April 9 (Bloomberg) -- Almost five years after a financial crash nearly thrust the world into depression, a peculiar paradigm still dominates economic thought.
Known as the neoclassical school, it aims to give Adam Smith’s notion of the invisible hand its mathematical form. It asserts that markets naturally seek an equilibrium that harnesses individual self interest to allocate investment capital in an optimal way. Even if that perfectly efficient ideal is never reached, the logic goes, markets work better insofar as they approach it.
Anyone who thinks our recent financial travails would have discredited this vision is underestimating the mental inertia of theoretical economics. To this day, the Federal Reserve and the European Central Bank go right on making plans using so-called general equilibrium models of the economy. In these models, financial firms don’t exist, asset bubbles are inconceivable and there’s no such thing as an international market in derivatives -- despite the obvious reality of one with a total notional value of around $700 trillion.
The economics profession hasn’t tried too hard to develop more realistic alternatives. But history tells us they can be found. In the 1950s, even as economists lashed themselves to the mast of equilibrium thinking, scientists studying the movement of air in the atmosphere turned in a very different direction.
How does air move around the planet? Back in 1735, an English lawyer and amateur scientist named George Hadley suggested a model that became the dominant paradigm: Warmer air near the equator should rise skyward, flow toward the poles in the upper atmosphere, and then descend and cool near the poles, afterwards flowing back toward the equator at the surface.
This balanced equilibrium explained many observations, such as the trade winds -- steady westerly flowing winds near the equator -- on which navigators had depended for centuries. Indeed, Hadley’s balance was so satisfying that it took about a century for scientists to notice that it was mostly wrong, or at least seriously incomplete.
In fact, the looping flow Hadley described stretches only from the equator out to about 30 degrees latitude -- that’s around Florida in the northern hemisphere, and South Africa in the southern. In the mid latitudes beyond, there’s no stable balance, but ceaseless change, storms and weather fronts, meandering cyclones and anti-cyclones.
The basic story identifying the source of all this turbulence emerged only in the 1950s, long after scientists had understood seemingly far more esoteric subjects such as nuclear physics. This actually makes sense: The weather is a tough problem, because nothing in it can be reduced to a state of balance or equilibrium (as a simple atomic nucleus can). Therein lies the key insight for atmospheric flow.
Storms and weather fronts aren’t accidental and unimportant “details” of the atmospheric flow at all. They are central to the way the Sun’s energy, once absorbed on Earth, flows about the planet. The jet streams that race around the planet at high altitude can’t remain stable. They have an inherent tendency to wander north and south, making a wavy pattern. Ultimately, this phenomenon, arising from something called baroclinic instability, creates large swirling vortices of air that drift through the middle latitudes, transporting huge quantities of heat and water all over the planet, and causing our unpredictable weather.
No mathematician can “solve” the complex equations for air in the atmosphere. Confidence in the explanation I just described came only in 1955, when a scientist named Norman Phillips used an early computer to simulate a virtual atmosphere based on a crude approximation of the equations of fluid dynamics.
Phillips did an experiment in which the air started at rest and gradually sped up as the earth passing beneath dragged it into motion, and as temperature differences made it rise and fall. The simulation, which took 12 hours to run, showed that baroclinic instability really does account for the fundamental character of atmospheric flows. Stable flows always fell apart, creating cyclonic storms and weather fronts just as we see.
It’s natural to wonder if a similar mechanism might be driving the financial crises and business cycles that typify the economic “weather” we’ve experienced over the centuries. Unfortunately, today’s equilibrium theories refuse to entertain the possibility.
While an appreciation of instability propelled atmospheric science forward, economics was binding itself into a rigid framework. One year before Phillips’ experiment, economists Kenneth Arrow and Gerard Debreu offered mathematical proofs that an abstract market model really does have an equilibrium with certain “optimal” properties. Yet when studies in the 1970s found that this equilibrium is generally unstable -- and so should tend to fall apart just like Hadley’s looping flow -- theorists for the most part simply ignored this inconvenient fact and went on as before. Most still do.
American economist Milton Friedman set the tone. “The study of the stability of general equilibrium is unimportant” because “it is obvious that the economy is stable,” he was quoted as saying. Friedman was notoriously mischievous and slippery in his argument, so I’m not sure he really believed what he said. But most economists today act as if they do.
This is too bad, because a focus on the origins of instability just might help financial economics achieve a conceptual liberation akin to that which atmospheric scientists achieved in the 1950s. Economists might come to accept that equilibrium doesn’t describe everything, or even very much, and that natural elements of instability and turbulence drive the outcomes that matter most.
(Mark Buchanan, a theoretical physicist and the author of “The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You,” is a Bloomberg View columnist. The opinions expressed are his own.)
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