Nonlinear Dynamics and Chaos Theory in

Economics: a Historical Perspective

Artem B. Prokhorov
EC 816

December 13, 2001

Abstract
The term paper focuses on the genesis of ideas of nonlinearity,
stochasticity, and dynamics in economic thought as a series of intellec-
tual advances that connected the linear static (quasi-dynamical) deter-
minism of the 18th -19th centuries with the linear mechanistic systems
with stochastic terms and the nonlinear deterministic and stochastic
dynamical models of the late 20th century, specifically, the chaos the-
ory. The emphasis is placed on the developments of the second half of
the 20th century. Technicalities are avoided.

We already know the physical laws that govern everything we

experience in everyday life . . . It’s a tribute to how far we have
come . . . that it now takes enormous machines and a great deal
of money to perform an experiment whose results we cannot
predict. – Steven Hawking (as cited in [13])

1 Introduction

Both deterministic and stochastic dynamical systems have occupied an im-

portant place in the history of science. They have been primarily connected

with the issue of predictability of natural and social processes. The latter,

in turn, has been pivotal in the discussions of such philosophical problems

as the extent of human will, the initial state and the final destination of

socioeconomic and natural systems, and others. It is the irony of dialectics

1
that deterministic dynamical systems may produce behavior that is essen-

tially equivalent to random and thus is ultimately unpredictable. Man’s

unwillingness to accept this irony has been leading the science throughout

its history and has produced a large number of valuable discoveries.

In economics, the question of stochasticity versus determinism has been

the essence of numerous critiques that mainstream economics inherited from

classical times. These critiques refer to the counter-classical phenomena ob-

served in the real life, such as persistence of irregular fluctuations in eco-

nomic indicators, and the almost ubiquitous absence of convergence toward

a stable equilibrium predicted by classical economists. Market economies

seem to many to have resembled dynamically unstable systems rather than

deterministic systems in which episodes of instability could be attributed to

external shocks. Nonlinearity is an issue that can potentially bridge the gap

between the classical stochasticity considerations and the real-life observa-

tions. Chaos theory could be an example of such a nonlinear reconciliation.

Chaos theory is arguably a special topic in every science dealing with

dynamics. In many sciences, such as physics, biology, meteorology, medicine,

and chemistry the history of is topic is almost exclusively a success story

about gaining ultimate insights into important phenomena, e.g., electrical

and mechanical oscillators in physics, species population growth in biology,

fluid and air convection patterns in meteorology, heart and brain functioning

in medicine, and chemical reactions in chemistry. In economics, however,

it has been a story of disappointment as not only no consistent evidence of

low-dimensional chaos has been presented for most economic processes, but

the discrepancies between the mainstream explanations and some observed

2
phenomena remain acute. It is, however, important to study how chaos has

enriched the theory of nonlinear economic dynamics because as an outcome

of this enrichment a variety of econometric methods have been invented and

new fascinating research topics discovered.

Since the objective of this paper is to discuss the development of non-

linear dynamics from the perspective of economic history, I will try to avoid

technical description of the subject wherever possible, focussing on the in-

tuition and connectedness that underlie the discoveries of science and their

application.

The first section focuses on the mechanistic view of the world inherited

by the mainstream economics from 18th century science and from classical

economics, in particular. The second section touches upon the evolution of

linear views that eventually encompassed stochasticity and nonlinearity in

the 20th century. The third section is entirely devoted to chaos theory. The

most recent developments are considered in more detail. Conclusions sum

up the discussions and address possible future research topics.

2 Dynamical Economics and Classical Mechanistic

World View

The formation of economics as a science is commonly connected with the sci-

entific environment of the second half of the 18th century and the beginning

of the 19th century. The Enlightenment philosophy that dominated in the

advanced countries at that time inherited much from the age of Renaissance.

The discovery and exploration of new continents, the significant advances

3
in science, the decline of the feudal system and the growth of commerce,

and, more importantly, the establishment of humanistic values and the re-

vival of classical learning after a long period of cultural stagnation in the

Middle Ages, were major landmarks of the age of Renaissance that shaped

the milieu of Enlightenment.

Central to Enlightenment thought was the power of unconstrained hu-

man intellect that enables man to understand the universe and possibly im-

prove the current state of affairs by means of scientific reasoning. Knowledge

and freedom were viewed as the major determinants of human happiness.

It was for this reason that the Enlightenment philosophy was closely tied

to the development of natural sciences that were deemed capable of help-

ing man in his pursuit of happiness. It was also for this reason that major

contributors to natural science, such as Newton, Leibniz, and others were

at the same time influential philosophers.

