We speak to Paul Ormerod about the limits of conventional economics, and the importance of understanding the effect of networks on economic behaviour.

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Paul argues that conventional economics has made the mistake of assuming all economic actors are individual and rational; that all of us, whether we are people or firms, calculate and act to our own economic advantage. This is not entirely true, for a number of reasons.

Probably the most important reason is complexity: the modern economy is extremely complex, and very few of us have the ability, time or inclination to be able to accurately calculate our economic interest. Instead we develop rules of thumb and provisional positions, based largely on what our peer groups tell us: for instance, if you buy an iPhone, it’s probably because you’ve seen other people with them, and they’ve confirmed that they like the phone. It’s unlikely that you’ve done detailed research into the hardware and software that runs the phone – we don’t have the time.

Paul calls this the network effect – economic behaviour is governed, to a large extent, by a complex interplay of interactions in our networks. This is true for small-scale economic actors – where we choose to spend our pay cheques – as well as large investors.

Policy makers have failed to understand the network effect, and have instead tried to manage the economy like a machine, with crude levers intended to bring about predicatble results. This has failed.

Many companies are currently sitting on large amounts of capital, in what amounts to an investment strike. The main reason for this that (almost) no one is investing, which has created a culture of caution that has become a self-fulfilling prophecy. Yet the state does have power, and there are policy levers that can be pulled.

Paul considers the best ways to use policy to – for example – send a message to companies that the investment climate has changed. This can be from the state priming the economy through intelligently directed infrastructure investment, but it can also be through events like the Olympic Games, which Paul argues created a favourable perception of Britain which benefits investment.