10 Disciplines of evolutionary economics
Thermodynamics & evolutionary stable structures - Emergence & hierarchies of evolutionary stable structures - Computer Simulation & non-linear mathematics - Molecular Biology & the copy/vary/select neo-Darwinian synthesis - Neuroscience & individual self-conscious decision making - Evolutionary Psychology & hierarchies of survival 'know how' - Anthropology & economic culture - Game Theory & economic cooperation - Biological History & evidence of social animal synergies - Complex Adaptive Systems & Universal Darwinism
1 - Wealth Creation
Wealth creation is not luck, nor providence, but rather the unleashing of a process of evolution ... of natural selection ... of differential survival ... of technological & institutional innovation involving the generating & testing of a diversity of ideas which discover & accumulate more survival value for the costs incurred than competing alternatives. The evidence suggests that it is adaptive efficiency that defines economic efficiency.
Economics is a science of choices ... of alternatives ... of opportunity costs ... the natural selection of the choices made results in survival 'know how'.
key - survival 'know how' emerges from social synergies under pinned by moral empathy
2 - Empirical Science
Empirical scientific methodology, not a priori reasoning, provides the supporting evidence for a process of discovery which feeds on itself –
observation - evidence of the senses, everything else is a woven web of guesses
mathematical theory - a precise imaginative description, a verifiable system of assumptions and rules in the mind which explain in general terms a wide variety of interconnected observations of physical reality
testable hypotheses - convincing predictions, suggested consequences of theory as a basis for verification and further observations without an assumption of truth
experimental validation - repeatable evidence, convincing the jury
peer review - the triumph of science over the whims of Bishops, Princes, Generals and bureaucratic despots
Over generations since 1500 scientific methodology has discovered & accumulated knowledge & understanding of the world by a relentless process of generating & testing ideas in the imagination and in reality. Science discovers models of reality ever closer to the laws of nature involving both prediction (usefulness) and change (progress).
The key to understanding complex economic systems is the differential survival of alternative ideas which are freely tested without harming others.
Stephen Hawkins -
'some individuals are better than others at drawing the ‘right’ conclusions about the world around them & act accordingly. These individuals will be more likely to survive & reproduce & so their pattern of behaviour & thought will become dominant'.
key - we are ignorant of what it is we do not know so we observe the outcomes of experiments and learn
Why is differential survival of inherited variants so counterintuitive & difficult to grasp?
Economic systems are not the result of the plausible top down intelligent design process of Bishops, Princes, Generals & bureaucratic despots and deliberate, rational, purposeful, intentional, planning but rather the counterintuitive bottom up process of natural selection ... the differential survival of a diminutive few inherited variants; the vast majority of inherited variants die!
The process is simple but the penny has to drop, natural selection involves -
copy = inherited accumulated successes start the process, there is no blank slate
vary = random mutations produce path dependent diversity, there is no foresight
select = survival 'know how' survives that is why it is survival 'know how', there is no supernatural intervention
Darwin was well aware that the penny wouldn't drop easily and delayed the publication of 'Origin of Species' for 20 years because of his concern about the adverse reaction as his insight confronted the plausible conventional wisdom of intelligent design.
Richard Dawkins -
'it is almost as if the human brain was designed to misunderstand Darwinism, and to find it hard to believe'.
Daniel Dennett of Tufts University, Boston, USA, claimed Darwin's idea was -
'a dangerous universal acid'
and he came up with one of the most succinct aids to understanding natural selection -
‘the giraffes long neck is undoubtedly caused by some complex chemistry but a more meaningful explanation is that short necked giraffes died out’.
Nobel Economics Laureate Paul Krugman argued that together with Ricardo's 'comparative advantage', Darwin's 'natural selection' was a 'difficult idea' -
'most folk somehow find this particular idea impossible to grasp'
Krugman's reasons for the difficulty -
natural selection is an exclusive alternative to 'intelligent design' which was and still is, an old 'intellectual fashion' ... a plausible 'conventional wisdom' ...
the idea is much harder than it seems for most people because it involves understanding 'a dense web of linked ideas' ...
emotional human beings have an aversion to the 'linear mathematical models' of rational science peddled by 'aliens armed with equations & computers' ...
Scientific progress is all too often counterintuitive ... remember the flat earth, the moving sun, the beautifully ‘designed’ lily ... and the homunculus in the brain …?
key - not intention but rather weeding out failures
How can genes do cost/benefit analysis?
Complex economies have evolved via a series of emergent systems and sub systems over deep time.
The simple copy/vary/select process and a long long periods of time ... 'miracles' do happen but they are not supernatural ... a dynamic continuity started at the big bang? ... long long before replicating genes discovered survival 'know how' which accumulated in human cultures.
Richard Dawkins wrote several books about ‘the long reach of the gene’, 'the extended phenotype' & the mechanisms of change –
genetic drift - random genetic variation can change neutral (non-adaptive) traits.
adaptation - genetic variation + natural selection.
responsive adaptation - adaptation + environmental change that favours natural selection of previously neutral genetic variations (spandrels) or previously differently functional variations (exaptations).
Baldwin Effect - responsive adaptation + behaviour (niche construction) ...
Something just happens - individuals change their behaviour by trial & error and a survival enhancing learned behaviour proliferates – a pre-existing genetic variation helps the new behavioural skill to be learned more easily - this genetic variety is naturally selected - assimilated behaviour can become an instinct.
Richard Dawkins noted in 'The Selfish Gene' in 1976 –
‘genes/memes act ‘as if’ calculating costs/benefits and all the optimistic conclusions about cooperation apply in the world of nature’.
The Selfish Gene (1976), The Extended Phenotype (1982), The Blind Watchmaker (1986), River Out of Eden (1995), Climbing Mount Improbable (1996), The Ancestors Tale (2004) ... all were history books ... biological history books!
key - historical economic change survives when survival value is in excess of costs
Was the Boeing 747 intelligently designed or naturally selected?
The Baldwin Effect explains the move from biological evolution to the reality of an evolving whole shebang & caboodle which includes everything we see in the universe. Baldwin described, a process which directly linked behaviour to the genes. Genes that programme a tendency to acquire certain behavioural traits can be inherited. Such a pre-existing tendency for a behaviour which makes survival easier can be naturally selected and eventually become genetically hard wired deep down in the skull.
This is not Lamark's inheritance of acquired traits where there was no direct change in the genotype based on the experience of the phenotype. Baldwin's idea is based on a pre-existing genetic variation.
Universal Darwinism is an idea powerful enough to explain everything - understanding ontology comes from the interactive whole shebang & caboodle, layer upon layer of hierarchical interactivity & emergence - energy, matter, chemistry, biology, immune systems, neural networks & circuits, instincts, language, social behaviour and culture - choices at one level are always tested against alternatives at other levels. Self consistency is guaranteed as everything effects everything else ... economic behaviour is embedded in an historical trajectory of a nested set of sets ...
Economic systems are an evolving complexity of hierarchical, interactive, interconnected sub systems ... whole shebangs & caboodles.
Daniel Dennett -
'Darwin shows us how to climb from absolute ignorance to creative genius without begging any questions. Sky hooks can't save the situation supernaturally, they are impossible. But cranes can do the lifting work from a firm base of existing ground. Gradual accumulation is powerful enough to have done all the design work that is manifest in the world'
... including the Boeing 747 ...
key - everything effects everything else without discontinuities; a whole evolving shebang & caboodle
Science and Human Behaviour
How do random mutations create wealth?
Human adaptive behaviour not just a useful biological analogy, it is ontology. Genes evolve, neural networks in the brain evolve, animal behaviour evolves and so too does human behaviour ... as survival 'know how'.
It is 'as if' genes do cost/benefit analysis and chase profit & cut losses. Human intention is not what most people think it is.
Geoffrey Hodgson -
'from analogy to ontology, an adequate evolutionary economics must be Darwinian'.
Survival value emerges from a Darwinian process of adaptation to a local environment by natural selection -
copy = innovative change starts by inexact replication of the pre-existing variants of survival 'know how' in a population of behavioural traits that have 'worked'
vary = a random diversity of many different variants are generated for testing, a diminutive few will have diminutive survival advantages, but nobody knows which? where? what? who? when? or how?
select = beneficial variants differentially survive & spread in changing populations, winners tend to monopolise localities as few survive as second best, close associates imitate, competitors adopt & new comers embrace the new 'know how' which spreads throughout the population as the old behaviour dies out
Future outcomes are unknowable in advance, not because of immense complexity but rather because -
mutations must random for evolution to work and nobody knows which? where? what? who? when? or how?
nobody can foresee the emergent novelty of the future of intended nor unintended consequences and
nobody knows how the flip flopping emotions of other folk will respond to interactions ...
Evolutionary equations modeling non linear complexity have no solutions and have to be run to see outcomes which makes even the interpretation of the past difficult.
Nevertheless statistical uniformities or patterns do emerge from diversity & natural selection, evolution is not random. But beware statistical uniformities in Complex Adaptive Systems aren't what they seem to be -
interconnectedness makes it difficult to identify the population of concern
uniformities may be correlations which are not cause & effect
patterns which do emerge may vary & change
and then random chance may upset the apple cart.