Physics, the admired paragon for the Enlightenment science, arguably

had the strongest impact on the scientific community. It was a science

that could exactly predict the outcomes of an experiment provided that

the environment in which it was conducted was carefully described. Several

physical constants determined the basic laws of motion of a system and hence

constituted the predictability of an experiment. It was believed that the

entire universe and everything and everybody in it were governed by “natural

laws,” a set of cause-effect regularities reflecting the precise predictability of

all phenomena. Crutchfield et al. [10] quote Laplace saying in 1776:

The present state of the system of nature is evidently a consequence

4
 of what it was in the preceding moment, and if we conceive of an in-
telligence which . . . comprehends all the relations of the entities of this
universe, it could state the respective positions, motions, and general
effects of all these entities at any time in the past or future.
Physical astronomy, the branch of knowledge which does the greatest
honor to the human mind, gives us an idea . . . of what such an intelli-
gence would be. The simplicity of the law by which the celestial bodies
move . . . permit[s] analysis to follow their motion up to a point; . . . it
suffices that their position and their velocity is given by observation
for any moment in time. Man owes that advantage to the power of
the instruments he employs, and to the small number of relations that
it embraces in its calculations. But ignorance of the different causes
involved in the production of events, as well as their complexity, taken
together with the imperfection of analysis, prevents our reaching the
same certainty about the vast majority of phenomena. Thus there are
things that are uncertain for us, things more or less probable, and we
seek to compensate for the impossibility of knowing them by deter-
mining their different degrees of likelihood. So it is that we owe to the
weakness of the human mind one of the most delicate and ingenious of
mathematical theories, the science of chance or probability.

This dictum by Laplace is characteristic of the entire scientific atmo-

sphere of the late 18th - early 19th centuries. In it, the world is viewed as

absolutely deterministic; stochastic behavior per se is absent; uncertainty is

understood as a lack of knowledge about the deterministic rules of a complex

system; free will does not exist.

Interestingly, without even knowing this, Laplace expressed in this state-

ment dating back more than two centuries the intuition behind what would

be the most rampant area of research in nonlinear dynamics in the second

half of the 20th century, namely, chaos theory.

The founding works of Smith, Ricardo, Mill, Marshall, and other classi-

cal economists were definitely influenced by the political and social implica-

tions of the natural philosophy of Enlightenment. The search for determin-

5
istic “laws of motion” of the economy is apparent in the classical discussion

of “the invisible hand,” the rational man, competitive markets, etc. The

idea that an individual behaves in accordance with certain typical patterns

was essential for shaping economics as a science. This similarity between

economics and natural sciences was becoming particularly obvious as eco-

nomics was increasingly mathematized in the second half of the 19th century.

The founders of modern mathematical economics such as Walras, Pareto,

Cournot often claimed their willingness to correct the mistakes of classical

economists by putting the “natural laws” in a logically consistent, physics-

like form. Many of them were physicists, engineers, and mathematicians by

education.

Importantly, this mechanistic world view was not always static. The

above quote suggests that there was an understanding of dynamical depen-

dencies between current and past states of the system. Marx’ theory of

socioeconomic formations can serve as an example of a dynamical theory.

But such considerations were generally implicit and took the form of what

is now known as comparative statics.

As argued in Lorenz [20] (p. 8), the classical physical world view was also

linear by nature. The interaction of different phenomena that were studied in

isolation from noisy environment, was viewed as additive, i.e., the behavior

of a complex system was believed to be “a linear superimposition” of the

behaviors of the system’s elements.

In 1844, talking about the “disturbing cause” that prevents economics

from reaching the predictive capacity of other abstract sciences, Mill [23] (p.

114) argued in spirit of the linear deterministic views:

6
 There are not a law and an exception to that law - the law acting
in ninety-nine cases and the exception in one. There are two laws,
each possibly acting in the whole hundred cases, and bringing about a
common effect by their conjunct operation.

The linear quasi-dynamic deterministic approach is particularly evident in

Marshall’s partial equilibrium analysis. In his Principles [22] (p. 18) he

compares economics with the study of tides, on one hand, and the law

of gravitation, on the other, and comes to the conclusion that it is the

unawareness of the complex nature of the former that prevents us from

reaching the degree of predictability equivalent to the latter:

. . . though many forces act upon Jupiter and his satellites, each of them
acts in a definite manner which can be predicted beforehand: but none
knows enough about the weather to be able to say beforehand how it
will act . . . The laws of economics are to be compared with the laws of
the tides, rather than with the simple and exact laws of gravitation. For
the actions of men are so various and uncertain, that the best statement
of tendencies, which we can make in science of human conduct, must
be inexact and faulty.

