Chen, Ping. “China and the West：The Metabolic Nature of Changing World Order,” in Svejnar, Jan. and Justin Yifu Lin eds. China and the West，Chapter 9, Edward Elgar (2021).
Abstract：An empirical and theoretical analysis of financial crises is conducted based on statistical mechanics in non-equilibrium physics. The transition probability provides a new tool for diagnosing a changing market. Both calm and turbulent markets can be described by the birth-death process for price movements driven by identical agents. The transition probability in a time window can be estimated from stock market indexes. Positive and negative feedback trading behaviors can be revealed by the upper and lower curves in transition probability. Three dynamic regimes are discovered from two time periods including linear, quasi-linear, and nonlinear patterns. There is a clear link between liberalization policy and market nonlinearity.Numerical estimation of a market turning point is close to the historical event of the U.S. 2008 financial crisis.
Tang, Yinan, Ping Chen. “Transition Probability, Dynamic Regimes, and the Critical Point of Financial Crisis,” Physica A, 430, 11-20 (2015).
Abstract：The central idea of analytical science is that the whole equals the sum of its part. This reductionist view with certainty was challenged by computational uncertainty in classical mechanics and system approach in biology and thermodynamics. The interdisciplinary science of complex systems shed new lights on nonlinearity dynamics and non-equilibrium evolution. There are three lines of thinking in studying economic complexity. The first school focuses on computational uncertainty including deterministic chaos and dis-equilibrium statistical distributions. The Santa Fe school and econophysics consider economies as a fragile order at the edge of chaos. The second school developed system approach of self-organization and dissipative structure. Brussels-Austin-Shanghai school pioneered by Ilya Prigogine emphasizes the role of time arrow in living systems. Order out of chaos reveals a new kind of viable order, such as life cycle and economic resilience. The third school was more pluralistic and inclusive in economic thinking. Some essential features of psychology, behavior and culture could be modeled by advanced mathematics. Basic doctrines in neoclassical economics are inconsistent with basic laws in physics and biology. Complexity economics may accomplish the dream of Keynes. A general economic theory is capable of integrating special cases from diversified economic thoughts.
Chen, Ping. “From Complexity Science to Complexity Economics,” in Beker, Victor A. Ed. Alternative Approach of Economic Theory, Chapter 2, pp.19-55, Routledge, London (2019).
Abstract:The view from inside improves our understanding on market failure and regulation failure in financial market. The EMH fails to understand the causes of financial bubbles and crashes. Behavioral finance introduces insight from psychology. The heuristic and biases (H&B) approach studied behavioral asymmetry in static environment that leads to market irrationality and information distortion. The fast and frugal (F&F) thinking in decision-making further explore more complex situation under changing environment. They argue that soft-paternalistic regulation is needed under information overload. The most critical issue is information uncertainty and complexity. Lacking information in frequency domain is the main barrier in managing business cycles. Data form inside reveals current limitations of financial data mainly in the short-term price changes. Microstructure studies show that pricing process is shaped by trading rules. Quantitative analysis reveals severe instability in high frequency trading (HFT) and derivative market. Feasible regulation should aim to encourage new technology and sustainable growth, rather than protect obsolete technology and short-term speculation. The most fundamental challenge to sustainable economic order is the excessive size of the derivative markets that crowding out investment in real economy. This is a more severe issue than the climate change.
Key Words: market uncertainty, information complexity, feasible regulation, financial crisis, regime switch.
Chen, Ping. “Market Uncertainty, Information Complexity, and Feasible Regulation: An Outside View of Inside Study of Financial Market” in Ippoliti, E. Ed. Methods and Finance, A View from Outside, Springer, Berlin (2019).
Abstract：As Keynes pointed out, classical economics was similar to Euclidean geometry, but the reality is non-Euclidean. Now we have abundant evidence that market movements are nonlinear, nonequilibrium, and economic behavior is collective in nature. But mainstream economics and econometrics are still dominated by linear, equilibrium models of representative agent. A critical issue in economics is the selection criteria among competing math models. Economists may choose the preferred math representation by philosophical preference; or by mathematical beauty or computational simplicity. From historical lessons in physics, we choose the proper math by its empirical relevance, even at the costs of increasing mathematical dimensionality and computational complexity. Math representations can be judged by empirical features and historical implications. Recent historical events of financial crisis reveal the comparative advantage of the advanced math representation. Technology progress facilitates future advancements in mathematical representation and philosophical change in economic thinking.
