The problem with evolution

In was talking earlier (link to come) about how it increasingly makes sense to see the economy as evolving, rather than only a market which returns to equilibrium. So there are books like Adapt: Why Success Always Starts with Failure which see the economy as a process of variation and natural selection.

There is one problem with this approach, however. Biologists have had a long debate over how natural selection actually works. For many years it was actualy difficult to explain why sexual reproduction exists at all, instead of simply asexual budding or splitting of organisms. Any gains from positive mutations might take tens or hundreds of generations to justify themselves.

It turns out the most accepted explanation is that organisms are always in a race with parasites. Species without much natural variability are soon prey to parasites which can unlock somatic or cellular defenses. It is a "red queen" race, according to Matt Ridley in his book The Red Queen: Sex and the Evolution of Human Nature. You constantly need natural variability not because it will lead to evolutionary advantage sometime in the future, but because it keeps one step ahead of parasites. And because parasites are much smaller and have shorter lifespans, they can evolve and adapt sixty times faster than people can. Hence "superbugs" and antibiotic resistance in hospitals.

So applying this to the economy, adaptability is not just a matter of responding to external shocks. It is a race against maladaptions and exploitative diversions which evolve WITHIN e economy.

And there is an unrelated tradition in economics which is relevant to this, most notably Mancur Olson is his books The Logic of Collective Action: Public Goods and the Theory of Groups, Second printing with new preface and appendix (Harvard Economic Studies) and The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities. He argues that the longer societies are stable, the more likely special interest groups are to arise which form "distributional coalitions" to siphon off resources.

They form because small focused groups get more marginal benefit from campaigning for resources for themselves, while the broad majority have little individual interest in stopping that. Steel manufacturers have huge interest in lobbying for limits on steel imports, for example, and will sound a large amount of money to gain what is for them a large benefit. But the average citizen - or legislator- does not have the same intensity of interest in stopping them. Small intense self-interested groups are much easier to from than broad groups which support broad public goods.

This is why, says Olson, even those groups which do campaign for specific policy outcomes often add specific individual benefits to make people join them, like unions offering health insurance or discount cards.

So economies and societies are most often in a race againt their own parasites - distributional coalitions which naturally build up to siphon off resources.

And if that sounds like K Street and Washington lobbying, that's because it IS. Olson notes that societies like Germany or Japan which got devastated in the second world war grew remarkably quickly out of the ruins. Part of the explanation, of course, is that they still retained immense human capital and knowledge. But part of it is also that the pre-war social elite and structure of privilege had been swept away, and with it many of the barnacle-like social rigidities that had impeded growth. Distributional coalitions were set to zero again.

In the past, the US had an advantage in that it had multiple elites spread around the country, with no single centralized privileged class. There was no single elite, like Paris in France or the court in a autocratic monarchy. But that has changed with the growth of the federal government. Resistance by coalitions to public action has grown much stronger. Distributional coalitions always threaten to strangle public goods and growth by diverting resources to their own narrow memberships. And breaking up those coalitions is traditionally one of the real underlying advantages of something like free trade.

Ripples

Actually, the downgrade may cascade to hurt munis and other debt, and may make Europe look a little worse. And of course if treasury yields did actually rise that would have both monetary and fiscal consequences.

A historic day

So payrolls came in above expectations - but S&P downgraded the US to AA+. In longer view the downgrade may be a good thing if it causes enough political motivation to do more. The rating statement specifically mentioned a need to do more on entitlements.

In the short term it ought not to affect the markets too much directly, as they should already be pricing in fiscal problems (although rates are near historic lows for cyclical reasons.) But it is a hit to broader psychology and a HUGE political story.

Most of all, the risk-free rate, used in all sorts of financial formulas, and always identified with the treasury rates, iis no longer risk-free. And that is something.

Short-termism and fear

Fear irradiated the markets today , and it could get ugly in coming days. The CDS market and money markets are vulnerable. European banks got renewed funding from the ECB this morning, but look unsteady.