To overcome this problem, Marshall isolates single elements of the complex

system and treats other elements as exogenously given. This method delivers

good explanations of relationships between endogenous variables and, in

specific cases, between endogenous and exogenous variables, but, in general,

no consistent dynamic picture of the system as a whole is possible.

As pointed out by Lorenz [20] (p. 12), although the comparative statics

procedure is useful only if a dynamic process converges to a new equilib-

rium after a shock and no feedback effect of the endogenous variables on

the environment is present, modern economics is still characterized by the

7
same emphasis on linear relations as at the beginning of the formalization of

the science. The analysis has certainly been extended by the sophisticated

literature on the issues of existence and stability in the general equilibrium

framework, in particular, by works of Arrow and Debreu, but neverthe-

less, throughout the late 19th - early 20th centuries, mainstream economics

concentrated primarily on the few kinds of linear dynamical behavior that

economist felt most comfortable with. These kinds of behavior produce

damped or oscillatory movement as a result of monotonic or oscillatory con-

vergence to a stable steady state (the so-called stable node or stable focus)

or as a result of steady oscillations (the so-called center dynamics).

In the beginning of the 20th century, it was, however, becoming increas-

ing obvious that the simple results of the linear deterministic quasi-dynamics

did not adequately depict the reality illustrated by the accumulating volume

of economic time series. Following the tradition of the earlier institutionali-

ists, Wesley Mitchell [26] wrote in his presidential address to the American

Economic Association in 1924 (p.11):

. . . [T]he statistical view involves the notions of variety, of probability,

of approximation . . . [T]he mechanical type of speculation works with
the notions of sameness, of certainty, of invariant laws. In economics
these notions do not fit the phenomena closely. Hence we must put
our trust in observations.

Mirowski [24] offers a vivid description of the general dissatisfaction of early-

century economists (in particular, of the so-called “Columbia school”) with

this state of affairs.

Similarly, Day [11] shows that if economic development is viewed “on a

8
bio-astronomical time-scale,” then not only do micro-, macro-, and growth

indicators exhibit irregular fluctuations, but the overall economic develop-

ment constitutes an exponentially unstable phenomenon; little if any evi-

dence can be found to support the classical belief in convergence of economic

processes to stationary states or regular periodic cycles.

More importantly, a major shift of the general scientific paradigm was

underway in the beginning of the 20th century as relativity theory and quan-

tum mechanics proved applicability of stochastic dynamical concepts.

3 Nonlinear Dynamics in Economics

The real time-series of economic data do not show the kind of regularity

that is predicted by the linear dynamical mechanistic systems. In fact,

contrary to the equilibrium theory, irregular frequencies and amplitudes

of economic fluctuations are persistent and do not show clear convergence

or steady oscillations. Their predictability with help of the deterministic

natural laws proved impossible. This situation in economics reflected the

general predictability problem of turn-of-the-century science, in particular,

physics. Discussing the possibility of predicting exactly the situation of the

universe from an initial moment, Poincaré stated in 1903 (as cited in [10]):

. . . [E]ven if it were the case that the natural laws had no longer any
secrets for us, we could still only know the initial situation approx-
imately. If that enabled us to predict the succeeding situation with
the same approximation, that is all we require, and we should say
that the phenomenon had been predicted, that it is governed by [de-
terministic] laws. But it is not always so; it may happen that small

9
 differences in the initial conditions produce very great ones in the final
phenomenon. A small error in the former will produce an enormous
error in the latter. Prediction becomes impossible, and we have the
fortuitous phenomenon.

As described in Mirowski [25], in spite of the burden of stochasticity

in real-life observations and the readiness of classical physics to deal with

it, classical economists were reluctant to give up the deterministic stance

that they had been the proponents of since the origin of the science. It was

not until the late 1930s - early 1940s that the neoclassical theory explicitly

included stochastic considerations. Yet, the way stochastic considerations

entered the so-called New Classical Macroeconomics was much of a compro-

mise: stochastic exogenous disturbances were superimposed upon (usually

linear) deterministic models to produce the stochastic appearance of actual

economic time series. Among others, Slutsky [34] showed that the behavior

of a linear dynamic business cycle model with additive random terms that do

not always have an economic meaning is very close to the behavior observed

in reality.1 For example, a simple linear model xt = xt−1 + t , where t is

a random term (white noise), produces a weighted moving average (MA)

process in  that may resemble the observed cyclical series. A slightly more

complicated autoregressive process (ARMA) with more than one lag of x’s

and an MA in errors may bring forth the same kind of behavior. Thus,

the ARMA models were an extension of classical autoregressive processes of

1
Surprisingly, the most widely cited and influential classical paper that brought rec-
onciliation between the classical determinism and the stochastic reality of economic ob-
servations came from the circles that were anything but classical. It was written by the
then-Soviet economist Eugene Slutsky when he was working on the Soviet business cycle
dynamics at Moscow’s Institute for Conjuncture. His work was reprinted in Econometrica
ten years later.

