New world order: biological science links patterns of economic behaviour

The summer heatwave in the US corn belt is going to hit grain production and has already raised food prices. So far, such price increases have not yet translated to global inflation, thanks to better food crop production in other parts of the world.

Commodity traders today use satellite maps to track global crop production and weather conditions in order to predict commodity prices. In 1878, British economist William Stanley Jevons even suggested that economic cycles are related to sunspots, because sunspots affected the weather, which in turn affected crop production and the economy.

The summer heat is also raising political tension in many countries, on top of the European debt crisis and the fear of the Chinese economy slowing, all adding to market volatility and uncertainty. What is the best economic framework to make sense of what is happening? All we can say with some certainty is that the economic and risk management models of the current efficient market hypothesis are not working well at all.

MIT Sloan School professor Andrew Lo, in a recent paper, 'Adaptive Markets and the New World Order', suggests that we should view financial markets and institutions from the perspective of evolutionary biology rather than physics. He suggests that today's efficient market hypothesis models are not so much wrong as incomplete. These models worked reasonably well from the 1930s to the mid-2000s in the US financial markets, but he suggests that the last decade is really the beginning of a 'new world order' of higher volatility, due to larger population and economic shifts caused by technology, competition for resources from population giants like China and India, and rising leverage and global imbalances.

His adaptive market hypothesis recognises that efficient and irrational markets are extremes, while most market conditions are somewhere in between. Market behaviour adapts to changes in the environment, such as policy changes. For example, the Peltzman study in 1975 found that seat belt requirements did not lead to much of a decline in highway deaths because people became more reckless, since they felt more safe.

The idea that the market knows best underpins current corporate governance theory, that share prices reflect the market assessment of how well a company is performing. However, the rule change to allow share buybacks meant that a company can use its own cash to keep its share price up, at least delaying the signalling effect of weak share prices on performance.

The adaptive market hypothesis suggests that rather than thinking that there is always 'the wisdom of crowds' - the logical extension that markets are always right - one should think about the creative tension between the wisdom of crowds and 'the madness of mobs'.

A useful insight brought by the adaptive market hypothesis is that conventional wisdom can become wrong over time, such as the notion of diversification. We are taught that we should diversify our risks, but, increasingly, most markets are highly correlated to each other, so moving money to emerging markets may not be a diversification, if these economies and markets have not decoupled from the advanced economies.

We live today in a highly complex world, where the only way to comprehend it is to have a system-wide view that looks at the interconnectivity, the interdependence and feedback mechanisms between the parts and the whole. George Soros is right to say that reflexivity - the feedback between the parts that create new situations that give rise to new opportunities as well as risks - may be a more important insight about the current world order, than the idea that we eventually go back to equilibrium.

Climate warming, ecology and economics converge because the issues are all interrelated and can no longer be thought of as independent of one another. What we have not understood is how to link the patterns of change into a new order. We can only do this when we see this graphically, by using data which have yet to be mined and analysed. This is now made possible by the rise of super-fast computers and new mathematics of complexity.

Biological scientists have long argued that biological organisms evolve through patterns - changing from one order to another through evolution. The big debate in using biological science to explain economic behaviour is whether collective human behaviour and human social order can be an imitation of biological life.

Social science has always been differentiated from natural science because of human determinism - the fact that man has been able to shape (some people think destroy) his natural environment and to impose social order. The fact that political leadership and order is being challenged almost throughout the world raises the question of whether we are as able to shape social order as we thought. Or, are we in the midst of a major move to a new order?

The study of the interaction between market and state needs to draw lessons from biology, ecology and systems theory. Markets are about self-organisation, and, according to biology, self organisation means the emergence of new structures and new forms of behaviour in an open system. Change feels like chaos.

So summer heat, political heat and market volatility are all inter-related. Sounds familiar?

Andrew Sheng is president of Fung Global Institute