The network effect

And what it means for policy

Economics assumes that individuals operate autonomously, isolated from the direct influences of others. But today’s social and economic worlds are not like this. The choices people make are directly influenced by others through "social networks" – not merely Facebook but, more importantly, real-life social networks such as family, friends and colleagues.

Network effects have been pervasive throughout history. Humans, whether Hittite potters three and a half millennia ago or traders in financial markets today, have a propensity to copy the behaviour of others around them. On the financial markets, this herd mentality can lead all too easily to the booms and crashes we have experienced in recent years.

Networks are especially important in finance. When Lehman Brothers went bankrupt, it precipitated a crisis that almost led to a total collapse of the global economy, and it was precisely because Lehman was connected into a network of other banks that the situation was so serious. Incredibly, neither the system of financial regulation that was in place, nor the thinking of mainstream economics that influenced policy so strongly, took any account of the possibility of such a network effect. Ironically, policy makers and the financial establishment thought that risk could be mitigated by spreading it across the system. They misunderstood completely the dynamics of financial networks and the possibility that such networks might not reduce risk but could create upheaval.

A world in which network effects drive behaviour is completely different from the world of conventional economics. Network effects require policy makers to have a markedly different view of how the world operates. They make successful policy much harder to implement but they also help explain many policy failures.

The intellectual underpinning of the burgeoning activity of the state has been provided by mainstream economics. Paradoxically, a theoretical construct that purports to establish the efficiency of the free market has been used to justify an enormously enhanced role for the state. The concept of "market failure", at first sight a critique of free market economics, has provided powerful backing to state intervention. When markets have not functioned in the real world as the theory suggests they should, then regulation, taxes, incentives of all shapes and forms have been used in an attempt to make the imperfect world conform to more closely to the perfect one of economic theory.

We have now had over sixty years of this vision. Yet the stark fact is that the combination of large- scale state activity and a mechanistic intellectual approach to policy-making has not delivered anything like the success hoped for. Deep social and economic problems remain. For example, the average unemployment rate in the UK in the six decades before the Second World War was 5.5 per cent – virtually identical to the average rate for the six decades since. Rational planning and clever regulation did not prevent the biggest economic recession since the 1930s from taking place in 2008/9.

It is time for mainstream economics to adopt a model of the world that more closely approximates the reality of networks.  A fundamental feature of any system in which network effects are important is that it is ‘robust yet fragile’. Most of the time, the system is stable and resilient to shocks. But every so often a particular shock can have a dramatic effect and the behaviour of individuals across the network will be altered. These events are extremely difficult to anticipate, and hard to control when they do occur.

But the network view highlights the importance of social norms in determining the success of legislation. When network effects are present, the most effective policies are unlikely to be generic changes to incentives, as per the mainstream view. Careful analysis and targeting become the order of the day. Fewer resources used more intelligently can potentially lead to much more effective strategies. The silver bullet of this approach is that there are no silver bullets. Instead, we need to rely much more on the processes of experimentation and discovery.

The focus of policy needs to shift away from prediction and control. We can never predict the unpredictable. Instead we need systems that exhibit resilience and robustness on the one hand, and the ability to adapt and respond well to unpredictable future events on the other.

Paul Ormerod is an economist and author of Positive Linking: How networks and nudges can revolutionise the world.

This is an edited version of a chapter from IPPR’s forthcoming book, Complex New World: translating new economic thinking into public policy. For more see http://bit.ly/IPPR9499

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I was wrong about Help to Buy - but I'm still glad it's gone

As a mortgage journalist in 2013, I was deeply sceptical of the guarantee scheme. 

If you just read the headlines about Help to Buy, you could be under the impression that Theresa May has just axed an important scheme for first-time buyers. If you're on the left, you might conclude that she is on a mission to make life worse for ordinary working people. If you just enjoy blue-on-blue action, it's a swipe at the Chancellor she sacked, George Osborne.

Except it's none of those things. Help to Buy mortgage guarantee scheme is a policy that actually worked pretty well - despite the concerns of financial journalists including me - and has served its purpose.

When Osborne first announced Help to Buy in 2013, it was controversial. Mortgage journalists, such as I was at the time, were still mopping up news from the financial crisis. We were still writing up reports about the toxic loan books that had brought the banks crashing down. The idea of the Government promising to bail out mortgage borrowers seemed the height of recklessness.

But the Government always intended Help to Buy mortgage guarantee to act as a stimulus, not a long-term solution. From the beginning, it had an end date - 31 December 2016. The idea was to encourage big banks to start lending again.

So far, the record of Help to Buy has been pretty good. A first-time buyer in 2013 with a 5 per cent deposit had 56 mortgage products to choose from - not much when you consider some of those products would have been ridiculously expensive or would come with many strings attached. By 2016, according to Moneyfacts, first-time buyers had 271 products to choose from, nearly a five-fold increase

Over the same period, financial regulators have introduced much tougher mortgage affordability rules. First-time buyers can be expected to be interrogated about their income, their little luxuries and how they would cope if interest rates rose (contrary to our expectations in 2013, the Bank of England base rate has actually fallen). 

A criticism that still rings true, however, is that the mortgage guarantee scheme only helps boost demand for properties, while doing nothing about the lack of housing supply. Unlike its sister scheme, the Help to Buy equity loan scheme, there is no incentive for property companies to build more homes. According to FullFact, there were just 112,000 homes being built in England and Wales in 2010. By 2015, that had increased, but only to a mere 149,000.

This lack of supply helps to prop up house prices - one of the factors making it so difficult to get on the housing ladder in the first place. In July, the average house price in England was £233,000. This means a first-time buyer with a 5 per cent deposit of £11,650 would still need to be earning nearly £50,000 to meet most mortgage affordability criteria. In other words, the Help to Buy mortgage guarantee is targeted squarely at the middle class.

The Government plans to maintain the Help to Buy equity loan scheme, which is restricted to new builds, and the Help to Buy ISA, which rewards savers at a time of low interest rates. As for Help to Buy mortgage guarantee, the scheme may be dead, but so long as high street banks are offering 95 per cent mortgages, its effects are still with us.