- Researchers propose a new method (derived from classical physics) to predict how economies respond to major disturbances.
- It outperforms all existing econometric forecasting systems.
Understanding economies in times of crises is one of the most complex tasks. So far, theories based on modern macroeconomic have been unable to predict the last Great Recession and could neither foresee its prolonged duration nor the recovery rate.
These theories are based on the assumption of equilibria: they are characterized by a balance of demand and supply which leads to prices that signal an overall equilibrium. However, the crisis occured due to interdependence, contagion, networks, interaction, and trust that led these equilibrium assumptions ad absurdum.
Now, researchers at Complexity Science Hub Vienna have proposed a novel method derived from classical physics that makes the effects of shocks on out-of-equilibrium economies computable. It focuses on resilience as non-equilibrium characteristics of networked production systems and develops a linear response theory for input-output economics.
This new method adds to existing economic models in numerous ways.
The economy of each country relies on several industrial imports and exports. The new technique collects these interdependencies in new data sets and calculates how the country’s different production sectors respond to disturbances.
For example, researchers analyze which specific sections of an economy are more vulnerable to a shock like a trade war. This way they determine the economy’s resilience.
The next step is to quantify how much a shock in a particular part of the world can affect the sector’s production far across the globe. Modeling outputs to shocks could answer important questions, such as why did the 2008 recession last so long.
Instead of simply evaporating, a shock generates waves that run through the entire system, following each of its interdependent connections (this is similar to throwing a rock into a still pond). The research team discovered that it usually takes 6 to 10 years for all sectors of an economy to digest a shock.
The predictions made by using this new novel technique can be tested. Researchers gathered input-output data of 56 sectors in 43 developed countries between the years 2000 and 2014.
They used this massive dataset to test the accuracy of economic projections related to aftermaths of the 2008 recession. They found that their technique outperformed all existing econometric forecasting systems.
The team also calculated the effects of new tariffs on EU aluminum and steel imposed in 2018 by Donald Trump. The model was able to find winners and losers. In Germany, warehousing, land transport, and electricity production show a decline, whereas the automotive industry show consistently increased levels of output, compensating the losses due to the tariffs.
In the next study, the team will try to measure all types of shock scenarios (using real-world data) that can occur anywhere in the world.
The Concept Is Derived From Physics
The new model is inspired by a classical physics phenomenon called susceptibility. The linear response theory describes how magnetic and electric materials react to strong magnetic and electrical fields. It can be either mathematically derived from material properties or determined with special instruments.
Researchers showed that the linear response theory can also be applied to input-output economics. They replaced material properties with economic networks and calculated the susceptibility of economies as well as their response to shocks (instead of calculating electrical resistance).
In order to better explain economies, researchers developed an interactive visualization tool that shows multiple dependencies of countries and industrial sectors. All types of parameters can be altered to quickly see the effects across different countries.