Perhaps they are the flows we have not yet learned to measure.