The result of increased connectivity has been a more volatile and less predictable economy -- and theories that no longer apply to our frenzied world.



For those of you who have been following my posts here, you'll notice a familiar refrain: I see the explosive growth in interconnections driven primarily by the Internet as something that, if ignored, can lead to dangerous situations. Because they're so powerful, interconnections must be handled with care -- something our current crop of economists and policy makers have failed to do.

Since the late 1980's, economists have been concerned about the effects of positive feedback, a term used to describe a process where growth creates more growth. As the Internet multiplied and strengthened interconnections, positive feedback increasingly drove our economic, financial, political, business, and social spheres, which in turn led to overconnectivity. The result has been a more volatile and less predictable economy -- an economy that has stymied policy makers.

I'm using the words positive feedback in an engineering sense. When interest compounds the growth in our savings account, we experience the power of positive feedback. That is, we are being paid 2 percent on our savings, then that 2 percent gets fed back into our account and our money doubles in 36 years. If we can earn 5 percent on our savings, this feedback process causes our money to double in just 15 years. An incremental increase in positive feedback drives much faster rates of change.

Positive feedback in economic and social systems does something else as well: It takes small errors in judgment and policy and magnifies them. The recent burning of Korans in Afghanistan -- the result of a bad error in judgment about how to dispose of Islamic religious material -- initiated positive feedback-driven processes that led to deadly riots.

The 2008 Financial Crisis, the current euro crisis, the economic meltdown in Iceland, and the explosive growth in high frequency trading were all made more virulent and more consequential as a result of enhanced positive feedback. In each of these situations, positive feedback multiplies any mistake. The Internet facilitated the positive feedback that drove the May 6, 2010 Flash Crash, in which the Dow Jones Averages tumbled 998 points and within 20 minutes experienced a rocket recovery of 600 points. Unfortunately, as the world has grown less stable, legislative and regulatory bodies have become more gridlocked and less capable of responding. When they make even small errors, virulent positive feedback processes often take charge.

Here's where economists come in. Positive feedback greatly magnifies the differences between reality and idealistic theory.

As W. Brian Arthur, a visiting researcher at the Intelligent Systems Lab at Xerox's Palo Alto Research Center, points out, "conventional economic theory tends to simplify its questions in order to seek analytical solutions." This has served us well in the past. But in more and more contexts, these theories are leading us astray, largely because they can no longer offer accurate approximations of reality.

Consider scientific theories, some of which are merely accurate approximations. Newton's Laws of motion describe the world very precisely -- as long as bodies are moving at low speeds relative to one another. When those speeds increase enough, Newton's Laws give us the wrong answer, and we have to call on Einstein and his relativistic effects. Without relativistic corrections, GPS systems would accumulate errors at the rate of about six miles per day. In one year, they would be off by more than 2,000 miles putting users on the wrong coast.

Today, many of our economic theories are putting us on the wrong coast. In posts that follow, I will be exploring potential policy that takes into account virulent positive feedback processes.

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