10
the simplest kind xt = αxt−1 which, as shown in Baumol and Benhabib [2]

among others, can generate regular oscillations.

In many cases, however, this classical extension often called the Frisch-

Slutsky paradigm fails to provide an economic explanation for the serial

correlation of the error terms and of the exact meaning of the ‘exogenous

shocks.’ Moreover, as Arrow (1989) argues (as cited in Jarsulic [19]), many

empirical phenomena are not explained well by linear stochastic equations.

Among such disturbing phenomena he mentions the non-converging trend

in per capita national incomes throughout the world, the persistent spans of

unemployment, and the observed periods of varying volatility. He concludes

that though the neoclassical approach has been successful with some empir-

ical questions, many remain unresolved because of the lack of nonlinearity

in classical reasoning.

Lorenz [20] (p. 31) argues that inability to discriminate between a lin-

ear model with a stochastic term and a nonlinear model also makes the

classical argument suspicious. Since accepting the hypothesis of linearity

only involves running a linear regression and obtaining a good fit for the

corresponding ARMA model, rather than performing the relatively sophis-

ticated nonlinearity tests, evidence for linearity in economics may have been

overestimated.

Interestingly, advances in other sciences have exerted a substantial influ-

ence on the considerations of stochasticity in economic theory. For example,

institutionalism, emerging in the beginning of the century as a synthesis

of economics and psychology and biology, opposed the classical notion of

determinism in economic processes. Instead, institutionalists proposed to

11
view progress as a random, ateleological, dynamical process of evolution

in which institutions both influence and are influenced by the system in a

never-ending sequence of variation, selection, and transmission, in which a

small variation can have unexpectedly significant consequences. In this way,

institutionalism reflected the nonlinear dynamical understanding of stochas-

ticity with a feedback that was becoming dominant in science. In statistics,

the concepts of Markov chains and of Brownian motion that also appeared

in the beginning of the century contributed to the emergence of the random

walk hypothesis in economics and called for a significant volume of both

theoretical and empirical inquiries that culminated in the relatively young

discussion of market efficiency.

Economists dissatisfied with the neoclassical linear stochastic explana-

tions, searched for alternative answers. Nonlinear economics promised such

alternatives. In the middle of the 20th century, a number of Keynesian

macroeconomists (see Lorenz [20]) introduced nonlinear macroeconomic mod-

els that were shown to produce plausible cyclicity. On the neoclassical side,

as reviewed by Day [11], introduction of nonlinearity invoked developments

that resulted in the contemporary real business cycle theory in which the

behavior of economic variables as an outcome of intertemporal optimization

can display the empirically supported complex characteristics that are gen-

erated by internal forces alone. Exogenous shocks are considered in such

models to account for an ad hoc external disturbance.

Boldrin and Woodford [4], Baumol and Benhabib [2] summarize similar

results obtained by introducing nonlinearities into a wide variety of fields

in economics. The nonlinear dynamic systems they discuss include taton-

12
nement, cobweb price adjustment processes, optimal growth models, over-

lapping generations models, Keynesian business cycle models, Kaldor and

Goodwin growth cycle models, Solow growth model, demand models with

adaptive preferences, Malthusian and neoclassical demoeconomic models,

models with financial feedback, models of choice with endogenous tastes,

models of productivity growth, duopoly models, and others. Interestingly,

classical general equilibrium model with standard competitive assumptions

of market clearing, perfect foresight, and perfect information also generated

irregular oscillations.

The papers by N. Kaldor [18] and R. Goodwin [14] are the most promi-

nent and the most frequently cited examples of this early literature. The

two models, often viewed as the prototypes of nonlinear dynamical sys-

tems in economics (see Lorenz [20]), produce business cycle dynamics of the

multiplier-accelerator type, in which the investment function is nonlinear.

