Friday, February 25, 2011

Leijonhuvud on adaptive systems, volatility and endogenous behavioral time horizons (fg)

A. Leijonhuvud gives a further insight on the state of macro research. Starting from the critique on rational expectations, he emphasizes the importance of agents adapting to an open system where agents must refine and adapt to events whose probability had not been estimated correctly. Intertemporal optimization cannot be the true representation of behavior, but it represents an approximation. In volatile times, however, agents are forced to react to current events. Volatility shortens time hoirzons in which short-sighted adaptive behavior generates non-linear dynamics with positive feedback.

Furthermore, Leijonhuvud distinguishes between three forms of feedback regions: region (1) with exclusive negative feedback dynamics and equilibrim outcomes, region (2) with tightly bounded positive feedback loops and business cycle fluctuations, for instance generated by the multiplier concept or the financial accelerator; and region (3) with dangerous instabilites and high positive feedback loops (Fisherian debt-deflation). Region 3 ist reached when budget constraints are violated; whereas the transformation from region (2) to region (3) is caused by leverage and financial budget constraint violations. The slow build-up of leverage in the economy increases the connectivity of the network of debts and claims, and combined with underlying maturity mismatch, it makes the system more fragile.

His main conclusion:
  • The first is that we have to think of an economy as an “open system” in the ontological sense of Tony Lawson (this will require us to adapt out methods to the nature of an economy – to change how we do economics).
  • The second is that the economy is not globally stable but harbors instabilities