Monday, December 5, 2011

Knowledge and Limits

I'm discussing Douglass North's book Understanding Economic Change. We've looked at uncertainty, institutions and incentives, the dynamics of change, and political transaction costs. 

But of course at the heart of economic change is knowledge.


But knowledge is sensitive to transaction costs, because the more you know about one speciality, the more you are reliant on others' abilities in other areas. Knowledge needs to be integrated.

It is the growth of knowledge about how to get things done that has been the central phenomenon of economic evolution. The greater the specialization and division of labor in a society the more dispersed is the knowledge in a society and the more resources must be devoted to integrating that dispersed knowledge.

This is something I think about all the time - the stupendous limitless amount of knowledge, far far beyond the ability of anyone to comprehend. People take refuge in specialities, and we all rely on huge volumes of knowledge we barely are aware of, from avionics as an aircraft is on final approach to language skills in international trade and diplomacy, to all those mysterious tech manuals about "Sharepoint" or "CISCO certification" which take up an entire section in the average Barnes and Noble.

And integrating knowledge involves more than just a market and price system. 

The integration of this specialized knowledge with low costs of transacting requires more than an effective price system. Institutions and organizations were necessary to supplement the price system where externalities, information asymmetries, and free rider problems had to be overcome. The increasingly dispersed knowledge of modern societies requires a complex structure of institutions and organizations to integrate and apply that knowledge. The implication is fundamental to this study: The growth of knowledge is dependent on complementary institutions which will facilitate and encourage such growth and there is nothing automatic about such development.

So growth has generally required effective impersonal mechanisms to mediate knowledge as well.  It gets harder and harder to integrate knowledge on an effective way - although tools like Google help.

In fact, there is a more general conclusion:

Growth has been generated when the economy has provided institutional incentives to undertake productivity-raising activities such as the Dutch undertook. Decline has resulted from disincentives to engage in productive activity as a consequence of centralized political control of the economy and monopoly privileges. The failures vastly exceed the successes.

On one level, that is obvious, as most major ideas in the social sciences are.

But on another level it is a distilled insight about what really matters. it is a point of clarity in a dark sea of surging opinion.

Limits to our understanding and limits to change

North had opened the book with a declaration that economic rules are ultimately about human beliefs and intentions. But that does not mean that we have a blank slate to design new societies. 

Social engineering is not easy. We could have guessed that from the results, of course, from the Greek welfare state to Mao's Great Leap Forward. But this helps explain why there are many countries which change their political constitution with limited or even disastrous results.

A mixture of formal institutions, informal institutions, and their enforcement characteristics defines institutional performance; and while the formal institutions may be altered by fiat, the informal institutions are not amenable to deliberate short-run change and the enforcement characteristics are only very imperfectly subject to deliberate control. The reason should be clear from the foregoing chapters. We are continually altering our environment in new ways (and there are also non-manmade alterations), and there is no guarantee that we will understand correctly the changes in the environment, develop the appropriate institutions, and implement policies to solve the new problems we will face. 

And it is all the harder to get it right when we have little experience of the new conditions and challenges and situations we have to grapple with.  

We tend to get it wrong when the accumulated experiences and beliefs derived from the past do not provide a correct guide to future decision making.

That is not good news when change is happening so quickly.

So in the end successful change depends on changing people's beliefs. 

Understanding the cultural heritage of a society is a necessary condition for making “doable” change. We must have not only a clear understanding of the belief structure underlying the existing institutions but also margins at which the belief system may be amenable to changes that will make possible the implementation of more productive institutions. 

It is an interesting combination of both left and right. It is very difficult to deliberately change society - it tends to evolve under a range of different selective pressures. But you can effect some change just by changing the terms of the debate.

The question I am left asking is - can beliefs, culture and therefore institutions and incentives change and evolve fast enough to keep up with technological change? Beliefs tend to change slowly.

The printing press and the cannon changed the world. Automation and AI can do the same thing - in a tenth of the time. Do we get disorder and breakdown, evolving in response to outdated beliefs, or do we get new incentives to make a new shift in the economic axis of the world?

Douglass North's Understanding Economic Change

I warned in the last post another serious book was coming up, and this is a major one. Douglass North is a Nobel-Prize-winning economist, or more specifically, an economic historian. I mentioned him before here. He thinks about the nature of economic change and the factors which make some societies more successful than others. 