The more recent applications of nonlinear dynamical models in economics

include works by T. Puu [30] and C. Chiarella [8]. Puu shows (p. 113-131)

that J. Robinson’s analysis of a monopolist facing a marginal revenue curve

that has two profit maximizing intersections with the marginal cost curve

[31] can also be presented by a nonlinear dynamical model with a nonlinear

marginal revenue function. Chiarella puts cobweb dynamics in the nonlin-

ear context. Interestingly, a series of publications of the so-called “Limits of

Growth” movement that originated under the auspices of the Club of Rome

in the early 70s can also be viewed as an application of nonlinear dynami-

cal concepts to growth. The movement used computer-simulated models of

complex exponential dynamical systems to support their “doomsday scenar-

13
ios” (see, for example, [9]). It is beyond the main objective of the paper to

discuss the details of every study. Suffice it to say that, in spite of the fact

that explicit solutions for such nonlinear dynamical systems are, in general,

rarely obtainable, these systems have greatly improved our understanding

of a wide range of economic phenomena.

Many of these nonlinear deterministic systems were found to exhibit a

behavior that was so irregular that most of standard randomness tests were

unable to distinguish between them and pure white noise. Such nonlinear

dynamical models characterized (a) by the intrinsically generated stochas-

ticity and (b) by high sensitivity to initial conditions and parameter values,

are the subject matter of chaos theory.

Nonlinearities and chaos theory, often cited as close if not synonymous,

are far from being identical terms although both appeared around the same

time in the 1960s-1970s as a fast-growing and promising field, first in statis-

tics and physics and then in economics and econometrics. It is necessary for

a chaotic system to be nonlinear, but not every nonlinear system is chaotic.

Nonlinear dynamics can be represented by nonlinear difference and differ-

ential equations. There are, however, other nonlinear models that can not

display chaotic dependencies, such as the nonlinear moving average (NMA)

model proposed by Robinson [32] in which xt = t +αt−1 t−2 , or the thresh-

old autoregressive (TAR) model proposed by Tong and Lim [35] in which xt

follows different AR processes depending on its values.

Particular interest has been drawn to models that describe a major

change in the process characteristics, often called “models with structural

breaks or regime shifts”. The simplest version of such processes (also called

14
“nonstationary”) includes two periods of data characterized by different

mean and/or variance. More complicated versions represent the statisti-

cal concept of Markov processes in which the so-called transition matrix

determines the probabilities of shifting from one regime to another. Many

view this nonlinear concept, originally introduced in economics by J. Hamil-

ton [16], as one of the most fruitful approaches to macroeconomics (see, for

example, Pesaran [28]).

A particular alternative to deterministic chaos is a set of nonlinear

stochastic models that also show no autocorrelation. These are the so-

called “ARCH-type” models (autoregressive conditional heteroskedasticity

models), proposed by Engle [12] and generalized by Bollerslev [5]. In these

models, xt = σt t , where σt2 denotes the variance of  represented by an AR

process such as σt2 = α1 + α2 x2t−1 + α3 σt−1

2 .

Among the “ARCH-type” models (Exponential GARCH, Asymmetric

Power ARCH, Threshold GARCH, etc.), the so-called integrated model

(IGARCH) and fractionally integrated model (FIGARCH) have been most

popular recently. Analogously to integration in the ARMA models, inte-

gration in GARCH models denotes that current information about variance

and mean remains important for forecasting the volatility of all future hori-

zons; in technical terms this means that there is a unit root in the AR

expression for σt2 or, equivalently, that, for the simplest version of GARCH

above, α2 + α3 = 1. In reality, however, volatility can be seen to change

quite slowly rather than to be infinitely persistent as in the case of integra-

tion (I(1)) or exponentially decaying as in the case of no integration (I(0)).

The FIGARCH model due to Baillie et al. [1] was introduced to eliminate

15
the too-restrictive distinction between I(0) and I(1); it proved to be quite

successful in the recent attempts to model financial time series. Various

combinations of the nonlinear volatility models and the Markov regime-

switching models seem to be the frontier of nonlinear dynamical economics

today (e.g., Beine et al. [3]).

Besides rich theoretical implications, substantial empirical evidence has

been found for nonlinearities in economic dynamical systems (see, for ex-

ample, Day [11], Hsieh [17], and Baumol and Benhabib [2]). This evidence,

however, only supports the kinds of nonlinear dependencies mentioned above

that are different from chaotic. Having had an exuberant outset, the search

for chaos in economics has been gradually becoming less enthusiastic dur-

ing the last two decades as no empirical support for the presence of chaotic

dependencies in economics could be found.

