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12 August 2012

The network effect

And what it means for policy

By Paul Ormerod

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.

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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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