He won the Nobel in 1993 for work done in 1982. But in 2005 he published a new book, Understanding the Process of Economic Change. I found it extremely valuable, partly because it organizes and reinforces some of the intuitions I have been gradually developing in this blog. It provides more of a conceptual vocabulary to discuss them. 

Here's the core of the book: You have to think about institutions and incentives.

The ideal economic model comprises a set of economic institutions that provide incentives for individuals and organizations to engage in productive activity. 

That would be tricky enough if society was static. But the nature of those institutions and incentives is always changing in response to growth in knowledge, changing beliefs  and other factors. 

So the success of an economy also depends on how well it adapts to those changes.

And some of these changes can be very broad-ranging. One of the most profound of all changes, he says  - which some societies have still not successfully managed - is when the physical environment is no longer the primary challenge for society. 

 The contrast between the institutions and beliefs geared to confronting the uncertainties of the physical environment and those constructed to confront the human environment is the key to understanding the process of change. 

So that is the outline. Let's look at it in more detail.


We develop economic and political institutions to try to reduce pervasive uncertainty.   

Standard economics has not properly come to grips with uncertainty, he says. 

Economists have themselves displayed a good deal of ambiguity on the subject, largely proceeding as though uncertainty was an unusual condition and therefore the usual condition, certainty, could warrant the elegant mathematical modeling that characterizes formal economics. But uncertainty is not an unusual condition; it has been the underlying condition responsible for the evolving structure of human organization thioughout history and pre-history. 

We simply do not live in a world which is constant and easily predictable, he says. It is a non-ergodic world. 

 An ergodic economy is one in which the fundamental underlying structure of the economy is constant and therefore timeless. But the world we live in is non-ergodic—a world of continuous novel change; and comprehending the world that is evolving entails new theory, or at least modification of that which we possess. In consequence, there is no implication that we “have it right” despite the awesome advances in science which have enormously reduced uncertainty about the physical environment. 

He notes that Paul Samuelson once said an assumption of an ergodic world was necessary for economics to be a science. Too bad for that hope.


People set up rules of the game to try to limit the uncertainty they face. Those rules of the game are institutions.

ALL ORGANIZED ACTIVITY by humans entails a structure to define the “way the game is played,” whether it is a sporting activity or the working of an economy. That structure is made up of institutions—formal rules, informal norms, and their enforcement characteristics.

Note those three components, which I think are very important. Where do the rules, informal norms, and for that matter the effectiveness of enforcement, come from? They are derived, he says, from the beliefs humans have. This not physics or mathematics, with unchanging natural laws. 

An institutional framework develops over time.

That institutional framework consists of the political structure that specifies the way we develop and aggregate political choices, the property rights structure that defines the formal economic incentives, and the social structure—norms and conventions—that defines the informal incentives in the economy. 

Zeroing on on the economic rules of the game:

 The formal economic rules are broadly speaking property rights defining ownership, use, rights to income, and alienability of resources and assets as expressed in laws and regulations. There is an immense literature on this subject; there is less on the way informal constraints influence economic performance. 

Institutions are not static, either. They are always changing, partly because the players change their behavior in response to incentives.

Institutions are the rules of the game, organizations are the players; it is the interaction between the two that shapes institutional change 

And here is one of the deepest themes - the more incentives provide for cooperation and productive activity, the better off a society will be. Altering our institutions, our rules of the game, is the main way people change their society.

How does this happen?

 Historically, institutional change has altered the pay-off to cooperative activity (the legal enforcement of contracts, for example), increased the incentive to invent and innovate (patent laws), altered the pay-off to investing in human capital (the development of institutions to integrate the distributed knowledge of complex economies), and lowered transaction costs in markets (the creation of a judicial system that lowers the costs of contract enforcement).

It is easier to change formal rules than informal norms and constraints, however.

History and Change

Institutional change is not easy.  You cannot simply write down an institutional framework on a sheet of paper and hope to enact it easily. Even if economic rules are ultimately a matter of belief and intentionality, they are still not easy to change.

Institutional change is typically incremental and is path dependent. It is incremental because large-scale change will create too many opponents among existing organizations that will be harmed and therefore oppose such change. Revolutionary change will only occur in the case of gridlock among competing organizations which thwarts the ability of organizations to capture gains from trade. 

The importance of informal norms about trust and cooperation means history profoundly matters. Culture matters. Economic change is path dependent. It depends on the existing institutional matrix, he says, as well as the kind of skills and knowledge people have already invested in.