Economic efficiency can be defined as adaptive efficiency - a trial & error process of discovering & accumulating survival value.
key - survival value spreads throughout populations as the uneconomic behaviour dies out
Why do top-down bureaucracies so often fail to adapt?
The laws of nature, discoverable by the accumulation of scientific 'know how', describe a confusing world of statistical uniformities and change of patterns and progress ... but the only scientific theory of change and progress is evolution.
Darwin's insight was restated by Daniel Dennett in 'Darwin's Dangerous Idea' in 1995 as a universal acid which ate through everything including alternative theories of economic growth -
A pre-existing inherited variant with a survival advantage in the local environment will always increase in population frequency as alternative variants die out, this changes the environment which then inevitably feeds back and influences the survival chances of any new variant ...
From Dennett's description it becomes clear why bureaucracies are seldom agents of change and progress - little diversity, little variation and little death.
Joe Schumpeter described the economic process of discovery & accumulation as 'creative destruction' but bureaucratic despots focus on continuity of their methods; the antithesis of 'creative destruction'.
Reassuringly the Financial Times in December 2014 'got it', John Kay -
'Such processes of adaptation are the means by which
economies and institutions change over time. They are rarely the outcome of
careful calculation but they are far from irrational in their origins or
their consequences. Evolution can bring about outcomes more complex and
sophisticated than any designer could achieve. That is what makes evolution
one of the most powerful, and paradoxical, of human ideas.
Successful adaptation looks very like rational decision making.
The selfish gene is not literally selfish, and if it were it would actually be less successful in propagating itself because it does not sufficiently know what its best interests are. Evolution is smarter than you, and smarter than rational economic man'.
Giraffes have long necks because pre-existing genetic variants from the past differentially survived and accumulated as short necked giraffes died out.
There is no evidence of any supernatural intelligent design alternative. Ignorance makes intelligently designed complexity a physical impossibility!
key - survival 'know how' growth tends to be stifled in bureaucracies through restrictions on diversity, variation & deaths
Why endless cycles of death & destruction?
As soon as there were stocks there were parasites and predators.
Theft proved to be a resilient survival strategy. But as fast as predators grew claws, prey ran faster, and 'arms races' were a zero sum cul-de-sac.
Lotka-Volterra did the maths and funny things happened when everything depended on everything else; cycles emerged, there were no easy solutions to 'non-linear' equations.
Something fundamental was going on, John Maynard Smith -
'Genes only succeed through their interactions with all the others. Newton's mathematics was adequate only for the description of simple dynamical systems but we now have a mathematical language for describing the change of quantity into quality; a bifurcation'.
But it wasn't all death & destruction, better cooperative strategies with synergies were available to be discovered ... but these were not intelligently designed, they differentially survived as other uneconomic strategies died out ...
Not intention but rather weeding out the failures.
key - as soon as there are stocks there are thieves
Why must surpluses be protected by property rights?
Once it was clear, as Darwin himself suggested, that the evolutionary process applied to human behaviour important behavioural traits began to be explained by scientists.
The 1994 Nobel Prize for economics went to John Nash who suggested a concept of equilibrium where there was an optimal response available to any position adopted by other people. A strategy that always was economically optimal whatever other people did.
John Maynard Smith called the Nash equilibrium an ‘Evolutionary Stable Strategy’, such strategies emerged from the evolutionary process and require no human intelligent design.
An ‘tit for tat’ behavioural strategy evolved in social species 'as if' to exploit the synergies of cooperation over time and protect the species from parasites & predators –
cooperate & trust - discover synergies, be nice, don’t try to win at the expense of others, share benefits
immunity & defence - avoid costly violence but retaliate if attacked to protect benefits from parasites & predators
social communication - respond clearly, simply, timely and emphatically to avoid misunderstandings and develop trust – cooperation is the rule but there will be a proportionate defensive response to all attacks
forgive & recruit – intensify interactions for scale economies and opportunities for cooperation next time round
persevere & learn from outcomes – cooperate with cooperators
Selfish maximising animals 'red in tooth and claw' was not an accurate description of social human beings. Evolution tended to drive decision making towards cooperation whenever 2 + 2 = 5 type synergies exist. But as soon as there were stocks there were parasites & predators. Cooperation was not universal, parasites & predators evolved but always tended to be confronted. Cooperative behaviour tended to differentially survive because of synergies. Cooperative instincts and cooperative institutions exploiting synergy advantages tended to proliferate in populations.
John Maynard Smith had discovered the foundations of -
morality & cooperative synergies and
resentment of cheats & the just war?
key - stocks are created by synergies but protected by defence systems
How is it profitable to cooperate?
Cooperative moral order tended to emerge naturally from evolved social systems without intelligent design because synergies were to be found everywhere from specialisation & scale & trust & exchange.
In 1983 Robert Axelrod explored computer models of the iterated ‘Prisoner’s Dilemma’ game and formalised the risks and payoffs associated with ‘evolutionary tit for tat’ strategy and with William Hamilton published ‘The Evolution of Cooperation’. There were no expensive prerequisites, the strategy was applied ‘blindly’, everybody participated, long term cooperation became understandable. The key was that the economics of human social behaviour was not a one off zero sum game -
‘The key to doing well lies not in overcoming others but in eliciting their cooperation. Individuals don’t have to be rational; the evolutionary process alone allows successful strategy to thrive, even if the players do not know why or how. No central authority is needed, cooperation is self policing’.
Downward spirals of ‘tit for tat’ were not ‘Evolutionary Stable Strategies’ because -
genes/memes acted ‘as if’ calculating cost/benefit, the development of the Peacock’s tail and ‘arms races’ always ended as random events always offered alternative options which avoided local cul-de-sacs.
This breakthrough in understanding had important implications for evolutionary economics and illuminated all decision making.
Matt Ridley –
‘Game Theory is an esoteric branch of mathematics but provides the bridge between biology and economics whenever there is an apparent conflict between self interest and the common good’.
Cooperating genes in genomes and cooperating behaviour in social groups tend to survive and proliferate because of the synergies involved.
key - continuous cooperation discovers synergies & punishes cheats
Evolutionary Economics via Behavioural Science
How can know how be communicated across the generations?
The key to understanding complex economic systems is the differential survival of alternative ideas which are freely tested.
Ideas which harm others will tend to die, cooperative ideas which deliver synergies will tend to survive.
Science progresses when moral sentiments are institutionalised in liberal democracies where free experiments are encouraged and minorities are protected.
Valuable survival synergies are discovered by individual creative interactions but 'know how' is accumulated in larger groups, in institutions by cultural learning.
Herbert Gintis -
'A Nash Equilibrium exists if every player's choice is a best response to the choices of the others. Homo Sapiens is exceptional in that human cooperation extends beyond close genealogical kin to include even total strangers. In the course of our history we created novel social and physical environments exhibiting benefits of cooperation, among them division of labour coordinated by market exchange and property rights, systems of production characterised by increasing returns to scale and warfare'.
The long hard slog from the foothills of Richard Dawkins' 'Mount Improbable' explained why so few economies reached a rising pinnacle of complexity where complex social institutions like freedom & democracy were found.
But this is evolution ... the pinnacle was not the best, just better than some of the competing alternatives at a particular time and place ... learning was forever ...
Richard Dawkins -
'The astronomic improbability of living wonders is precisely the problem that Darwinism uniquely solves. It solves it by going round the back of Mount Improbable and crawling up the gentle slopes, inch by million-year inch'.
'Why is it so hard for even sophisticated scientists to grasp this simple point'?
There were dwarfs standing on the shoulders of giants from the past!
key - survival 'know how' is accumulated in cultural institutions
How is the public interest served by private endeavour?
Biology was economics and economics was politics as moral sentiments led to cooperative synergies and on to liberal democracies ... but the evolutionary path was fraught & difficult as parasites & predators coevolved.
Robert Axelrod (1983) suggested how cooperation could evolve and develop immunity from cheats but it was Thorstein Veblen (1898) who had earlier reminded us of the age old problem of the synergies of specialisation & scale being eroded by parasite & predator theft.
Veblen's ceremonial/instrumental dichotomy described how the new 'instrumental' (technological) imperatives for survival value (know how) from social synergies confronted the old 'ceremonial' (hierarchical pecking orders) thieving of the Bishops, Princes, Generals & bureaucratic despots (rent seeking for conspicuous consumption).
New stocks and value from innovative technology created new opportunities for parasitic & predatory elites.
As men became domesticated in social groups interactions intensified and because fighting was so expensive systems of conflict resolution co-evolved to protect the emergent economic benefits. Evolved moral sentiments and natural law pushed the incentive system towards productive positive sum synergies and away from zero sum 'rent seeking'.
Conflict resolution by the rule of law was much cheaper than bloody violence and instinctively attractive.
The long evolution of custom & practice and protection of individual freedoms were embodied in Tort Law and also found in the Universal Declaration of Human Rights.
