Dr. John Rutledge: Far from Equilibrium Economics, Finance and Investing

Summary: I believe the key to managing financial crises is to understand the how systems behave when they are far from equilibrium. You can read more about the theoretical foundations of Far-From-Equilibriuim economics and finance by clicking here, which will take you to a downloadable PDF file of a recent article that I wrote for the Journal of Financial Economics. I hope that you enjoy the article.

In my last article I posted a set of graphs that illustrate a framework for understanding the sudden collapse of a robust economy into a financial crises and the nature of its subsequent recovery. This piece is to provide a foundation for understanding the theory of financial crises embodied in the graphs. I believe it is a good basis for understanding the economic and financial impacts of the coronavirus crisis that is taking place today.

This framework views an economy at full employment as a smoothly functioning information network of the sort proposed almost 100 years ago by Friedrich von Hayek. It views the sudden onset of a financial crisis as a cascading network failure, or phase transition, to a less efficient state, something like what happens when an electricity grid fails. And it treats the gradual return to full employment as a second phase transition as the information network reconnects people over time. Unfortunately, in economics as well as nature, these phase transitions are unavoidable but to some degree they can be mitigated and managed.

This approach, known as Complex Adaptive Systems (CAS), is the result of thousands of scientific papers over the past thirty years in physics, chemistry, biology, and mathematics. In the document above, I describe the framework and summarize a number of the results. My hope is that it will help people understand and manage their way through the situations like we find ourselves in today.

I have been fascinated by the area since my daughter Jessica–also burdened by the math geek gene–introduced me to CAS and network theory 30 years ago. Since then, I have studied CAS, written about it, lectured on it at the Chinese Academy of Sciences, and taught a course in it every year to the PhD students at Claremont Graduate University. I believe it is the key to understanding one of the black holes in standard economic–why market economies can be both highly efficient most of the time and also subject to periodic, sudden financial crises. I will attach the syllabus for that course to my next post.

As you will see, this is a relatively nontechnical discussion of the ideas behind financial crises. The topic itself, however is not nontechnical (pardon the double negative.) It is based on a relatively new area in physics known as  far-from-equilibrium thermodynamics, pioneered by Belgian chemist Ilya Prigogine (Nobel Prize, 1977) and others.

I won’t try to explain the subject matter here. You can get a good start on the ideas, as well as some of the most important references, in the article. Suffice it to say that the difference between near- and far-from-equilibrium change is like the difference between a gentle breeze and a hurricane. Or, as the late Per Bak wrote, “Almost all changes are small. Almost all changed is big.” I will write more on this subject this week.

JR

Summary: I posted these charts several months ago with a promise that I would write more to explain them. Well, I got distracted and didn’t do so even after a request from one of the best economists I know. I am posting it again and will write more tomorrow to explain it. It is the way to think about financial crises as phase transitions. I think it is the explanation for the impact of the coronavirus on the economy. We are suffering a cascading network failure. More below.

I want to warn you that this is a seriously nerdy piece so don’t blame me if you stare at it for a long time and suffer brain damage as a result.

Long ago I was a tenured Professor. Then I got bored and wandered off to do strange things. I advised governments, pension funds and big investors, helped restructure companies, started a mutual fund, founded a private equity firm, served on the boards of dozens of public and private companies, and got about 20 million air miles.

Then I started teaching PhD students again. What I saw being taught as macroeconomics blew my mind–and not in a good way. Here is a peek at how I teach it.

I still loved working with the students, which was the reason I started teaching in the first place. But I found that what passed for state-of-the-art thinking in both macroeconomics and finance made no sense to me at all. So I taught the stuff to the students, then taught them what was wrong with it, and finally taught them a framework I had developed over the previous 30 years that I think of as far-from-equilibrium economics to help understand what goes wrong when an economy falls out of textbook full-employment general equilibrium into financial crisis and ultimately fights its way back to health again.

It’s a complicated story that requires understanding some unfamiliar ideas drawn from unfamiliar literature so I’m going to tell it bit by bit. In this piece I am only going to give you a few of the key summary graphs showing an economy initially cruising along at full employment, hit by a sudden financial crisis (something we will later call a cascading network failure), experiencing a phase transition to a recession state, eventually fighting its way back to general equilibrium as the network recovers.

The graphs, below, are the summary of the ideas we will develop in further posts. I hope to convince you that they represent a much more fruitful approach to macroeconomics and finance than the stuff currently described as accepted wisdom. I will also write about the investment strategies that make sense in this view of the world.

Needless to day, more to come.

JR