Chen, Ping. “Mathematical Representation in Economics and Finance: Philosophical Preference, Mathematical Simplicity, and Empirical Relevance,” in Emiliano Ippoliti and Ping Chen Eds. Methods and Finance: A Unifying View on Finance, Mathematics and Philosophy (co-edited with Emiliano Ippoliti), pp.17-49, SAPERE Series (Studies in Applied Philosophy, Epistemology and Rational Ethics), Springer, Berlin (2017).
Abstract：The sub-prime crisis in the U.S. reveals the limitation of diversificationstrategy based on mean-variance analysis. A regime switch and a turning point can be observed using a high moment representation andtime-dependent transition probability. Up-down price movements are induced by interactions among agents, which can be described by thebirth-death (BD) process. Financial instability is visible by dramatically increasing 3rd to 5th moments one-quarter before and during the crisis.The sudden rising high moments provide effective warning signals of a regime-switch or a coming crisis. The critical condition of a marketbreakdown can be identified from nonlinear stochastic dynamics. The master equation approach of population dynamics provides a unified theory of a calm and turbulent market.
Key Words: high moments, birth-death process, transition probability,regime switch, crisis warning
PACS: 89.65.Gh, 05.45.Tp, 05.10.Gg, 89.75.-k
Tang, Yinan, Ping Chen. “Time varying moments regime switch and crisis warning The birth–death process with changing transition probability,” Physica A, 404, 56-64 (2014).
Introduction：It is widely believed that the idealized world without friction is a unifying foundation for equilibrium economics. This belief faces fundamental challenges from new findings in complexity science, which will lead to a paradigm shift in economic thinking and quantitative analysis.
Two basic models in equilibrium economics are the optimization model and the representative agent, which are based on a Hamiltonian framework in economic theory. The Hamiltonian approach is valid only for a conservative system without friction, i.e., no energy dissipation in the form of heat. Notable examples in physics are planetary motion and harmonic waves, including electromagnetic waves and the atomic spectrum. Two economic features go beyond the scope of the Hamiltonian system: business fluctuations and economic growth. Specifically, the building block in econometrics is random noise, which is the typical feature of energy dissipation or entropy production. In other words,an economic system is more like a biological system than a mechanical system,since they are dissipative systems not Hamiltonian systems in nature.
According to nonequilibrium physics, potential function no longer exists under far from equilibrium conditions, which indicates the limit of the optimization approach (Prigogine and Stengers 1984). Nonlinear dynamics told us that nonlinear interaction is the internal deterministic cause of seemingly random movements, an alternative mechanism for external explanation of business cycles. Positive feedback is a constructive force for growth and innovation, which is outlawed by equilibrium economics under the equilibrium condition of non-convexity. The many-body problem (such as social behavior) is essentially different from the one-body (in a representative agent) and two-body (in bilateral bargaining) problems. If we accept these new understandings in complexity science, we will easily realize that many doctrines in mainstream economics are simply equilibrium illusions, which are equivalent to perpetual motion machines against the laws of physics and the history of division of labor.
In this review chapter, we will examine two central beliefs in equilibrium economics: the self-stabilizing market and institutional convergence. We will see that both computational and natural experiments demonstrate the limits of the equilibrium approach and the potential of an evolutionary perspective based on a nonlinear and nonequilibrium approach.
In section 2.2, we give a brief review of how technical progress in complexity science led to a paradigm shift in economic thinking. In section 2.3, we discuss equilibrium illusions in economics and econometrics. In section 2.4, we demonstrate the main results of computational experiments in testing competing economic theories. In section 2.5, we study transition economies and their implications to economic theories. In section 2.6, we address fundamental issues to be solved by the next generation of economists. We hope that a new dialogue between scientists and economists will be fruitful in bridging the gap of two cultures, i.e., the mechanical and living world.
Ping Chen, “Equilibrium Illusion, Economic Complexity and Evolutionary Foundation in Economic Analysis,” Evolutionary and Institutional Economics Review, 5(1), 81-127 (2008). Also, Chapter 2, pp.11-52, in Chen (2010).
Abstract：The 2008 financial crisis shocked the equilibrium paradigm of neoclassical economics. According to the efficient market hypothesis and rational expectation theory, there is little possibility for a market crisis under the “invisible hand” of a self-stabilizing market. The disequilibrium school emphasizes the destabilizing effect of herd behavior, but falls short in policy recommendations if markets are governed by fat tail, fractal, unit root, power law, or Black Swan models. The study of economic complexity greatly extends our scope to nonlinear and non-equilibrium mechanism in economic dynamics.In this article, we will first study the origin and nature of the crisis that reveals the fundamental flaws in neoclassical economics and requires a paradigm change in economic thinking. Then, we will discuss alternative policies in complex evolutionary economics, which is capable of understanding the changing world after the crisis.