4 Chaotic Behavior in Economics

Without quantum mechanics and chaos theory the classical predictability

paradigm (à la Laplace) might have hoped that errors in a process might be

small enough over time (no greater than the initial measurement error) so

that forecast might be possible. As foreseen by Poincaré in his quote above,

however, this is generally not the case – quantum theory (the Heisenberg

principle) provides for the initial conditions of a system to be always uncer-

tain, while chaos guarantees that these uncertainties make prediction im-

possible. In other words, determinism and predictability are two absolutely

different things.

16
 When we measure a state of a system we locate it in a possibly small

region of the space that is defined by all the possible states of the system.

If the world was fully predictable, the future development of the system

(the orbit of its states) would need to remain in the same small region

overtime, forming a stable attractor of the system, i.e. a set of orbits to

which the system will gravitate, providing for its complete predictability.

Several attractors of deterministic dynamic systems such as fixed point, limit

cycle, and torus attractors, were known to scientists from earlier studies

of predictable nonlinear dynamic systems. In the early 60s, however, the

number of known attractors of dynamic models was extended to include the

so-called strange (or chaotic, unpredictable) attractors. A strange attractor,

like any other attractor of a dynamical model, attracts orbits of a system,

but the orbits do not stay close to one another for a long time, they quickly

diverge within the attractor, but at certain stages, they pass close to one

another again. In such an attractor, the orbits are randomly mixed and are

never the same, no matter how similar the initial conditions are. Thus no

long-term predictability is possible in such systems.

This continuous shuffling of orbits within an attractor can be viewed as

stretching and folding of the attractor that create folds within folds indefi-

nitely. A chaotic attractor is therefore a fractal, i.e., a geometric object that

reveals more details as it is magnified more and more. Benoit Mandelbrot

is considered to be the father of fractals. In several pioneering works in

economics, geometry, and physics in the early 70s, he introduced fractals

(see, for example, Mandelbrot [21]) and applied them to solving several old

“puzzles” (see, for example, Mirowski [25]).

17
 Chaotic systems therefore generate randomness without the need for

any external random input. The random behavior does not simply come be-

cause of amplification of random errors but because of the special character

of orbits generated by the kind of stretching and folding described above.

Authors repeatedly stress (see, for example, Jarsulic [19], Baumol and Ben-

habib [2]) that even if the deterministic rule of a chaotic system was known

with complete certainty, a failure to specify with infinite precision the ini-

tial conditions or to make perfect numerical calculations of period-to-period

dynamics would yield exponentially increasing errors of forecast. Only very

short-term dynamics can therefore be forecast in chaotic systems.

Brock, LeBaron, Scheinkman, Day, Ramsey, Dechert, Hsieh were among

the pioneers of chaotic research in economics as this field was becoming

increasingly popular in the early 1980s. Among a variety of examples of dif-

ference and differential equations that have been used to represent a chaotic

relationship between xt and xt−1 such as tent map, Hènon map, Lorenz map,

Mackey-Glass equation, pseudo-random number generator, etc. (see Hsieh

[17] for a summary of the most common low-dimensional chaotic maps), the

logistic map of the general form xt = αxt−1 (1 − xt−1 ) has been particularly

useful for demonstrative purposes. While for small values of α the system is

stable and well-behaved, for the values close to 4 the system shows chaotic

behavior. Even though it is a deterministic process, xt appears stochastic

with the empirical autocovariance function ρ(k) = E[xt xt−k ] → 0 as t → ∞,

which is analogous to white noise. Any small error in measuring the initial

state x0 exponentially increases in xt , and sudden jumps can follow a series

of small increases and decreases.

18
 The early economic publications on chaos seem to be overwhelmed with

enthusiasm about the prospects of building an entirely novel theory of econ-

omy based on chaos theory. Reading works by such popularizers of chaos

as J. Gleick, whose book on chaos was a bestseller of the New York Times

in the late 80s, one gets the impression that science was on the brink of up-

heaval. Economics was about to substitute the neoclassical deterministic or

quasi-stochastic linear stance with the more realistic chaotic explanations

that left little space for such neoclassical cornerstones as the concepts of

rationality, predictability, and perfect foresight.

This belief, however, gradually faded as economists looking for chaos in

economics faced the reality of short economic time-series and the wide range

of other nonlinear effects to test for. Mirowski [24] and [25] argues that it was

the neoclassical resistance to accept chaotic concepts that played the major

role in the failure of chaos theory to make better progress in economics. It

can, however, be seen from the empirical and theoretical works on chaos in

economics as compared to natural sciences (see, for example, Lorenz [20] and

Puu [30]), that although the theory of chaotic behavior in economics still

brings valuable insights about how economic systems behave, the empirical

task of extracting evidence of chaotic dynamics from economic time series

is objectively more difficult than in natural sciences and may not justify the

effort required, given the promise of alternative fields of relevant nonlinear

research.

