The Chaos Theory

Let’s take our mind off Mainstream Economics today, and consider something just as important. This is related to “Chaos Theory” that is built upon the idea of Ripple Effect or Butterfly Effect.

Ripple/Butterfly effect is an idea that a slight change or a small seemingly irrelevant event can lead to an unpredictable series of great and impactful consequences. The basic idea is that a tiny insignificant event, like a butterfly flapping its wings, can lead to one or a series of much larger and grave natural disaster like hurricane. It might take a very long time, but if the butterfly flaps its wings at the right point in space-time, given the presence of other conditions conducive to hurricane, hurricane can happen (seriously).

A flap that kills

You know… like a proverb “For Want of a Nail” (“Want” here means “Lack”.), which was also quoted in the Fast and Furious: Tokyo drift. The proverb has several variations, but one goes like this:

“For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the message was lost.
For want of a message the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail.”

So, you see, this is one of the major factors that reduces the accuracy of future economic projection/forecast. Fear of losing investment instilled in one investor can lead to a mass panic in the investment world, then lead to mass panic in ordinary people’s world; thus, leading to bank run, to financial crisis, etc. This is something that is extremely hard to capture in economic models or equations. So, the next time you wonder why a prediction about future stock price is not so accurate, remember “Chaos Theory”.

This very idea also helps explain why individual decisions, though insignificant if acted out alone, can have a far reaching consequences on the entire economy in the long-run due to the inter-dependence nature of decisions and the complex system within which we, humans, operate. There is more to it, but that’s a wrap for now. Hope you enjoy this short note on probably one of the most significant topics in economic forecasting.