The survival benefits of cooperation always involved a defence cost -
To protect minorities social animals vote with their feet & join clubs of their choice with their friends.
All folk clubs have rules of behaviour involving biological systems -
universal moral sentiments to nurture cooperation and
tit for tat immune systems reward cooperation & cope with parasites & predators.
A solution to Plato's democratic conundrum 'mob rule and emasculation of the wise' involved constraints on the mob, and checks & balances on the wise. The 'democratic trap' was avoided by institutional rights & obligations which outlawed 51% majorities voting to impose on 49% minorities.
The rule of law was not the elitist whim of powerful Bishops, Princes, Generals nor bureaucrats ...
The UDHR Article 30 Caveat was unequivocal -
'Nothing in this Declaration may be interpreted as implying for any State, group or person any right to engage in any activity or to perform any act aimed at the destruction of any of the rights and freedoms set forth herein'
The state itself had no right to interfere with the evolved individual freedoms and an obligation to protect minorities.
Behavioural choices were mediated by universal moral sentiments and individual freedoms were checked & balanced by Tort Law. Folk were free but not free to harm others. Synergy is the key to understanding.
Diversity in social animals was mediated by universal biology, innate empathy; Adam Smith's 'moral sentiments' underpinned the vast scale of human productive interactions.
Different folk at different times in different places had different ideas and behaved differently ... diversity was celebrated as the feedstock of evolutionary change.
Global social and economic interactions were so diverse and interactive that it was physically impossible for any demagogic Nation State to control them effectively. Incorporation by command & control regulation stifled competition, spawned interest groups bribery and hindered productive endeavour in the name of unattainable solidarity, security & stability. Such hubris, never achievable, would have stopped evolution in its tracks ... physically impossible.
Insights from biology lead inexorably to understanding economics ... not in impossibly complex detail but as a process of change ... genes do cost benefit analysis.
key - liberal democracy involves UDHR caveat 30; 51% cannot thieve from 49%
Why are deliberate, rational, purposeful, intentional, plans an illusion?
If biological organisms evolved by natural selection, it was necessary that new variants had a minimum probability of being beneficial. Random mutations were expected to be mostly detrimental, as there were more ways of being dead than alive. However variants seemed to be beneficial more often than randomness dictated? This suggested that the process structures made beneficial changes more likely than they would otherwise be. Evolution created not just fitter organisms, but populations that were better able to evolve.
Path dependency pruned out vast swathes of randomness and accumulated an increasing diversity of 'likely' candidates ... evolvability increased. Sex, immune systems and brain activity were all examples of adaptive mechanisms generating path dependent diversity.
The inherited brain, generated a diversity of ideas and sifted them for testing in the imagination with flip flopping emotional and reasoned criteria. The suggestion that the evolutionary function of the brain was the generation of diversity for further evolution of more basic functions was an affront to the more plausible idea as self consciousness and rational purposeful intentional planning ... but self consciousness appeared very late in the evolution of the brain.
The imagination both generated a diversity of ideas and pruned out many of the failures acting as a lever to speed up natural selection. The choices for testing which eventually emerged from the sifting mill of biological history were always 'good bets'. No longer random mutations but survival ideas ... otherwise they would never have made it to self conscious choice.
key - self consciousness is not supernatural it emerges from preexisting activity
Why do evolved institutions tend to be immune from treachery?
Local economic activity leads to the emergence of economic institutions. Again the institutions which survived the rigors of reality had been through the sifting mill of biological history.
The necessary knowledge did not exist for the intelligent design of economic activities in an environment rampant with uncertainty & risk and problems of -
Rational calculating economic man of neo-classical equilibrium economics was a myth.
But for many it was blindingly obvious that the ingenuity of the human brain was continually creating wealth and designing the most complex of machines like the Boeing 747?
Such intelligent design suggested –
evidence was evaluated, weighed and balanced
future consequences were thought through
appropriate decisions were taken
necessary actions to deliver the desired result were then implemented
Progress seemed to result from a plausible process of logical cause & effect, an imagined outcome was implemented by design.
But if this was so the economic plight of Burundi becomes a stupendous puzzle; why couldn't they design economic efficiency?
The alternative paradigm of universal Darwinism suggested that ideas evolved just like everything else, and intelligent design was just an experiment in the imagination and only a part of a complex dynamic –
evidence was incomplete, dispersed, diverse and complex
future consequences and responses of others were unpredictable and unknowable
decisions were experiments in the imagination and there were always better alternatives
successful outcomes differentially survived
Better behavioural & institutional alternatives emerged from the bottom up social interactions of trial & error.
Some evidence from English history confirmed the evolution of Tort Law, from Magna Carta to UDHR. A continuous 'golden thread' of survival incentives and sanctions as the rule of law emerged to resolve conflicts which enabled larger and larger groups to specialise and trade unhindered by Bishops, Princes, Generals and bureaucrats by -
identifying property rights
lowering transaction costs
and constraining parasites and predators
Douglass North emphasised the institutional innovations which enabled larger & larger groups to secure the rewards of cooperation while at the same time providing 'free rider' sanctions.
The institutions of property rights, low transaction costs and contracts embedded in Common Law together with enlightened behaviour provided cohesive rewards & sanctions.
North described the economic change as 'adaptive efficiency'; a society's effectiveness in creating institutions that were productive, stable, fair, broadly accepted and flexible enough to respond to political, economic and predator feedback.
Douglas North -
'adaptive efficiency copes with novel uncertainty in a non-ergodic world, the best recipe is the maintenance of institutions which enable trial & error experiment to occur, and an effective means of eliminating unsuccessful solutions'.
Successful economic institutions emerge as the failures don't survive; bankruptcy becomes an essential part success.
key - emergent institutions must have some immunity from treachery otherwise they wouldn't exist
How do we decide the who, what, which, when, where & how?
Adaptive behaviour and adaptive efficiency emerged 'as if' to speed up adaptation from the sifting mill of biological history, so how do we actually, in real life, decide what to do tomorrow?
Herbert Simon’s ‘satisficing’ described the instinctive cultural 'rules of thumb' which were emergent economic behaviour... actual 'rules of thumb' -
build on proven inherited success, chase profits/cut losses by hard work & mediating moral urgency - imitate
choose freely between options available here & now, unhindered by Bishops, Princes, Generals & bureaucratic majorities - tort, trade & technology
experiment to generate diversity & increase the chances of discovering new tricks, unhindered by risk adversity - innovate
cooperate with others to discover better tricks from synergies which are not available to individuals - specialisation, scale & science
retaliate to protect value from inevitable parasites & predators, growing trust & accumulating colonisation benefits - invest
learn from the emergent outcomes of differential survival & start again - hard work, honesty & thrift
Inheritance with modification now involved a process which generated experimental ideas in the imagination and then tested out promising options in reality ... and folk learned from the outcomes.
In ignorance folk did the best they could ... and learned ...
Herbert Simon -
'Actual business decision making conforms reasonably well with the assumptions of bounded rationality. The failures of science are largely ignorance all the alternatives, uncertainty about relevant exogenous events and inability to calculate consequences. There was needed a more positive and formal characterization of the mechanisms of choice under conditions of bounded rationality. Two concepts are central to the characterization: search and satisficing'.
key - continuous improvement via discovery, accumulation & protection of survival 'know how'
Why the flip flopping excitement & fear of social behaviour?
In 2002 Daniel Kahneman earned a Nobel Prize with his Prospect Theory which suggested 'behavioural economics' was often in conflict with the 'rational expectations' of neoclassical economics.
Although Adam Smith himself was the first behavioural economist? Kahneman added to Smith's notion of innate moral sentiments with other innate 'gut feelings' associated with risk which appeared to be irrational. There were two decision making systems in the brain -
System 1 = 'gut' responses were instantly remembered
emotional survival aids from biological history. The gut was a genetic
inheritance and was heroically good and got
it right most of the time ... otherwise folk wouldn't have survived!
But what was good for the savannah of Africa was perhaps not appropriate for Lombardy Street ... irrational biases were built into emotional behaviour.
System 2 = rational expectations of neoclassical economic theory were based on slow evaluation of evidence & statistics from experiences with empirical science.
The interesting ‘catch’ was that System 2 proved that System 1 involved irrational biases -
'It was costly to be risk averse for gains and risk seeking for losses'.
Rational folk must try to put these biases to one side as experience on Lombardy Street suggested chasing profits and cutting losses was the best strategy ... more risky new experiments and learn quickly from failures.
Irrational emotional biases were almost impossible to eradicate, how can you stop yourself falling in love? 88% of brain activity involved emotions which were unconscious and difficult to counter by slow reason which managed only 12% of brain activity.
But help was at hand from education, enlightenment, institutions & cultures ... which suggested biases could be countered by cultural 'rules of thumb' ... chase profits & cut losses.
Neoclassical economics had taken a wrong turn. Folk were not rational maximisers. Human emotions often trumped reason but were sometimes flawed as the biases cost. Philosopher kings thought they knew (arrogance & hubris) and flip flopping into rationality was seldom even tried. But some scientists worked it out slowly, even though the complexity was almost overwhelming.