Institutional constraints cumulate through time, and the culture of a society is the cumulative structure of rules and norms (and beliefs) that we inherit from the past that shape our present and influence our future. Institutions change, usually incrementally, as political and economic entrepreneurs perceive new opportunities or react to new threats affecting their well-being. Institutional change can result from change in the formal rules, the informal norms, or the enforcement of either of these. 

Adaptive Efficiency

So we are constrained by the past, by our existing institutions and skills and beliefs. But we must also constantly adapt to the future. So the other main  theme in the book is  the importance of adaptive efficiency. Our institutions and environment are always changing, and incentive systems must change too. 

 Adaptive efficiency—the kind of efficiency that has characterized the United States and western Europe—entails a set of institutions that readily adapt to the shocks, disturbances, and ubiquitous uncertainty that characterize every society over time. Conformity can be costly in a world of uncertainty. In the long run it produces stagnation and decay as humans confront ever new challenges in a non-ergodic world that requires innovative institutional creation because no one can know the right path to survival. Therefore, institutional diversity that allows for a range of choices is a superior survival trait, as Hayek has reminded us.

Indeed, one of the most important transitions in economic history required a fundamental change in belief and incentive systems. 

 Problems posed by the transition of a belief system from one constructed to deal with the physical environment to one constructed to confront the complex problems of the human environment are at the core of the problems of economic development. There is nothing automatic about such a transition being successful. 

This is particularly interesting to me, of course, because I think we are confronting another huge change in the underlying nature of our environment, one which needs significant adaptation in our institutions. 

The previous shift required a change from personal exchange to impersonal exchange, with less reliance on personal and family ties and more on a "formal structure of rules and enforcement mechanisms." Each structure, he says, fostered a set of beliefs, which in turn shaped politics, economics and society as a whole.  Such institutional changes are often difficult stumbling blocks.

 The shift from personal to impersonal exchange has produced just such a stumbling block both historically and in the contemporary world. Personal exchange relies on reciprocity, repeat dealings, and the kind of informal norms that tend to evolve from strong reciprocity relationships. Impersonal exchange requires the development of economic and political institutions that alter the pay-offs in exchange to reward cooperative behavior. 

How does on adapt to large-scale change? The important thing is to experiment and try alternatives, he says. 

 Adaptive efficiency entails an institutional structure that in the face of the ubiquitous uncertainties of a non-ergodic world will flexibly try various alternatives to deal with novel problems that continue to emerge over time. In turn this institutional structure entails a belief structure that will encourage and permit experimentation and equally will wipe out failures. The Soviet Union represented the very antithesis of such an approach. 

This helps explain the failure of the Soviet Union. it may have been statically efficient. But its centrally planned economy found it difficult to experiment and adapt. And that is the secret, he says, of US success.

 The best recipe for confronting such novel situations is the one that Hayek put forth many years ago and that has been the source of U.S. material success, which is the maintenance of institutions that permit trial and error experiments to occur. Such a structure entails not only a variety of institutions and organizations so that alternative policies can be tried but also effective means of eliminating unsuccessful solutions.

Competition helps spur organizations to adapt:

Competition forces organizations to continually invest in skills and knowledge to survive. The kinds of skills and knowledge individuals and their organizations acquire will shape evolving perceptions about opportunities and hence choices that will incrementally alter institutions. 

There is a clear link here to two books I talked about near the beginning of this blog,   Adapt: Why Success Always Starts with Failure by Tim Harford and Origin of Wealth by Eric Beinhocker. They both talk about the fact that the economy is an evolutionary system. You need a mechanism to generate diversity, as well as a selection mechanism. Together those can produce dazzling complexity and beauty over time. 


Politics and Transaction Costs

Much depends on how easy it is to make agreements, monitor adherence and enforce them. This is particularly important in politics. 

Transaction costs - the costs entailed in the measurement and enforcement of agreements, in this case - are a basic economic concept. They can often be very high in the political sphere, because, among other things, 

Imperfect models of the complex environment that the politician (and constituent) is attempting to order, institutional inability to get credible commitment between principal and agent (voter and legislator, legislator and policy implementer), the high cost of information, and the negligible payoff to the individual constituent of acquiring information all conspire to make political markets inherently imperfect.

The political sphere is naturally different to the economic sphere,

 Bargaining strength and the incidence of transaction costs are not the same in the polity as in the economy, otherwise it would not be worthwhile for groups to shift the issues to the political arena. Thus the selection process is one in which the high transaction cost items gravitate to the polity. Madison’s insightful views about the inherent nature of the political process as described in Federalist Paper no. 10—in effect he maintained that polities tend to be captured by special interests and used by them for their own advantage at the expense of the general public and that this was a universal dilemma of polities throughout history—are as pertinent today as they were two centuries ago. 