In the mid 1980s also came the understanding of the fact that a highly

complex chaotic process (i.e., a nonlinear dynamic process that involves

many variables) is for any practical purposes equivalent to randomness (see,

19
for example, Hsieh [17] and Brock et al. [7] for the discussion of the pseudo-

random number generator used in computers as an example of such systems)

and that only not-very-complex chaotic systems (low-dimensional chaos)

may have short-term predictability that cannot be captured by traditional

linear forecasting methods such as the ARMA-methodology (see, Baumol

and Benhabib [2]).

By the same time, several tests for low dimensional chaos had been

proposed. The notion of correlation dimension, developed by Grassberger

and Procaccia [15], has been arguably the most influential. It provides

a check for chaos by using the non-random property of chaotic systems to

leave “holes” in the spaces of high dimensions. The test goes as follows. The

series xt is transformed into a set of vector sets of dimensions 1 through n

(the dimensions are called “imbedding”): xt , (xt−1 , xt ),. . . , (xt−n+1 , . . . , xt ).

Then the fraction of pairs of these vectors which are within a certain distance

d from each other (correlation integral) is calculated. Correlation dimension

is essentially the limit of the slope of the graph of logarithm correlation

integral versus log d as n → ∞. If correlation dimension approaches infinity,

too, this means that the process uniformly fills up the n-dimensional space

which is an attribute of randomness. Whereas if correlation dimension stops

growing at certain n, this is the evidence for n-dimensional chaos.

It is clear from this procedure why a highly complex chaotic system (n

is greater than five) is very difficult to detect. It is impossible to verify

that the correlation dimension is infinite using a finite time series. Hence

there is effectively no practical difference between pure randomness and

high-dimensional chaos. Moreover, Hsieh [17] suggests that while natural

20
scientists use over 100,000 observations to detect low-dimensional chaos, the

largest time series usually available to economists consist of about 2,000

observations; the corresponding 200 vectors of the imbedding dimension

of 10 are not enough to verify if they “fill up” the 10-dimensional space.

In addition, Ramsey et al. [27] proved that in relatively short economic

time series (even as long as 2,000 points), chaos might have been found

where it was not actually present as the slope of the graph of logarithm

of correlation dimension was biased downward in small data sets. They

also surveyed the evidence for chaotic dynamic and concluded that if the

small sample bias was taken into account, no simple chaotic attractors were

established in most of the studies although evidence for nonlinear dynamics

in general was supported. These results were also confirmed by Scheinkman

and LeBaron [33] who argued that some nonlinear stochastic systems, such

as those described by the “ARCH-type” models were capable of producing

behavior similar to that produced by chaotic maps, and that the correlation

dimension test for chaos also picks up such nonlinearities.

The so-called BDS statistic is an extension of the correlation dimension

test that was developed by Brock, Dechert, and Scheinkman [6] in 1987 to

make verification of nonlinearity more quantifiable. Using the correlation

dimensions, they constructed a variable that had a limiting standard nor-

mal distribution, thus, enabling a test of the hypothesis of randomness of a

time series. Hsieh [17] uses Monte Carlo simulations to check the power of

the BDS test to distinguish between a random sample of independent and

identically distributed observations (IID), generated by a “good” pseudo-

random number generator, and various kinds of linearity and nonlinearity,

21
both stochastic and deterministic. He establishes that the BDS test re-

jects the IID hypothesis for a wide variety of processes including ARMA-,

GARCH-, TAR-, regime shift models, and several low dimensional chaotic

maps. He then tests stock returns for randomness using the BDS test and,

in line with Scheinkman and LeBaron [33], strongly rejects the hypothe-

sis that stock returns are IID. The nonlinear behavior can therefore come

from different sources and is not necessarily chaotic. As a matter of fact,

using methods of nonparametric statistics, Hsieh comes to the conclusion

that the cause of nonlinearity appears to be conditional heteroskedasticity

rather than chaotic dynamics, regime shift, or other factor. Although the

standard “ARCH-type” models do not account for all the nonlinearity in

stock returns, a more flexible GARCH-model with an IID term in the vari-

ance equation does. Other authors working on exchange rate, interest rate

dynamics almost universally confirmed these findings.