And of course it is not a matter of market psychology alone. There are serious fiscal problems in all the major developed countries that have been building up for years - indeed deeper problems with the entire social model. Europe as we know it could crack open.

I can already see the press tonight is full of speculation about a double dip recession in the US. A lot more people could lose their jobs or their businesses or their homes, and that is terrible.

But maybe we also need to look beyond the business cycle as well. Beyond prospects for next quarter.

So much analytical attention will be devoted to tomorrow's non-farm payrolls number, so much focus on prospects or GDP in the next year... But where are we going beyond that? How do we make economic change work for us, rather than live from crisis to crisis? It seems we have been doing that for twenty years or more, and this at a time when central bankers talked about 'the great moderation.' Asia, Russia, LTCM, dot.com, 9/11, Enron, housing, Bear, Lehman.

The real questions are ultimately about how people live, not their portfolio balances.

So often we think of money or wealth as a store of options, of choices, rather than simply deferred material goods or possessions or comfort. The choice itself, the independence to choose is what we want. That is in large measure freedom. But it also a tether that leaves us exposed when the markets plunge. Then it is not so much choice, as vulnerability.

Today's market action is major news, but also static and noise in medium-term perspective. And in the longer run we all forget what the Dow was at on a particular day.

So let's see what happens with NFP tomorrow

Expectations for the payrolls number were about 85k earlier this week. The nature of jobs may be changing, but right now if there are fewer of them markets will take fright.

Positional Competition

I was talking earlier (link to come) about important differences between economies where marginal costs are rising in the key sectors, and those where marginal costs are falling. It is one of the most important influences on what kind of growth you get, and what kind of daily life you live.

But there's another major factor as well. A lot of what people want is often dependent on where you are in the pecking order, and not how much absolute wealth you have. Some things are inherently limited to small groups at the top - beachfront property in Malibu, say, or the proportion of students who can go to Harvard.

This kind of relative competition can limit the gains from growth in important ways. If 50% of the population have degrees, for example, a degree is not as valuable as a mark of extra skill as when only 10% had one. But there may be a lot more student debt which weighs people down. Of course, in this case it may still be worth it foe the education itself. But it won't give the same vocational leg-up. That may now need a master's degree. It is a "red queen" type of problem. You have to run faster to stay in the same place.

One of the first decisive books to make this point was Fred Hirsh's Social Limits to Growth (Twentieth Century Fund Study). I haven't read it a while, but I should take another look.

Anyway, the real upshot is - how do we stop ourselves wasting much of society's effort running faster to stay in the same place? How do we avoid diverting wealh into zero-sum comeptition over pecking order, status and rank? People very much care about status.

What is this damn thing about?

I was reading a new short book called Do the Work on the subway this morning, and it contained this little gem.

"I ask myself agin of a project - what is this damn thing about ? Keep refining your understanding of the theme, keep narrowing it down.. It is the thorniest nut of any creative endeavor.. It is pure hell to answer this question. More books, movies, businesses get screwed up ( or rather, screw themselves up) due to failure to confront and solve this issue than for any other reason."

The book itself is a little rah-rah, but is a whole new model of publishing as well from domino project.com.

Dow go boom

Bad day in the markets, with the Dow down almost 3%. Could be a wild ride. Italy is the big underlying worry.

Still, it reminds me of the old story about JP Morgan himself, who was asked during one early panic - probably 1905 - what the market would do next. He glared at the questioner and said "it will fluctuate, sir. Fluctuate."

On the edge of another Crisis?

It was a bad day in US equities yesterday, with the S&P down 2%. US 10-year yields plunged as well, touching 2.2%. Italian yields have spiked again this morning, up 19bp at one point. There are signs of problems in European money markets. it all feels like another Lehman-style hurricane is forming.