Chen, Ping. “Alternative Policies after the Financial Crisis:New Thinking from Complex Evolutionary Economics,” in Claudius Gräbner, Torsten Heinrich, and Henning Schwardt Eds. Policy Implications of Recent Advances in Evolutionary and Institutional Economics: Essays in Honor of Wolfram Elsner, Chapter 9, pp.155-172, Routledge, New York (2016).
Abstract：Both exogenous and endogenous growth theories in neoclassical economics ignore the resource constraints and wavelike patterns in technology development. The logistic growth and species competition model in population dynamics provides an evolutionary framework of economic growth driven by technology wavelets in market-share competition. Learning by doing and knowledge accumulation ignores the interruptive nature of technology advancement. Creative destruction can be understood by using knowledge metabolism. Policies and institutions co-evolve during different stages of technology cycles. Division of labor is limited by the market extent, numbers of resources, and environment fluctuations. There is a trade-off between the stability and complexity of an ecological-industrial system. Diversified patterns in development strategy are shaped by culture and environment when facing learning uncertainty. The Western mode of division of labor is characterized by labor-saving and resource-intensive technology, while the Asian and Chinese modes feature resource-saving and labor-intensive technology. Nonlinear population dynamics provides a unified evolutionary theory from Smith, Malthus, to Schumpeter in economic growth and technology development.
Key words: growth theory, market-share competition, technology wavelet, learning uncertainty, knowledge metabolism.
EL Classification: C30, E37, D83, L50, O00
Chen, Ping. “Metabolic Growth Theory：Market-Share Competition, Learning Uncertainty, and Technology Wavelets” Journal of Evolutionary Economics, 24(2), 239-262 (2014).
Introduction: bridge the gap between economics and biology
Alfred Marshall once remarked that economics should be considered closer to biology than mechanics (Marshall 1920). Living systems have two essential features: life rhythms, and the birth-death process. However, the current economic framework is far from Marshall’s dream: Economic order is widely formulated by a steady-state solution plus random noise. Can we bridge the gap between equilibrium economics and evolutionary biology？
There are two fundamental problems in theoretical economics: the nature of persistent business cycles and the diversity in developing the division of labor. To study these problems, there are two different perspectives in economic dynamics: the equilibrium-mechanical approach and the evolution-biological approach.
The existence of persistent business cycles and chronic excess capacity is hard to explain by using equilibrium models in macro econometrics: External noise cannot maintain persistent cycles in the Frisch model (Chen 1999); Aggregate fluctuations in the Lucas microfoundations model are too weak for generating large macro fluctuations according to the Principle of Large Numbers (Lucas 1972, Chen 2002); Random walk and Brownian motion are not capable of explaining persistent fluctuations in macro indicators(Chen 2001). Adam Smith once observed that the division of labor was limited by the extent of the market (Smith 1776). Stigler noted that the above Smith theorem was not compatible with the Smith theory of “the invisible hand” (Stigler 1951). Needham asked why did capitalism and science originate in Western Europe not in China or other civilizations (Needham 1954). Diversified patterns in the division of labor and corporate strategies cannot be explained within the equilibrium framework.
In our analysis, the time scale plays a key role in understanding economic dynamics. The birth-death process is the first approximation of growth fluctuations. Business cycles can be further decomposed into a smooth trend, plus color chaos and white noise.Persistent cycles and structural changes can be directly observed from a time-frequency representation. Market-share competition and disruptive changes in technology can be described by the logistic model with resource constraint. Innovative corporate strategies can be studied from a behavioral model of risk culture and learning by trying. Logistic curves and product cycles can be inferred from marketing strategy and technological progress. Division of labor is limited by the market extent, resource variety and environmental uncertainty. The Smith dilemma can be solved by the trade-off between stability and complexity (Chen 1987). Resilient market and economic complexity can be understood from persistent business cycles and technological metabolism. Economic evolution and structural changes can be directly observed from a wide range of time scales, including product cycles, business cycles, and Kondratieff long waves.
Chen, Ping. “Evolutionary Economic Dynamics: Persistent Business Cycles, Disruptive Technology, and the Trade-Off between Stability and Complexity,” in Kurt Dopfer ed., The Evolutionary Foundations of Economics, Chapter 15, pp.472-505, Cambridge University Press, Cambridge (2005). Also, in Chen (2010), Chapter 3, pp. 53-82.