These cognitive biases were of central importance to economic theory - sunk costs, endowment effects, planning optimism, illusion of control, risk aversion, animal spirits, anchoring, bandwagons, hindsight, confirmation, money illusion, stereotyping ... all irrational biases.
But flip flopping between exciting planning optimism & fearful risk aversion was, perhaps, no bad thing for generating & testing ideas in the imagination?
Deeply ingrained universal behavioral traits of folk seemed to justify 'the gut'. Resentment of loss was ingrained as folk did all they could to avoid losing their hard earned stocks and became risk averse and resentful of theft. Furthermore they sought risky options when confronted with losses in the hope of avoiding the alternative, death.
Adam Smith suggested, good gotten gains were 'fair' and ill gotten gains were 'resented'.
Losses of good gotten stocks loomed much larger than accidental gains.
The pleasure that folk experienced from empathising had momentous sociological implications. For sure it was more pleasant, to empathise with the joy of riches than to empathise with the misery of poverty. The joy of success was rare & sweet, enjoy, as the Californians said, discover the dopamine kicks! Life was precious, so there was a loss aversion bias.
Unfortunately the trial & error of evolution always resulted in more failure than success simply because there were many more ways of being dead than alive. Life's a sod then you die. The misery of failure was the norm, folk had to get used to it.
Kahneman opened a Pandora's Box and delivered a lethal blow to the rational economic man of neo-classical economics.
key - emotional bias from history is confronted by continuous improvement in 'know how' & reason
How is wealth created?
Wealth creation emerges when survival synergies are discovered in complex social interactions associated with -
specialisation - time consuming acquisition of skills with complex cooperation & exchange trade
scale - conflict resolution in large groups of different individuals with trust in strangers and trust in capital accumulation
science - high fixed costs of education & disciplined methodology
imitation - inspired transmission & reliable reception of language
innovation - creative hitherto unconnected connections & uncertain risky change
investment - scarce delayed individual consumption rewards the magic of property & compound interest
Wealth creating productivity, more value for less cost, a 2 + 2 = 5 process.
Peter Corning -
'Synergy is the very stuff of history. Time & energy resources are limited and must be used efficiently ... or else. Survival advantages, including behavioural innovations, define the trajectory of evolution. Natural selection differentially rewards different genes based on the effects they produce in a given environment. It is the economic payoffs that matter; characterised by John Maynard Smith as synergistic selection'.
key - social synergies from specialisation & scale
Can you specialise without trade or trade without trust?
Economic activity, doing deals, emerges from trading different individual aptitudes & skills, different opportunity costs, different specialisations.
Adam Smith identified the necessary behavioural traits present in human nature -
moral urgency - an innate sense of moral sentiments mediates decisions and nurtures the necessary trust for different social economic interactions, trades in rights & reciprocal obligations, 'The natural effort of every individual to better his own condition. The natural propensity to truck, barter & exchange' - Theory of Moral Sentiments 1759.
markets & division of labour - individual striving to discover & accumulate 'survival tricks'. 'It is not from the benevolence of the butcher that we expect our dinner but from his regard to his own interest' - Wealth of Nations 1776.
Individual freedom to experiment is a vital element in creativity and learning.
The economics of the pecking order and the top down exercise of power is an irrelevance for modern industrialised economies where synergies emerge from social interactions in social institutions.
Adam Smith -
'The division of labour is limited by the extent of the market'.
key - exchange trade is synergistic otherwise no deal
Why is democracy an idea pregnant with economic significance?
Larger groups involve more differences, more experiments, more specialisation, more interactions and more synergies.
Francis Fukuyama has suggested that the cultural evolution of trust in democratic institutions nurtured by moral sentiments has helped the cohesiveness of larger social groups.
The democratic ideal of free participation is geared by the scale economies from wider participation - the more the merrier. Over deep evolutionary time there is a clear tendency for larger and larger interactive groups exploiting increasing specialisation and scale.
Democratic ideas play an important role in intensifying economic interactions in larger groups ... genes, phenotypes, families, tribes, religions, cities, nation states, democracies, globalisation ...
Economics is the science of decision making in an environment of scarcity, risk and uncertainty. Democratic decision making is self determination by 'we the people', freedom under the law, as minorities experiment.
Democracy widens and deepens participation thus increasing the chances of discovering harmless survival value from synergies. More activity in larger groups!
Some authoritarian decisions which make some people worse off will tend to be resisted by those people, destroying the benefits of co-operation.
In 1789 Jeremy Bentham’s ‘greatest happiness’ principle defined Democracy as maximising the sum total of the happiness of the all individuals who compose society. But what about differences and ignorance.
Plato’s conundrum was debated at the birth of the democratic idea -
'mob rule and emasculation of the wise'.
Economies of scale, require the participation & contribution of both the mob and the wise because nobody knows the who? which? when? where? or how? of the next good idea ... democracy cannot be based on majority voting which outlaws the aspirations of the minorities who voted the other way.
key - the more the merrier
Who fixes the prices?
Markets tend to balance the prices and quantities of desired goods and services sold and produced at minimum cost -
demand curves sloping down to the right reflect the decreasing marginal utility of consuming increasing quantities and
supply curves sloping up to the right reflect the increasing opportunity costs of producing increasing quantities
producing a market clearing price where gluts and surpluses from high prices and queues and shortages from low prices disappear 'as if' by magic.
Leon Walrus used mathematical models to demonstrate a supply & demand equilibrium. His maths required unrealistic assumptions about rational calculation, static equilibrium, perfect information and perfect competition and a strange method of price fixing my a mythical 'auctioneer', he called it 'tatonnement'? Groping!
key - market prices minimise costs of gluts & queues
Who's in control of the wealth creating process?
21 - Market Coordination The Control Loop.
sensors - inherited price information from millions of trades in technological 'know how' are compared to
set points - diverse innovative alternatives generated by competing entrepreneurs by
algorithms - as customers select and test by sifting value & cost resulting in
actuators - responding as some investments differentially survive and change the population frequency of successful 'know how'
Emergent order is an unintended consequence of free market activity.
Adam Smith -
'Led by an invisible hand to promote an end which was no part of intention'.
But be afraid, instability abounds, non linear mathematics indicates there are stable 'attractors' but also 'bifurcations' ...
key - not human intention rather natural selection
Who does the calculations?
Deals are done, decisions are taken by many individual value judgements about the costs & the added value of alternatives.
'Equilibrium' prices are dynamic and are tendencies which emerge from economic activity as inefficient prices are continually adjusted by consumers and suppliers who want to avoid unnecessary waste for their own survival. Gluts & queues cost.
Nothing supernatural just a process of adaptation, inefficient prices don't survive! Same as short necked giraffes!
Richard Dawkins suggested in the 'Selfish Gene' that genes act 'as if' they do cost/benefit analysis. It is 'as if' marginal utility and opportunity costs were calculated ... but it is not a rational process rather a statistical tendency resulting from adaptation - 'no part of his intention'.
Social animals are distinguished from sparrows by a Theory of Mind. Folk can live in a purely imaginary world and ascribe human emotions and intentions to the laws of nature ... but the real world was not like that ... and calculating opportunity cost is impossible; the mind can't cope with the levels of introspection. Normal behaviour involves 'rules of thumb' which tend to produce economic results otherwise they wouldn't have survived to become normal behaviour?
key - ignorance and impossible calculations
Why pay transport costs to import Barbie dolls from China?
Trade takes place because different people in different places at different times have different opportunity costs ... because of comparative advantage not because of absolute advantage.
Nobel Economics Laureate Paul Krugman argued that together with Darwin's 'natural selection', Ricardo's 'comparative advantage', was a 'difficult idea' ... most folk 'somehow find this particular idea impossible to grasp' ...
Economic success lay in expertise & innovation, synergies from specialisation & scale. Import substitution was not a 'me too' imitation but the development of local advantage through expertise & innovation.
In 1817 David Ricardo identified the principle of comparative advantage when confronting protectionism and the Corn Laws. Trade is at the heart of economics so it is well worth while going through the mathematics –
Nigel, a world beater, is an excellent bricklayer and a very good typist.
In 8 hours he can lay 100 bricks OR type 1000 words …
NB = 1 brick barters for 10 words.
Joe, an incompetent, is a terrible brick layer and he is a
barely adequate typist.
In 8 hours he can lay 20 bricks OR type 400 words …
NB = 1 brick barters for 20 words.
Nigel has an absolute advantage in both activities (his 8 hours is more productive in both activities) but he has a comparative advantage in bricklaying (his brick will barter for 20 of Joe’s words but only 10 of his own)
Joe has a comparative advantage in typing (20 of his words will barter for 2 of Nigel’s bricks but only 1 of his own) specialisation and trade will tend to evolve (unless there is intervention) because of mutual benefits.
Nigel will tend to do more bricklaying and Joe more typing increasing total output.