This means it is critical to have limits on political power.

Well-functioning markets require government, but not just any government will do. There must be institutions that limit the government from preying on the market. 

Order and Disorder

Change does not necessarily produce positive outcomes, however. It can produce much more uncertainty and disorder than before. People want to feel the basic rules are predictable.

Disorder increases uncertainty because rights and privileges of individuals and organizations are up for grabs, implying disruption of existing exchange relationships in both political and economic markets; and conformity disappears as a result of disintegration of norms and/ or change in enforcement. Disorder can result from changes which lead to a reduction of coercive enforcement of rules or from the weakening of norms of cooperation, which induces organizations to attempt radical changes in the rules of the game. One kind of change is an event that dislodges the old mechanisms that provided credible commitment in society without providing adequate substitutes.
This is a serious warning about how weakening old mechanisms can undermine a society. Radical changes in the rules of the game can be destabilizing, and so will therefore bring forward equally fervent opposition.

I think some radical evolution is necessary, simply because economic institutions have not kept up with the extraordinary changes in knowledge and productivity that we have experienced in recent decades. But this underlines how hard it can be to change without undermining the system as well.

 I'll talk more about knowledge and the limits of change in the next post.

Sunday, December 4, 2011

The Coffee shop question and books

Here I am in Starbucks on Sunday morning, Pike Place Roast Grande and an Apple Bran muffin to hand. One iPad and a keyboard. Fully equipped for blogging! 

I'm about to launch into a discussion of another book. But before I do, I thought I'd talk about why I have such extensive discussions about books. Why not interviews or stories or anecdotes? I know reading about books is harder going than entertaining little stories, which seem to be the basic formula for much non-fiction. And when the books I am discussing are about philosophy or economics it can be much harder going still. 

So I admit it: the personal book review section is  not prime entertainment. It's not front page revelation.  G tells me she likes the more personal stories about how we are living our lives together above all, which I like as well. But my aim so far is not to build an audience (which is still minimal) 

So why talk about all these ideas? Well, it's in the name of the blog. And the more fundamental answer is what you see depends on what you are looking for. I think much knowledge is just seeing the same things more clearly, and being able to see the things that matter. It is about education of perception. 

You have to know enough about an issue or area to understand what you're looking at. You have to read through some of the previous thinking and discussions to know what the essential questions are, and arrive at the questions which matter most to you. You have to map out the contours of the territory.  You have to watch out for fundamental mistakes, or old, tired refuted points of view.  You have to grapple with some counterarguments to know if what you think makes sense. 

And, to be honest, it all appeals to the intellectual side of me. I like reading new thought-provoking books and deciding what I make of them. I like concrete problems. But I am more thinker than journalistic by nature. 

Some blog about restaurants. Some blog about current politics. Some blog about celebrity gossip or episodes of Gossip Girl. Thinking about how the world is changing in larger perspective is my own passion, my own niche which I want to spend time doing on a Sunday morning. 

Unfortunately, the ability to add photos is temporarily down in both Blogger and the offline program I use, Blogsy, so I can't add change of pace images temporarily, which help break the intellectually more intense stuff. But hopefully that will come back soon. 

I started out with a coffee shop question back in July this year, written at the same Starbucks table I am sitting at now. And I feel I have made a lot of progress, at least to my own satisfaction and pleasure, in working towards some answers. 

More "End of Work"

I'm discussing Jeremy Rifkin's 1995 book, The End of Work.

The postwar model of the American corporation started to run into problems in the 1980s, he says. 

The managerial system of corporate organization was like a lumbering giant, a powerful producer able to turn out a large volume of standardized goods but lacking the flexibility to make the kind of rapid changes necessary to adjust to sudden fluctuations in the domestic or global market. (p94). 

New technology increasingly eliminated what he calls "the increasingly bloated ranks of middle management" who just processed information flow up and down the hierarchy. 

In the information era, "time" is the critical commodity, and corporations bogged down by old-fashioned hierarchical management schemes cannot hope to make decisions fast enough to keep up with the flow of information that requires resolution. (p101)

This is driving re-engineering, and leaner corporations, he says. He then diligently examines the impact of technology and automation on a series of sectors, including agriculture, manufacturing, retail and banking. 