The Hungarian economist Janos Kornai has warned the West of the possibility of a reversal of liberalization in Eastern Europe. He advocates a new policy of containment aimed at countries such as Russia and China. This prompts us to investigate the truth concerning the transition in Eastern Europe. After 1990 the West recalculated economic data from the former Soviet Union and Eastern Europe (FSUEE thereafter) before 1990, for creating an illusion that “shock therapy” had made progress in FSUEE. However, the Eastern Europeans including the Hungarians, who were enthusiastic for liberalization from socialism, soon discovered that joining the European Union (EU) was damaging the interests of the majority of people in Eastern Europe, while Western Europeans also came increasingly to oppose the financial burdens imposed by EU enlargement and immigration inflows. The short-sighted transition strategy carried out in Eastern Europe and the preoccupation with geopolitical interests have in fact exacerbated the EU’s economic crisis, triggering a civil war in Ukraine and causing Russia to become disillusioned with the West. Kornai’s theory of soft-budget constraints as well as his anti-Keynesian policies during the transition recession, is responsible for the economic downturn triggered by rapid liberalization in Eastern Europe. The reversal of the liberalization trend in Eastern Europe and the change in the mass psychology of Eastern Europeans towards the West together constitute an important rebuff to utopian capitalist thinking in China. Has capitalism defeated socialism, as Western propaganda claims? The success of China’s autonomous open-door policy and the failure of Eastern Europe’sunilateral opening indicate that the collapse of the FSUEE occurred mainly for political rather than economic reasons.
Keywords: Eastern Europe; transition; containment; real per capita GDP
Chen, Ping. “Has Capitalism Defeated Socialism Yet—Kornai’s Turnaround on Liberalism, and the Evaporation of Myths about Eastern Europe,” International Critical Thought, 5(1), 1-22 (2015).
This ongoing Grand Crisis originated in the United States, then transmogrified into an international crisis. It represents a natural experiment. The positive side of this crisis is its fundamental lesson. It is not a theoretical debate confined to ivory towers, but a historical event that has destroyed social confidence in the mainstream equilibrium theory of the so-called efficient market. This has accelerated the rise of the nonlinear evolutionary theory of the viable market.Three observations reveal where the equilibrium theory of asset pricing and business cycles went wrong: (1) the meso foundation of macro fluctuations; (2) the endogenous nature of persistent cycles in financial macro indexes;and (3) the trend of collapse and higher moment risk in the derivative market. The new perspective of nonlinear population dynamics in continuous time provides a better alternative to existing rational-actor/linear models of finance, not only for understanding the cause of the present situation, but to inform efforts related to redesignand reform. The systematic failure in the mortgage security market, unprecedented concentration in the international financial market, and unfettered speculation in the commodity and currency markets have all contributed to the current disaster. A new international financial order can be achieved if a robust and workable international antitrust law can be enacted and a Tobin tax on foreign exchange transactions can be established through global efforts. An overhaul of financial theory is needed to develop a viable market for sustainable economies.
Chen, Ping. “From an efficient to a viable international financial market,” in R. Garnaut, L. Song and W.T.Woo eds. China’s New Place in a World in Crisis: Economic, Geopolitical and the Environmental Dimensions, Chapter 3, pp.33-57, Australian National University E-Press and The Brookings Institution Press, Canberra (2009). Also, Chapter 16, pp. 301-319, in Chen (2010).
Q1. How would you briefly state your perspective on economics?
Q2. How does this compare to the mainstream?
Q3. What are the main lessons resulting from your experiences with the Chinese economy?
Q4. Do you think that a more pluralist approach to economics might gain traction? What factors constrain and support such a development?
Chen, Ping. “Reading Piketty in Peking: The Case Against Capitalist Inequality in Communist China,” Worldpost, Jun. 30, (2014).
Abstract: Conflicting agendas in corporate governance show the limits of the transaction costs approach and property rights theory. A top-down approach of control and monitor may have negative effect on the competitiveness of the firm. The mechanic picture of transaction costs and agency costs is rooted in reductionism of firm theory. The Coase world of zero-transaction costs is contrary to the law of thermodynamics and historical trends of industrial economies. Diversified patterns in corporate governance and corporate culture can be better explained by the creative nature of the firm in evolutionary economics. China’s experiments under mixed property rights during economic transition shed new light on life cycles in changing ownership and corporate governance. The survival of a firm is more associated with the emergence of selective mechanisms and adapting ability.
Keywords: transaction costs, corporate governance, selective mechanism, life cycles,evolutionary thermodynamics.
*Chen, Ping. “Complexity of Transaction Costs and Evolution of Corporate Governance,” Kyoto Economic Review, 76(2), 139－153 (2008). Also, Chapter 14, pp.270-282, in Chen (2010).