With no trade both have to be self sufficient in both bricks and words …
Say in 8 hours Nigel lays 50 bricks and types 500 words.
Say in 8 hours Joe lays 10 bricks and types 200 words.
Combined output 60 bricks 700 words.
With specialisation & trade …
Say Nigel lays 60 bricks types 400 words and trades 5 to 10 bricks to Joe for the 100 words he needs (NB = I brick barters for 20 words) he has up to 5 bricks EXTRA to share with Joe.
Say Joe lays only 5 bricks but types 300 words and trades 100 words with Nigel for the 5 bricks he needs plus a share of the 5 brick SURPLUS (NB = 1 brick barters for 10 words).
Combined output 65 bricks 700 words = 5 EXTRA bricks.
The counterintuitive conclusions are –
both parties gain from specialisation and trade even though Nigel is better at both activities.
the principle explains trade benefits at individual and national level, with money or barter.
specialisation and trade will evolve because extra 'value' is created (and genes do cost/benefit analysis!); specialisation and trade do not require the intervention of a government 'designer'.
everybody has a comparative advantage in something (even inadequates like Joe) and everybody will benefit from trade.
The Open University summary –
'The principles of comparative advantage and gains from trade are the most important results in the whole of economics. They apply at national, and also individual level. It maybe that a doctor is better than a farmer both at practising medicine and growing potatoes. It does not follow that the doctor should do both. If each specialises in the activity in which they have comparative advantage and engage in trade they are both better off than if each tries to be self sufficient'.
Nobel laureate Paul Samuelson –
'Thousands of important and intelligent men have never been able to grasp it or believe it even after it was explained to them'.
A mathematical model can easily be constructed to introduce money, transport costs, wage costs, market prices, exchange rates … confirming this wealth creation principle.
NB. understand -
real wages are determined by the value of output
real prices are determined by supply & demand
prices & exchange rates don’t determine trade, they result from trade, they are measurements of opportunity costs ... if everyone specialises on what he does best and everyone is included in for economies of scale then everyone benefits …
everyone benefits, but some benefit more than others because of different opportunity costs ...
innovators benefit most ... redistribution of know how comes from education, education, education ... not fake money nor fixed prices?
Ricardo's principle of comparative advantage was an explanatory breakthrough building on Adam Smith's earlier insight in his descriptive account of specialisation and trade in his pin factory.
Adam Smith has an ongoing influence on economics, guiding us from an innate moral sense to the increasing returns of the industrial revolution, as he and his friends in the Scottish Enlightenment explained what was happening in a complex free and individualistic English culture.
Most folk just don't get how everyone can benefit. Most are blinded by lost jobs in sectors with no comparative advantage. Many are unhappy with retraining and education, education, education ... moving into new high value jobs is a pain. Particularly when the benefits are constantly distorted by price fixing. Market prices avoid the costs of gluts & queues and deliver 'fairness of shares'. The powers that be invariably fixed prices and rigged the markets and they were 'resented as cheats' as crowd trouble inevitably brewed. The usual suspects -
Regulations and non tariff barriers (NTB)
Foreign Exchange (FX) manipulation
Environmental and Health and Safety costs
Intellectual Property theft
Five distortions made a mockery of 'free trade' ...
key - most folk just don't get it
Why are land, labour & capital red herrings?
Economic growth overwhelmingly results from technological and organisational innovation and not from natural resources, hard labour nor investment capital.
In 1957 Robert Solow used 'growth accounting' mathematics to analyse historical GDP data and identified the importance of a residual, ‘total factor productivity’. Growth tended to be relatively independent of the neo-classical endogenous inputs variables, capital (resources) and labour (effort).
Solow defined ‘total factor productivity’ as technological innovation, 'know how' or understanding & practice.
Paul Romer dramatically extended Solow's insight and integrated economic growth into evolutionary theory with his Endogenous Grow Theory' in 1990.
key - measuring 'know how'
Can we avoid fighting over the spoils?
Economic efficiency results from synergies which avoid harm to others.
In 1906 Vilfredo Pareto illuminated the issue of liberal democratic progress by defining as Pareto Optimal any decision which results in perceived betterment but does not result in anybody else being worse off, in their own estimation and after compensation where appropriate.
The institutions of civil society which spontaneously emerge in liberal democracies will tend to exploit this optimal – churches, clubs, societies, associations, co-ops, partnerships, public limited companies and cities. Diversity & choice enables the discovery of Pareto Optimal decisions, the successful synergistic institutions will tend to increase in frequency and size provided they are protected from parasites & predators within Tort Law.
For Nigel and Joe the Pareto efficient improvements from initial conditions X are to anywhere on the production possibilities curve from N1 to J1.
The initial conditions X grossly favour Nigel but the economic significance of the idea is that Joe’s position can be dramatically improved without harm to Nigel by pushing the ppf1 to ppf2 through the process technological & organisational innovation.
Pareto's analysis is robustly criticised as –
involving unrealistic assumptions about perfect competition and clear legal property rights
static and tending to protect the status quo and inhibit progress because most economic activity in the real world hurts somebody
dependent on inequitable initial wealth distributions
requiring all markets to be distortion free; ‘The Theory of 2nd Best’ suggests imposed uniform distortions maybe better than some free market distortions
However an evolutionary analysis of Pareto decision making suggests these criticisms have no foundation. Evolution involves a scientific theory of dynamic change and the differential survival of synergy benefits –
a scientific theory of reality (observation, mathematical theory, testable hypotheses, experimental validation, peer review)is the best way to avoid unrealistic assumptions
a dynamic process suggesting decisions will tend statistically to be driven in a Pareto Optimal direction because of synergies of cooperation and retaliation against parasites & predators
current initial conditions are themselves the result of evolution (both cooperative and predatory) and the only starting point for all innovative improvements, there is no 'blank slate' to write on
interactions with all 'harmed' counter parties and ongoing refinements from 'compensation contracts' will tend to drive decisions towards economic efficiency, ‘The Theory of 2nd Best’ is not ‘Evolutionarily Stable’ it harbours inefficiencies, all distortions will tend to be eliminated as niches are filled and opportunities seized to -
make somebody better off without harming others
retaliate against parasites & predators who inhibit Pareto improvements
key - mutual benefit, it is not a zero sum game
Why has Paul Romer not been awarded a Nobel Prize?
Productive output growth results from 'know how', not physical factors of production, and 'know how' is -
nonrival, used over and over without depletion to the extent of the market resulting in increasing returns
lumpy because it involves fixed costs and clusters associated with specialisation & scale generated by monopolistic competition in commercial R&D
discovered, therefore risky & uncertain, making government design and entrepreneurial incentives a problem
partly appropriable as intellectual property, making investment in commercial R&D rewarding
temporary and dissipates as people learn
Goods and services are welfare spread by trade (comparative advantage) but 'know how' is spread by cultural learning -.
Human Capital -
- Tort Law, Trade, Technology.
- Education, Health, transport/planning interactions.
- Specialisation. Scale. Science. Investment. Imitation. Innovation.
Market Coordination -
- free trade – free capital movement – competition – property rights – free wages & prices – low tax – low intervention – low inflation – trust for investment and saving
The production of 'know how' makes growth endogenous and monopolistic competition keeps growth rolling, a constant stream of innovation is necessary to secure temporary monopoly profits.
Many evolutionary economic principles are threatening to 'the powers that be' as human intention is perceived as impotent. This is erroneous as human intention drives the creative trial & error experiments which discover new survival value.
key - returns from profitable projects trumps all interest rates, golf clubs and all mythical instruments of control
How can market prices eliminate the costs of gluts & queues?
Adverse Selection - ‘Would you buy a 2nd hand car from this
Asymmetric information results in price fixing & a glut of lemons ...
unless confidence & trust can be established ...
NB Deal transparency increases with advertising quality reputation, convincing innovations, brand loyalty & credible endorsements...
Moral Hazard - ‘If it’s free put me down for two please!’
Tax funding & insurance jobs result in queues for ‘freebies’ ...
unless costs can be aligned to products ...
NB In return for their votes poor folk are bribed with their own taxes into excess debt to pay for a dream of affordable housing ...
key - beware of parasites & predators
How can property rights confront the tragedy of the commons?
Externalities, law and the problem of social costs can be understood by economic analysis - social costs secure social benefits and Coasian Bargains involve the price mechanism, supply & demand and the unappreciated value of evolved price mechanisms and legal institutions.
Two parties are always involved in troublesome externalities - costs AND benefits; the polluted and the polluters. The polluters can stop polluting OR the polluted can move elsewhere (and benefit!) but there is a cost - who pays? - how much? Coasian Bargains in markets resolve the problem efficiently by deals between the antagonists - the higher cost avoider paying the lower cost avoided market determined 'compensation'.
Transaction costs always exist under all legal institutions ... but they can be reduced.
When transaction costs are low and property rights are defined contracts will be negotiated to satisfy both parties. But transaction costs are the problem not the externalities. Transaction costs make some markets prohibitively expensive.
With zero transaction costs the allocation of resources remains the same whatever the legal position, however, with positive transaction costs, the law plays a crucial role in determining how resources are used ... the marginal productivity of capital.