Several other chaos tests have been developed. To date, none of them

has, however, delivered solid evidence of chaos in economics data. The

failure to find convincing evidence for chaos in economic time series redi-

rected efforts in modeling nonlinearity from conditional mean (e.g., chaotic

systems) toward conditional variance (“ARCH-type” models). Predicting

volatility has become a new challenge of nonlinear economics although the

increasing amount of economic data still provides opportunity to reconfirm

absence of low dimensional structures, too.

22
5 Conclusions

Chaos theory has significantly changed the methodology of science. The

classical method of making a theoretical prediction and then checking it

against the experiment is not quite fit for chaotic processes. Since in such

processes, long-term forecasting is impossible, verification of a theory should

involve more delicate considerations of statistical properties of the theory

rather than its predictive power.

Nonlinear dynamics and chaos theory have also corrected the old reduc-

tionist tendency in science, and in particular, in classical economics, to study

a system by means of superimposition of its separate elements. As mentioned

above, this linear view is not necessarily adequate in all dynamic systems.

Specifically, in chaotic systems, where there is a critical dependency of the

system behavior on the interaction of its components, the complex global

behavior cannot be deduced from knowledge of individual components.

Modern financial economics deals with high-frequency, or tick-by-tick

financial data. This improves data availability for nonlinear model testing

and in particular, for chaos tests. As argued by Hsieh [17], tick-by-tick

data, however, captures micromarket phenomena such as bid-ask jumps,

limit price order executions, and others. These irrelevant dependencies will

be picked up by the nonlinearity tests unless a larger sampling interval is

used to average them out. Larger intervals, in turn, require larger time

series that are often nonstationary. Since nonstationarity is also picked up

by nonlinearity tests, the economic data set must also be not too long so

that nonstationarities (regime shifts) are avoided. This, evidently, imposes

23
significant limitations on the possibility of success in the search for chaos in

economics.

Efforts to improve predictability of economic processes now shifted to

volatility analysis. Evidence for nonlinear dependencies in variance rather

than in mean has been quite convincing in financial economics. Apparently,

future endeavors in nonlinear research will include the search for a connec-

tion between volatility of economic and financial indicators and measures

available to policy maker to control it such as central bank interventions.

Evidently, chaos represents a somewhat uncomfortable state of affairs in

science and, in particular, in economics. First, its presence makes forecast-

ing almost impossible and the remedy relying on the increased precision of

measuring the initial conditions and on the reduction of computation errors

does not help in practice, as the exponential rate of error propagation implies

that in order to obtain a marginal extension of the prediction horizon, one

might incur astronomical costs. Second, with the economic time series avail-

able at this time, it has been proven impossible to find convincing evidence

that nonlinearities in economic time series are caused by chaotic dependen-

cies. The development of chaos in economics has therefore been influenced

by the high technical difficulty and high costs of looking for something that

may not exist in a useable form whereas one might more successfully explore

other variants of nonlinear dynamics that can improve predictability. The

history of chaos research in the timeframe between its enthusiastic outset

and today’s fadeaway suggests that economists have largely chosen to shift

to a less troublesome research agenda.

The fact that low-dimensional chaos cannot be detected does not mean

24
that chaos is irrelevant in economics. Chaos theory still improves our un-

derstanding of general nonlinear dynamics. Plus, economic systems do not

have to be low-dimensional. At this time, high-dimensional chaos, if present,

cannot contribute to predictability of time series as high-dimensional de-

terminism essentially equates randomness in the conditions of limited data

amounts, but future developments in data collection and analysis techniques

may change this situation.

The insurmountable unpredictability of high-dimensional nonlinear de-

terministic (or purely stochastic) processes (à la Hawking) is consistent with

the ideas of the father of chaos, Benoit Mandelbrot who believed (as de-

scribed in Mirowski [25]) that most of the processes fell between pure de-

terminism and white noise so that they could be equally well described as

complex stochastic processes or as chaotic dynamics.

Finally, the inseparability of determinism and stochasticity evident from

nonlinear research in economics is consistent with the philosophical tradition

of duality in questions of free will and teleology. Even if we knew all the

dependencies of the universe there still would be a place for randomness

for a complex regular rule is the randomness itself. In his analysis of the

problem of freedom of man, Karl Popper [29] writes about clouds that “are

highly irregular, disorderly, and more or less unpredictable” and clocks that

“are regular, orderly, and highly predictable in their behavior”(p. 5):

. . . [T]he world [is] an interlocking system of clouds and clocks, . . . to

some degree all clocks are clouds; . . . only clouds exist, tough clouds of
different degree of cloudiness.

25
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