You will probably hear me reference "systems thinking" when explaining free markets. I thought that this post would be a good way to introduce systems thinking and its relevance to economics and free markets. To start, I want to offer a concise definition of a system:

Definition

"A system is an entity which maintains its existence through the mutual interaction of its parts."

by the late Austrian Biologist Ludwig von Bertalanffy.

An accurate description of free markets fits perfectly with this definition. Markets become a unified system through the interaction of individuals making exchanges and not by an elaborate design imposed upon individuals.

As part of an introduction, I have borrowed "The Laws of the Fifth Discipline" from The Fifth Discipline by Peter Senge. I will give each of the eleven "laws" and describe how they apply to free markets.

"Today's problems come from yesterday's solutions.'"

The presence of feedback represents one of the distinctive characteristics of systems. Many of the processes in systems create information that, when fed back into the system, changes the input to the next iteration. Feedback becomes particularly crucial in human systems — i.e., systems that include humans as an element. For example, the system that includes both car and driver provides feedback to the driver so that he knows when to speed up, swerve, or brake.

The solutions that we apply to today's problems simply shift the problem to a different time or space. The people who inherit the "new problem" frequently don't recognize it as the return of an old problem.

This explains why many market interventions seem to address problems for which solutions have already been applied.

"The harder you push, the harder the system pushes back."

Because systems contain "compensating feedback," well-intentioned interventions frequently stimulate responses from the system that offset the benefits of the original interventions.

The higher lawmakers raise minimum wages, the higher the resulting unemployment.

The more lawmakers attempt to regulate segments of the market, the more frequent the occurrence of black markets or illegal activities.

"Behavior grows better before it grows worse."

Any success at overcoming structural influence will only last for a short while. We find simple, "easy" interventions enticing because they seem to work — in the short term. Then, again, compensating feedback takes over, and things get even worse.

Economic "stimulus" gets people to spend more money. This causes a nominal increase in GDP. It also causes a lack of savings and investment, resulting in a cutback in employment and reduced availability of goods in the future.

"The easy way out usually leads back in."

Familiar solutions to apparently similar problems usually keep us mired in the same problem.

Adjusting tax rates to cure the "Social Security" problem eventually leads us back into the difficulty caused by the structure of this unsustainable "Ponzi" scheme.

Making significant structural changes to a poorly designed system will have more effect on eliminating recurring problems than making small changes to processes that only address symptoms.

"The cure can be worse than the disease."

Sometimes the easy, familiar solutions have no effect. Indeed, sometimes they become addictive and dangerous. By misguiding market players, the monetary expansion creates an addictive dependence that eats away at healthy, productive investments.

When we don't account for the feedback from changes we make, we sometimes don't see the full impact of our actions. Our central banking system increases the money supply to stimulate the seemingly slow economy. The misinformation sent by this artificial cure causes malinvestment, which leads to a depression worse than the apparent, but natural, slowdown.

"Faster is slower."

Remember the tortoise and the hare. Systems operate at the pace allowed by their structure. Pushing them too fast will cause delay or breakdown.

In our persistent efforts to create economic growth, we forget that the economy has a natural rate of growth. Rapid rates of business growth, brought on by market intervention, frequently outrun the capability of businesses to generate capital to support that growth. High rates of broader economic growth have the same effect. High rates of consumption eat away at capital growth, which slows future consumption.

"Cause and effect are not closely related in time and space."

People intervening in market systems frequently commit the error of equating proximity of events with cause and effect. Human systems share the fundamental characteristic that cause and effect do not occur closely in time and space.

We may not see the results of the actions we take today either at the same time or in the same place. What appears like a sound expenditure now may prove catastrophic when the effect finally reaches the market.

"Small changes can produce big results—but the areas of highest leverage are often least obvious."

Chaos theoreticians speak of the "butterfly effect," in which a butterfly flaps its wings in some distant location, causing a local storm in the future. Although this so-called "butterfly effect" serves mostly as a metaphor, it does give a sense of the importance of small events.

Frequently, the most obvious solutions either don't work or make matters worse. Small, targeted actions, however, can often produce significant and enduring changes. These high-leverage actions do not seem apparent to the participants in the system. A one percentage point increase in the rate of saving might, through increased investment, improve long-term consumption by more than 15 percent.

"You can have your cake and eat it too—but not at once."

Sometimes dilemmas only appear as opposing choices. For example, the false choice between "low cost" and "high quality." The short-term cost of higher quality may lead to both lower cost and higher quality in the long run.

The "low cost" bidding process employed by the government frequently leads to the early crumbling of vital infrastructure, imposing higher costs on future taxpayers.

"Dividing an elephant in half does not produce two elephants."

As logical as it may seem, dividing a problem into smaller problems seldom works. If you have a big problem, you must treat it as such. You may have to take sequential steps to the solution, but you must coordinate these steps to solve the single problem.

The integrated, holistic nature of living systems requires that they must remain intact to realize their full benefit. The whole equals more than the sum of its parts.

Governments build their reputations on promising half an elephant as if it were one elephant. Treating government spending and taxation as independent issues amounts to dividing the government interventionist elephant.

"There is no blame."

We tend to blame outside influences. "Systems thinking shows us that there is no outside; that you and the cause of your problems are part of a single system. The cure lies in your relationship with your 'enemy.'" (Senge page 67.) Don't blame the people when they do the best they can within the system in which they operate.

When you, as a customer, encounter a surly government employee, remember they work for a system that does not recognize you as the customer. They owe their allegiance to other bureaucrats and politicians, not to you. You have no influence on a system for which you do not pay directly.

Conclusion

Many of the characteristics of systems seem counterintuitive until you think about them. Human systems, such as markets, add a higher level of complexity. These systems reflect on the results of their own behavior and adjust their behavior to achieve different results. In other words, they learn.

Interventionists simply cannot outsmart markets.

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Reference

Senge, Peter M., The Fifth Discipline (New York: Doubleday), 1990