The usual conventional suspects almost invariably fail -
regulation = reduces incentives for technological innovation. Restricts new competition. Adds administrative and compliance costs which
customers and shareholders pay. Zero sum activity; some win, some lose and regulation
becomes impossible to implement in a democracy.
Pigouvian Taxes = a one-size-fits-all theory does not distinguish between
high and low cost avoiders. Pigouvian taxes are inefficient if they tax the
highest cost avoider. Tax is often used as a revenue raising device in excess of
the 'unknown' social costs.
Coasian solutions -
rights trading = define property rights then freely bargain.
Property rights are required to discover the costs.
Social costs will be paid by the lowest cost avoider. If the legal rule chosen is inefficient, parties will bargain around it. Rights will be acquired by those who value them most highly, which creates an incentive to discover and implement transaction cost minimizing governance forms.
Don't build houses near polluters, build other polluters thus confining cleanup costs to the periphery. Which costs less, you stopping or me moving? Pareto efficient, nobody loses.
Example - the Kyoto objectives were admirable apple pie but Coasian solutions involve technological alternatives driven by the high social costs & high avoidance costs - piecemeal, tentative and adaptive.
1. Throwing filth at other people harms them, it is an illegal nuisance.
2. The polluter must pay the cost but how much? Who is the least cost avoider? Polluters could pay the costs of 'know how' for fuel cells, flood relief or relocation?
Competitive Property rights with tradable permits -
Process A emits 100 tons of obnoxion p.a. costs £100 per ton to reduce
(this process could be new technology in industrialised countries or a high cost of relocation).
Process B emits 100 tons of obnoxion p.a. costs £1 per ton to reduce
(this process could be old technology in developing countries or a low cost of relocation).
Competitive Property rights with tradable permits, reduction in obnoxion costs £2 per ton + transaction costs = £99 cheaper than regulation!
Policy should be targeted on reducing transaction costs ... through institutions & privatisation.
Ronald Coase wrote - The Nature of the Firm (1937) and The Problem of Social Costs (1961)
key - property rights in clean air involve costs & benefits ... deals minimise the costs of gluts & queues
How can a poll tax avoid the XS burden of tax on society?
29 - Tax Distortions.
The dead weight loss or the XS burden is an irrecoverable loss of welfare to the community. Discriminatory taxes are not Pareto Efficiency; not only inefficient but also unfair. Equity and efficiency are not alternatives. Pareto improvement implies no one loses.
Critics suggest all economic and evolutionary activities involve choices and the rejected failures must be harmful to some?
But there is a
difference between a ‘hard' and a 'harm’. An essential part of
cooperative evolutionary progress, natural selection, requires alternatives ‘not selected’
to die off. That is a 'hard' essential for synergies to grow in the
population and benefit the species. However theft & killing are 'harms', a
zero sum game for parasites & predators.
Morality evolves, thus making the distinction between a normative & an evolutionary criteria meaningless?
The only non discriminatory tax is a poll tax. The UDHR confirms the morality of non discrimination; rights essential if synergies are to be discovered and wealth created.
key - tax is a cost reducing output
How can tax rates determine tax revenue?
The Art Laffer Curve – average tax rates v. tax revenue.
Average tax rates. A flat non-discriminatory tax rate leads to higher output and higher real income = more tax revenue. Rich people pay the additional tax.
High marginal tax rates. People won’t pay and never have, they change their behaviour lead to lower output and lower real income = less tax revenue. Hard work, honesty & thrift are discouraged.
key - tax discriminates
Who controls the money supply & interest rates?
The money supply & interest rates are endogenously determined as credit growth and GNP growth are 'matched' by loans & deposits on the Balance Sheets of commercial banks.
Elites have always interfered with the supply and cost of money but the idea of an 'expert', perhaps in the basement of the Bank of England, who controls money is a plausible myth – a myth because the value of money depends on confidence & trust of partners in exchange. Confidence & trust ebbs & flows with economic activity and so does the value of money.
Money is a wonderful tool for lubricating economic activity having value as a -
unit of measurement - money x velocity of circulation = price x output of goods & services
medium of exchange – money avoids the double coincidence of wants in barter but with the ‘costs’ of caveat emptor & moral sentiments
store of value over time – value associated with marginal utility & opportunity cost
In the past Cowry shells, gold, cigarettes, LETS (Local Exchange Trading Systems) and paper IOUs promising to pay 'the bearer' have been generally acceptable as money however in modern economies money is overwhelmingly created through credit and its many innovative variants.
Commercial Banks produce money by creating credit for sale to customers, credit has a price – the interest rate – which is determined by supply & demand in exchange –
supply is determined by the interest rate cost necessary to induce saving after individuals have satisfied their liquidity preferences. Savings are claims on the bank for repayment of deposits in the shorter term.
demand is determined by the opportunities for profitable investment. People and their projects with promises to the bank to repay in the longer term.
These deals, like all co-operative deals, will only take place if there is –
confidence & trust between the co-operative parties (ethics & moral sentiments are involved)
prospects of mutual benefit & synergy without harm to 3rd parties (risk & moral hazard are involved)
Ethical judgements and assessments of risk are unavoidable. Would you buy a second hand car from this man? Would you behead a coin clipping king?
Thus prospective profitable economic activity is funded by banks selling credit and the Balance Sheets of the banks reveal the deals –
A initial liability of a $10,000 deposit becomes an asset of $10,000 cash which (after maintaining a prudent loan/cash ratio of say, 10/1) is put to work to fund other assets – a series of loans – BUT these loans will result in further deposits (where else would the money go?) which will be available to finance further loans ... etc ... etc ...
$10,000 of initial savings generate $90,000 of growth!
However the growth of the system does not come out of thin air it is dependent entirely on a series of profitable economic activities where careful project selection and assessment of risk is essential. Without profit, the interest could not be paid and the loans could not be repaid.
Banks make their own profit by maintaining a loan portfolio whilst minimising bad debts. The 363 interest rule - pay 3% for deposits, receive 6% on loans & be on the golf course at 3pm!
Such earning potential of the commercial banks does not involve divining the future, technology foresight nor any supernatural knowledge but it does require specialised skills in selection and risk –
honesty, as confidence and trust has to be built up over years as reputations for prompt repayment of sound money on demand must be earned – would you buy a second hand car from this man?
hard work, as a diversity of loans increases the chances of discovering the profitable projects – portfolio risk management.
compound interest, as social experience & memory of the people & projects which worked in the past – chasing profits & cutting losses.
Reputation, risk, reward!
Commercial banking practice is an 'Evolutionarily Stable
Strategy' for redistributing funding to those with the ideas from those with
the money for mutual benefit. But the banks are not simply intermediaries,
the system has its own in built control. Economic growth feeds back as real
economic output of goods & services is ‘matched’ by the money supply which
determines the ‘value’ of the $10,000 initial deposit.
The money supply is determined endogenously by interest rates as a function of national income as the balance sheets of profitable commercial banks will ensure the credit base does not increase at a rate faster than GNP and cause inflation.
Unfortunately prudent risks and sound money institutions have proved remarkably difficult to nurture, as parasites and predators abound in all evolved systems cheat detection systems must co-evolve.
Democratic politicians, by definition take popular decision not economic decisions.
Government interference in commercial banking is an irrelevant and inefficient distraction -
'in a market economy where money includes deposits with private sector banks, monetary policy can never be simply a question of the 'authorities' deciding on the quantity of money it will 'allow' to circulate in the economy'. Economic Briefing No 5 August 1993
money cannot be 'created out of nothing' bank balance
sheets always balance, otherwise the go bust. Money has to be purchased from
savers at a price (interest rate) to be lent to borrowers at a price (higher
interest rate) otherwise th bank goes bust. Printing money cannot resolve
the necessity for solvent banks!
NB 1. The commercial banking skills involve borrowing short and lending long so they may need central banks liquidity support. As a lender of last resort the Bank of England can influence interest rates ... but then so too can India, China and America.
NB 2. The mutual benefits from the 2 + 2 = 5 synergies of profitable investments produce a surplus to pay interest to banks and depositors ... usury is not immoral after all.
key - projects must be profitable and Balance Sheets must balance
Why bother to save for a Rainy Day?
32 - Capital Accumulation & Credit.
His analysis involved five myths -
a class conspiracy to impoverish the poor by command & control
a labour theory of value, without reference to moral sentiments & synergies
a nation state acts in the public interest, immune to predators & parasites, tyranny & oppression
a revolutionary solution, not the evolution of trial & error
justified by a priori science and dialectic logic, not observation and empirical science
But human intention was not what it seemed to be (Kahneman), total factor productivity measures value (Solow), the state itself is a rent-seeking vested interest (Jefferson), revolution replaces one dictator with another (UDHR), non-linear evolutionary equations don't have solutions (Axelrod).
Marx missed the essential 'moral sentiments' underpinning evolved wealth creating institutions -
public limited companies
key - profitable projects, involve risk & insurance
Who controls the debasement of fiat currencies?