The nation state and government in general is declining. Governents can no longer guarantee market functioning, either.

So what is his answer? There needs to be more growth in "the third sector" - the non-market, non-government, "social economy." 

Most people would find it difficult to imagine a society in which the market sector and government play less of a role in day-to-day affairs. These two institutional forces have come to so dominate every aspect of our lives that we forget how limited their role was in the life of our society just one hundred years ago. Corporations and nation-states are, after all, creatures of the industrial era. ... 

Now, however, that the commercial and public sectors are no longer capable of securing some of the fundamental needs of the people the public has little choice but to begin looking out for itself, once again, by reestablishing viable communities as a buffer against both the impersonal forces of the global market and increasingly weak and incompetent central governing authorities. (p238)

The independent sector includes voluntary activities, tax-exempt organizations and charities, running from "social services to healthcare, education and research, the arts, religion and advocacy" which together are responsible for 9% of total employment.  The third sector creates social capital.  

Community service is a revolutionary alternative to tradtional forms of labor. Unlike slavery, serfdom and wage labor, it is neither coerced or reduced to a fidiuciary relationship.. It is an act entered into willingly and often without expectation of material gain. In this sense, it is more akin to the ancient economics of gift-giving. 

It is also, he argues, very American. Toqueville thought voluntary organization was one of the most distinct and remarkable features of the new American democracy: (Rifkin's quote of Toqueville, p 243)

Nothing, in my view more deserves attention than the intellectual and moral associations in America... In democratic countries, knowledge of how to combine is the mother of all other forms of knowledge; on its progress depends that of all the others.

The third sector, Rifkin says, is an antidote to the excessive materialism that dominated twentieth century industrial thinking. 

He thinks the third sector can restore social services which are being abandoned by over-indebted governments, despite suspicions on the left of what the first President Bush called "a thousand points of light." Interestingly, Rifkin defends himself against being seen as advocating a partisan Republican idea. 

Rifkin argues for a "shadow wage" - a deduction from income tax for volunteer hours given, as well as a "social wage" for those unemployed people who want to do community service full-time as an alternative to welfare. 

It would be a form of guaranteed income, but linked to community service. Interestingly, he notes Lyndon Johnson established a National Commission on Guaranteed Incomes in 1967. It went nowhere as many politicians feared it would undermine the work ethic. But the idea was not confined to the left. Milton Friedman proposed a "negative income tax" as a cash alternative to the mess of bureaucratic welfare dictats which amounted to a guaranteed income in any case.

Rifkin concludes:

finding an alternative to formal work in the marketplace is the critical task ahead for every nation on earth. Preparing for a post-market era will require far greater attention to the building up of the thrid sector and the renewal of community life.. The end of work could spell a death sentence for civilization as we have come to know it. The end of work could also signal the beginning of a great social transformation, a rebirth of the human spirit. The future lies in our hands. (p291,293)

So what should we make of the book? It is detailed, it is diligent, it is in many ways quite moderate. 

It was perhaps premature. Economies have grown substantially since the mid-1990s, but it seems we have done it in part by ever more boom and bust, and with a huge infusion of debt. 

His arguments for the third sector are also well-taken. Indeed, they are strenghhened by new forms of cooperation like open-source software, Wikipedia, and other huge voluntary endeavors at the heart of the new economy. More than ever is being done voluntarily. 

But I don't think the expansion of the voluntary sector in itself is a full solution. For one thing, why will the third sector expand? It needs to be encouraged and supported as well. I think Martin Ford's book, The Lights in the Tunnelwhich I discussed earlier, is more interesting in its emphasis on incentives, and the motivations people might have to do the right thing. 

The growth of voluntary organizations and restraint of exploitative or deviant behavior needs to be explained

I fully agree with Rifkin that more government is not the answer. This is where he parts company with liberals. There needs to be a wider range of organization and collective activity than just centralized activity. 

Perhaps the biggest contribution he makes, though, is his history of fears of automation in the twentieth century. So far we have always put such fears behind us, as growth has indeed being a swift incoming tide that raised all boats. 

After the second world war, for example, the huge expansion of the service sector, the vast increase in the scale of government, and the expansion of the market sphere as women went out to work enlarged the scope of the market and consumer demand. Suburbanization led to a huge wave of demand for many goods too. That made up for the increasing automation or loss to foreign markets of heavy industry.

But the fact that we have escaped the problems once does not mean we will inevitably escape them every time, or by using the same tools in the same way.