Coping with Complexity

by | November 15, 2021

Amongst my many interests is military history, especially the lives of famous generals. I like a quote attributed to the Duke of Wellington: “Napoleon built his campaigns of iron and when one piece broke the whole structure collapsed. I made my campaigns using rope, and if a piece broke, I tied a knot.”

Wellington was referring to the importance of flexibility, whether in command on the battlefield or the complexity that is the modern economy. In what follows, I examine how economies move in and out of equilibrium, and the growing threats to complex systems, including the tipping points as entirely new economic regimes appear. Externalities matter—in theory markets work without them, but too often markets fail in their presence.

The concept of equilibrium is central to the economics profession. From the earliest days of classical economics much work has gone into trying to understand how, where and when an economy might be in equilibrium, what shocks might cause a boom or bust cycle, and how stability might return. 

Today’s modern economies face both cyclical and structural shocks. Typically, the former are shorter and resolved by the price mechanism. For instance, a dearth of semi-conductors has recently stalled global auto production. One imagines, however, that higher prices caused by such scarcities will curb demand and encourage investment in new capacity, alleviating shortages before long. 

Structural shocks, on the other hand, necessitate a lengthier, difficult adjustment. New technologies, such as artificial intelligence, will disrupt existing industries for years to come. And major epochal events, like pandemics, can ‘permanently’ change attitudes towards work and consumption.

In macro-economics, inflation has long been associated with departures from equilibrium. Recent jumps in headline inflation are likely to be transitory, with pressures abating as short-term bottlenecks are overcome. Nevertheless, a long-term realignment of global supply chains also suggests that some costs may remain higher for much longer and may be passed along via higher prices or absorbed through shrinking profit margins. Barriers to trade from the pandemic, a backlash against globalization, and geopolitics in the form of China’s growing isolation, all play into the narrative of more costly global production.

No matter the shock, the speed of adjustment depends on flexibility. In economic terms, the question is how rapidly resources can be transferred from one sector to another. Typically, capital and technology are easier to shift around than labour. Today, however, barriers to capital and technology are surfacing, especially between the USA, Europe and China, which may lengthen adjustment periods. 

Where systems are inflexible, it pays to have spare capacity, larger buffers of inventories or redundancy of production. Yet in a world of short-term profit-seeking, those backups are unlikely to be sufficiently delivered by the private sector. To quote Oxford’s Dieter Helm, “Security is a public good. The private markets will never provide it.”

Energy is a prime example. This year, coal, oil and gas markets across Asia, Europe and the Americas were hit by a series of man-made and climate disruptions. Little margin for safety resulted in surging prices. The resultant ripple effects through natural gas, fertiliser, carbon dioxide, food and medical sectors forced unprecedented government intervention to prevent even wider collateral damage. 

Climate change offers other examples of inflexibility, slowing much needed adaptability. The absence of sensible carbon pricing policies means that demand only sluggishly responds to environmental needs. Government subsidies slow the shift from fossil fuels, meaning that the marketplace will not respond quickly enough to meet the challenge of limiting greenhouse emissions. Sadly, reliance on outmoded infrastructure, skills and technologies imperils transformations and curbs future growth. It also exposes the economy to large losses, including write-offs of stranded assets.

One might think that the collective wisdom of investors would facilitate change before it is too late. Yet, markets are not always able to anticipate crises, even as they unfold. The shock of World War I is an obvious and oft-cited example. Or, as Ian Bremmer at Eurasia warns, “the world’s biggest dangers today are less about geopolitical conflict than systemic breakdown, from the pandemic to climate change, from disruptive technologies to financial crisis”.

A major shock can overwhelm unprepared systems. Fragilities are exposed, including the absence of redundancy, or the inadequacy of proper planning. Belief in the ability of markets to recognize, parcel out and manage risk was exposed as a complete fallacy by the global financial crisis of 2008. In fact, the opaque and overly complex systems of finance created just the opposite situation –  namely the inability of businesses, investors, and regulators to foresee inter-connected risk, much less manage it. 

Tipping points occur when an overly complex system crumbles under its own inconsistencies. For years, scientists and economists have sent clear warnings about the dangers of climate change. As the IMF has forecast, “the number of category 4 and 5 storms in the North Atlantic is expected to increase by 45 to 87% over the course of 21st century”. Yet financial markets, which assign high discount rates to future outcomes, tend to undervalue long-term risk relative to short-term risk, increasing the probability that such tipping points will materialize.

How should modern society address the challenges that markets cannot? One measure is to increase flexibility where it is insufficient, such as in labour markets. Worker training is an obvious step in the right direction, providing workers with the ability to adjust to shifts in demand, production and technology. Fiscal flexibility would also be helpful, although today the margin for action is constrained by the enormous debt burdens built up during the pandemic.

Other forms of resilience and flexibility will be required, for example investing in spare capacity. An IMF climate report argued “Building adaptive capacity calls for substantial investment at a time when debt levels are high. Bolstering resilience will require retrofitting existing climate-exposed assets or developing new infrastructure”. 

Resilience also requires better planning. Flood risk can be ameliorated by better urban development. As the Yale epidemiologist Gregg Gonsalves has said “Hurricane Katrina didn’t happen because Louisiana never had a hurricane before; it happened because of policy choices that led to catastrophe.” Pandemics are not new, but preparation can lessen their impact. Yet preparedness cannot be measured merely in terms of numbers of syringes or anti-viral drugs. Investments in public health resources, including testing facilities, paid sick leave, safe public housing, eviction moratoriums, food assistance, and universal health care are also required.

In theory, shifting from one equilibrium to another is the function of markets. Yet because of multiple externalities, high discount rates and complex systems, markets are prone to fail or are inadequate by themselves. Keynes famously made that point in the realm of macroeconomics, but it applies just as much in microeconomics. Market failure can be rectified by incentives (taxes or subsidies), regulation (to manage a utility or tech monopoly), and public investment (education, health, or basic science). Yet all too often the political support and foresight are lacking. 

Today we are confronted by rapid change and fundamental, even existential, challenges to overly complex systems. More elasticity, redundancy, spare capacity, and better planning are required to meet those challenges. 

Markets and economies can be made more flexible, but only if we have more flexible thinking. 

About the Author

Andrew Milligan is an independent economist and investment consultant. He is a Board member of the Asia Scotland Institute, an adviser to the Health Foundation, to Balmoral Asset Management and to the Educational Institute of Scotland, and a Fellow of the Society of Professional Economists. From 2000-20, Andrew was the chief market strategist for the global fund manager Aberdeen Standard Investments.

After graduating from Bristol University, Andrew started in H.M. Treasury where he specialised in the IMF and World Bank’s handling of the Latin American debt crisis. He then worked in turn for Lloyds Bank, the broker Smith New Court, and New Japan Securities as an international economist. In 1995 he entered the asset management industry, becoming Head of Economic Research and Business Risk for Aviva Investors. In 2000 he moved to Edinburgh to work as the Head of Global Strategy for Standard Life Investments, in charge of a team covering economic and market research, tactical and strategic asset allocation decisions, client advice and communications for retail and institutional clients globally.

After its merger with Aberdeen Asset Management to form Aberdeen Standard Investments, the company became the second largest active fund manager in Europe with over 30 offices across the major financial centres. Andrew is well known as a public speaker while his writing, commentary and interviews have appeared in all the mainstream media.

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