33 - Central Bank Balance Sheets.
As the natural cycle of human survival emotions flip flops from -
- economic activity, money supply & tax revenues follow this pattern resulting in inevitable 'financial instability' or what Hyman Minsky called 'Minsky moments'. The business cycle is driven by the exciting discovery of synergies & wealth creation followed inevitably by the fear of failure.
Steins' Law, 'if a thing can't go on for ever it will stop' and 'when you're at the top there is only one way to go'.
Superimposed on the business cycle is a second government cycle -
tax & spend to bribe voters to win elections
borrow to cover inevitable tax shortfalls and
print money and coin clip when you run out of credit.
The cycle is driven by the central bank monopoly of money creation - nationalisation of the central bank, legal tender statutes for tax payments, central bank deals in government debt and the 'creation of money out of nothing' to 'earn' seigniorage and provide 'guarantees' to interest groups in return for votes.
Nationalised Central Banks became the instrument for -
issuing fiat currency as legal tender for tax revenues
managing government debt and
responding to economic recessions by debasing the currency.
In this way the problems of tax & spend and debt leads to the spending of fake money in a recession.
This age old problem has modern justification in the name of a misunderstood Keynes; but Keynes was clear - spending in a recession was to be balanced by saving in the boom.
Central Bank activities -
lender of last resort - providing business liquidity as lending long and borrowing short is required for investment for later revenues. Conventional money market operations keep commercial bank Balance Sheets in kilter.
bailout - providing commercial bank facilities for bailouts when reserves & credit facilities have gone but long term prospects are viable. Similar to the Administration process; buying time to get the commercial bank Balance Sheets in kilter. Of course, if the bank assets are viable & performing and commercial lender would be interested in a commercial loan?
debasement - provision of 'fake money' by money printing to keep insolvent commercial banks & businesses operating as zombies.
Central Bank facilities are used by commercial banks in three ways -
commercial lending to profitable businesses for economic growth.
financial repression as negative real interest rates boost the money supply and erode savings & debt.
arbitrage & the carry trade; buying appreciating assets with borrowings at negative real interest rates. Commodities, gold & oil; emerging market assets; appreciating currencies. Fundamentals suggest supply & demand prices adjust to real imbalances as too much money chases too few goods & services.
Abenomics; the stated purpose was 'to get inflation going again'. The Yen devalues by 25% and debt is 2x tax receipts ... and the third arrow of structural reforms was 'too difficult'! ... what on earth is going on?
Carry Trade; buy high yielding Italian Sovereign Bonds with an ECB guarantee - use them as collateral to borrow cash at the discount window at negative real interest rates - use the cash to buy high yielding Italian Sovereign Bonds with an ECB guarantee.
Basle 3 classifies sovereign debt as risk free tier 1 capital with no restriction on quantity held. Commercial Balance Sheets are repaired but sovereign debt balloons ... and the central bank returns the sovereign debt interest to the government! ... what?
The Conspiracy Theory - Karl Marx proclaimed the 'power' of the central bank monopoly in The Communist Manifesto, 'centralization of credit in the hands of the State, by means of a central bank with State capital and an exclusive monopoly'.
Bad Consequences Hidden in the Dust of Ancient Controversies - Walter Bagehot proclaimed the deception of creating money out of nothing in Lombardy Street -
'free banking, the natural system, which would have sprung up if Government had let banking alone. As in all other trades competition would bring the traders to a rough approximate equality where no single bank would permanently obtain an unquestioned predominance. I shall have failed in my purpose if I have not proved that the system of entrusting all our reserves to a single board, like that of the Central Bank directors, is very anomalous; that it is very dangerous; that its bad consequences, though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies'.
Sovereign manipulation of prices result in imbalances, gluts & queues, which are exploited for gain as prices readjust to market reality.
key - money can't be created out of nothing, manipulating mind games always flip the flop
Who's in charge?
Perceptions of value and perceptions of money to keep Balance Sheets in kilter.
In 2015 Paul Krugman pointed out that in 1933 Irving Fisher had written -
'Deflation caused by debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over indebtedness with which we started was great enough, the liquidation of the debts cannot keep up with the the fall in prices which it causes. In that case, the liquidation defeats itself, while it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depression: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing'.
and in 1950 Milton Friedman weighed in -
'If internal prices were as flexible as exchange
rates, it would make little economic difference whether adjustments were
brought about by changes in exchange rates or by equivalent changes in
internal prices. But this condition is clearly not fulfilled. The exchange
rate is potentially flexible in the absence of administrative action to
freeze it. At least in the modern world, internal prices are highly
inflexible. They are more flexible upward than downward, but even on the
upswing all prices are not equally flexible. The inflexibility of prices, or
different degrees of flexibility, means a distortion of adjustments in
response to changes in external conditions. The adjustment takes the form
primarily of prices changes in some sectors, primarily of output changes in
Wage rates tend to be among the less flexible prices. In consequence, an incipient deficit that is countered by a policy of permitting or forcing prices to decline is likely to produce unemployment rather than, or in addition to, wage decreases. The consequent decline in real income reduces the domestic demand for foreign goods and thus the demand for foreign currency with which to purchase these goods. In this way, it offsets the incipient deficit. But this is clearly a highly inefficient method of adjusting to external changes. If the external changes are deep seated and persistent, the unemployment produces a steady downward pressure on prices and wages, and the adjustment will not have been completed until the deflation has run its sorry course'.
key - perceptions of reality flip the flop
Why one damned cycle after another?
Kondratiev started it all in 1925 with 'Kondratiev waves' ... Irving Fisher 'debt deflation cycles' ... Joe Schumpeter 'creative destruction' ... Hyman Minsky 'Minsky moments' ...
Cycles were discovered everywhere it seemed to be the way the world worked, everything depended on everything else, cycles on cycles within cycles as all the cycles were -
and novel emergent cycles were also ... dynamic, contemporaneous & interconnected & interactive & interdependent & emergent!
Complex Adaptive Systems are the focus of Evolutionary Economics
In 1938 Nikolai Kondratiev who was shot by Stalin's firing squad. He died for his beliefs. His work confirmed that -
the capitalist system would not collapse as a result of the great depression
and command & control of economies was an illusion.
key - arrogant Bishops, Princes, Generals & Bureaucratic Despots
Why not ban 'animal spirits'?
A cycle of flip flopping human emotions drive the generating & testing, the diversity & choice which feed the evolution of business survival 'know how' - Optimism - Excitement - Thrill - Euphoria - Suspicion - Anxiety - Denial - Fear - Desperation - Panic - Capitulation - Despondency - Depression - Hope - Relief - Optimism ...
Joe Schumpeter described this discovery process as 'creative destruction'. Innovative creativity and bankruptcy.
Hyman Minsky was also on to it 'the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles'.
The bad news - banning the boom & bust business cycle is physically impossible, ultimately it is the 2nd law of thermodynamics.
The good news - the unstoppable trend line for the discovery & accumulation of technological 'know how' is 3% pa compound.
key - creative destruction
Is the urban trek to the cities an inevitable part of economic growth?
Economic interactions are intensified by cooperating folk in cities generating more synergies; more opportunities for specialisation & economies of scale.
Once the rule of law is established, a process of dynamic economic change emerges spontaneously in regions - not a 'homogeneous society' but a tapestry of different individuals who group together in cooperating families, tribes, religions and states but above all in towns and cities.
The explosion of the industrial revolution was in the cities and such intensification of activity was inconceivable without the rule of law.
The evidence was in the biological history of the urban trekkers as social economic interactions intensified in cities leading to social & economic betterment ... diversity was celebrated -
'empathy' in social animals provided perspective and guidance for interactions with others and nurtured tolerance of differences; moral sentiment was a universal human emotion.
'different' folk in different places at different times had different ideas and behaved differently but the urban trek was a universal global behavioural trait.
'diversity' was essential feedstock for the evolutionary process which generated the synergies of specialisation & scale; the only game in town.
'know how' was the key to specialisation and consequent exchange, nobody knew where the next good idea was coming from and 'know how' was accumulated in different cultures in different ways; there was more than one way to skin a rabbit.
'learning' was discovery mediated by innate emotional empathies and accumulated in specific experience & cultures where differences didn't stop community growth & economies of scale; live and let live.
'parasites & predators' thrived on ignorance, prejudice & violent imposition; immune systems necessarily coevolved.
'our heritage' and 'our experience' are proudly different; celebrate diversity.
'education' was institutionalised, each year invested in human capital produced 8% higher earnings; if you think education is expensive try the alternative.
The biology spawned the institutions and the global cities.
Jane Jacobs described a process of institutional adaptation enabling the intensification of economic interactions in cities -
the economic unit was the city, not the nation-state
cost / benefits analysis of development and the urban trek
competing diverse decentralised city based currencies instead of national currencies
cities were interdependent on trade specialisations
industries grew funded from profits but technology transfer was difficult
five forces of cities - rural supplies, well paid jobs, productivity, factory transplant, capital accumulation.
Economics & Ecology were inseparable
Six regions are usually involved in interconnected economic activity -
innovative heart (high density interactions & immigration) - low tax?
resource supply (food & raw materials) - low prices?
clearance (labour saving investment & emigration) - job mobility?
transplants (low density mature technology & routine) - planning freedom?
obsolete (abandoned technology & the rust belt) - no subsidies?
subsistence (non-participants & bypassed) - skill acquisition?
The delicate dynamic is easily destroyed by 'breaking the rules' of property rights, low transaction costs and parasite/predator constraint, by misunderstanding the integrity of the whole system and separating the political from the economic.
Cities died when they stopped innovating -
complacency? - resistance to change, without innovation and jobs quickly went elsewhere first to other innovative cities then to the council then to competitors in New York in Tokyo and Seoul as industrial cites in 'the rust belt' failed to reinvent themselves.
obsolescence? - it was easy to see that when
semiconductors were discovered thermionic valve production ceased.
But more jobs were created in semiconductor factories than were lost in thermionic valve factories.
comparative advantage? - it was less easy to see that different opportunity costs and specialisation could result in job losses.
stifled by bureaucracy? - Bishops, Princes, Generals & bureaucrats always thought they had better ideas than economists who never agreed, elites always had grandiose schemes, 'infrastructure' schemes.
chaos & anarchy? - every club had coherent rules and elected short term administrators to avoid factional infighting.
blame & hatred? - nobody was to 'blame' for unemployment, congestion, disease, squalor, pollution & poverty.
population explosion? - folk stopped dying before birth rates declined. The urban trek was relentless, poverty exploded with the population explosion but so too the middle class bulge as more and more folk became connected.
feet voting? - the mobility of the enterprising
exclusion? - some cities excluded some folk from some opportunities but each disconnection from the network reduced productivity and innovation as nobody knew where the next good idea was coming from ...
The political evolutionary process was part of the game, but politics does not write the rules of the game, 'know how' was institutionalised.
Darwin’s Natural Selection or the Intelligent Design of Bishops, Princes, Generals & bureaucratic despots? But no one can choose!
key - intensification of economic activity
Why is the joint stock company the growth miracle of capitalism?
Economic growth is measured in The Balance Sheets of joint stock companies.
It is usual to be in awe of the great individual achievements of Charles Darwin and Isaac Newton but the overwhelming success of wealth creating cooperative institutions is less easily grasped and often denied.
Definition - the jsc is an economic institution, a complex adaptive system built by evolutionary processes 'as if' to cope with the age old problems of scarcity, conflict, complexity & change.
Evolutionary Success - a neat survival trick evolved, an incentive system for rewarding individuals who satisfy customers. A self-policing system based on private property where competing alternatives to vie for customer sales, encouraging the preservation and enhancement of assets and contracts for employment and supplies. Evolution inevitably produces a diversity of competing institutions, some of which differentially survive. Innovations are not 'a best way' which is known in advance, but more simply those institutions which produce more survival value for the cost incurred than competing alternatives survive -
wealth creation - understand the jsc as a wealth creating institution it has proved remarkably successful. The jsc has cemented the survival of western civilisation, the international jsc is the driving force of the global economy, this success is exposing the inability of national governments to control their own economies
robustness - immune from internal and external treachery and responsive, able to learn from past outcomes and exploit future innovations.
NB The jsc suffers from inefficiencies -
hierarchical organisations like the jsc are less efficient than perfectly competitive markets, but perfectly competitive markets don't exist - new institutional economists describe how the jsc exists only because market transaction costs can be prohibitive
managers cannot always be relied upon to act in the interests of the shareholders - the moral hazard and the principal / agent problem.
The evidence of history - a mix of elements contribute to the success and robustness of the jsc.
The elements did not evolve sequentially but gelled into a coherent whole displaying all the characteristics of a complex system.
The emergence of these elements was not an accident but the result of a selection process from the trial and errors of experiments to secure synergies of specialisation & scale Folk specialised and acquired creative skills and associated in 'clubs' to achieve scale.
The jsc emerged in a modern form in England - some significant landmarks in the evolution of the jsc -
private innovations and funding of clubs from surpluses was always an alternative to the whims of Bishops, Princes, Generals and bureaucratic majorities whenever folk were freed from tyranny & oppression -
The Scottish Enlightenment - Adam Smith & natural systems of moral sentiments, simplicity & spontaneity of improvements.
Privateers - Sir Francis Drake, Britannia rules the waves and defence from the Spanish Armada.
Private Enclosures - Turnip Townsend and the agricultural revolution of husbandry & cultivation improvements.
Industrial Revolution - Sir Robert Peel and the repeal of the Corn Laws.
Privatisation & Globalisation - Margaret Thatcher, Ronald Reagan and the gains from trade.
Glasnost & Perestroika - Michael Gorbachev and the collapse of the USSR.
Shenzhen - Deng Xiaoping and private farming and Special Economic Zones.
Origins - economic activity grows and prospers when folks co-operate to benefit from synergies associated with scale, specialisation, science, imitation, investment and innovation. Groups of people associating together and sharing resources, in order to pursue a common purpose. They joined a 'club' of their choice.
Historically economic interactions intensified initially in towns and cities and then further intensified in institutions within the cities -
as money replaced payment in kind there were more opportunities to save and accumulate capital
as trade in the cities grew there were opportunities for profit from risky trading ventures, particularly far away and overseas
in England in the 17th century there was an increasing opportunity for free men to choose the form of their co-operative endeavours. The jsc was the result of voluntary co-operation between merchants who copied earlier Italian practice and pooled their resources in return for a pro rata share in any profits. The prizes these merchant sought were - property ownership - limited liability - succession and continuity - legal remedy for debts
in mercantilist times a tempting source of state revenue was the granting of licences to trade as joint stock companies. State sponsorship was common when ventures were unsupportable by taxation - East India Company, Hudson Bay Company, Virginia Company - many of the first companies were privileged state monopolies
1624 Repeal of ‘The 1571 Act of Usury’ - confirming a change of moral attitude to investment returns, rewarding risk taking became legitimate. Risk was uncomfortable and discouraged investment - ‘a glimpse of risk made the crowd shrink’ -
risk associated with saving, why delaying consumption today when tomorrow is unknowable?
risk associated with lending your savings to others, do you trust him?
communities which evolved the new morality started creating more wealth as more people took more risks. Those with the money have no ideas, those with the ideas have no money
those seeking investment opportunities realised that trust was essential not only because of some inner driven ethic but because honesty was seen to be profitable
1773 Securities Exchange - traders started to deal in utility and industrial stocks as future income streams were bought and sold -
risk was reduced as information became more transparent, investment choice started to become an important indication of value
value was enhanced as resources were allocated to the more profitable ventures, private commercial decentralised decisions start to provide an alternative to central taxation
1825 Repeal of ‘The 1720 Bubble Act’ - for 100 years the jsc was indictable as a common nuisance and, although fraud remained illegal, at a stroke regulation could no longer inhibit legitimate creativity and innovation -
investment scale increased as savings from larger numbers of smaller folk were mobilised
investment flexibility increased as investments could be freely transferred to others
1834 Legal Entity - opportunities for legal remedies -
companies could sue for the recovery of debts through the courts
companies could be sued for the recovery of debts through the courts, honesty was the best policy
1844 Board of Trade Registration - a specific act of Parliament was no longer necessary to form a company -
companies could be readily formed by anyone, for any legitimate activity quickly and easily with minimal cost and red tape
profitable trading no longer depended on political influence, vested interests and monopoly power
1856 Limited liability - savings capital could be mobilised to exploit profitable opportunities with a minimised personal risk, innovation took off! -
investors liability for debts was limited to the amount of the investment
rewards for choosing profitable investments correctly were going directly to substantial numbers of people who could not prevent others from proving them wrong! Investors had only themselves to blame if they burnt their fingers. A restatement of an old principle of Caveat Emptor?
1890 Stock markets - business finance became readily available as small packets of risk were freely valued and exchanged -
information flows around the world as folk were able to quickly and flexibly move funds into wealth creating activities
mass participation becomes possible.
1989 Fall of the Berlin Wall and abandonment of Clause 4 - the success of the jsc is more generally accepted -
privatisation is embraced
massive populations in China and India join the globalisation gravy train.
1989 Fall of the Berlin Wall and abandonment of Clause 4 - the success of the jsc is more generally accepted -
'mind your own business'
'open for business'
2008 Financial Crisis reinvents the polarised beliefs about business & markets as the nationalised banks are rescued from bankruptcy AND private business is instructed to create the jobs ...
The line of causation runs from economics (survival necessity) to an institutional and legal response. There was a competitive economic necessity for investors to share the risks associated with business innovation in co-operative ventures. Specifically the global trading rivalry between England and the Netherlands.
The Wealth Machine - here is a 'PowerPoint' presentation describing how the machine works and why it works ... this material was originally put together for a business appreciation course for first line managers during the 1980s ... still relevant & necessary for business students?
Don't forget to send me your comments, corrections and critique ... here
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