So how do I feel about it? I have a strange kind of detachment on one level. We've seen so much stress and turmoil these last four years it doesn't seem that new any more. It doesn't have the feeling yet of dropping off a cliff into the unknown yet that October 2008 did.

But there is also a sense of more chronic, deeper cracking up going on. The fire brigade was called out in 2008 and 2009 and doused the world with liquidity. The central banks cut rates and governments spent trillions on stimulus.

We don't have those policy options now. They're done and we won't be able to put out the next fire so easily.

I just want to build up more money in cash (and not money market funds either).

I'm not selling out of equities. Like last time I'll grimly ride the storm through rather than try to time the market. There could be short-term rallies as well, especially if we occasionally get good data.

But this feels bad. Italy in particular could be a Hurricane-level storm if it continues.

Health spending devouring the budget

As I've argued before, the political issue isn't really the tea party or cuts. it's the titanic growth in health care costs, which, as this NYT piece shows mean both the government and the debt will be larger at the end of the 10- year period than today.

nyti.ms/qqOVQr

Neither party has a good plan to reduce healthcare costs. But if we don't, then those costs will squeeze out much of the rest of the spending in the economy. Teachers will get laid off because states will be spending most of their budgets on medicaid. Universities will be squeezed because state budgets are in disarray. just look at the University of California already. The federal government will be forced to restrain spending that is good for everyone, public goods, like upgrading air traffic control because Medicare is out of control.

US companies will face vastly higher benefit costs than competitors in other countries. And wages will be stagnant because any increase in take-home pay will be reduced to pay for companies' spiraling health insurance bill. So all other sections of the economy will see lower demand, because it has been diverted into bloated healthcare costs.

The Endless variety in cities

My other half read the post about cities below, and as usual had something smart to say. It's about variety and specialization, she says. That's why people move to New York and places like it.

A lot of people are familiar with the old distinction (most familiar from Isaiah Berlin) between the fox and the hedgehog. Foxes know many things. Shakespeare was a fox, and so was Aristotle. Hedgehogs know one big thing very well - they are system builders. Dante was a hedgehog, and so was Plato. Most people lean towards being one or the other.

She says a fox likes the big city because there are so many different things to do - so many different things to try and dip in and out of. The sheer surprising multiplicity enhances life.

For a hedgehog, there are so many people and groups that there are endless opportunities to specialize in your one big thing. If you are into collecting antique buttons or contemporary flamenco, there will be something to engage your passion. So hedgehogs like it too, and ignore the variety.

Why spend so much to live in New York?

it is 88F and sunny. I am sitting in a park near the office on a glorious August afternoon. Relaxed people are dotted around, sitting in the shade and eating sandwiches and looking at the parade of New York City life. The tourists and the t-shirts and the suits and the squirrels all go by. I am ringed by trees and skyscrapers and the distant sound of taxis and music playing.

My other half was talking about the 'Medium Chill' article I posted the other day. The author deliberately chooses to live in a tumbledown house in a rougher area of Seattle, and does not feel the need to get more ambitious and acquisitive. It is not tuning out for him, it is not being countercultural. It is making a choice about what you value most. More time, less stuff.

It sounds good, marvellous in fact. We intrinsically have sympathy for the idea as a couple. it sounds all the better after vast consumer spending and debt binges have created economic disaster around the world. It is more environmentally sustainable as well, most likely.

But then again I write this on a park bench in Manhattan. We live in a nice apartment upscale part of town. There are few other places on earth more driven than New York. The rats run faster races here than anywhere else.

Why do we do it? What makes it worth it to live here? After all, we could have much more living space in most other places. We could have trees and grass of our own.

What is so compelling about living here then? We do love it. Every time I fly back to JFK, my heart still lifts when we round a curve on the Long Island Expressway coming into town and see the great forest of skyscrapers again.

But why shouldn't we downshift to a slower life somewhere quieter? We could manage it financially, to slow down and downshift significantly, work fewer hours. We could have just as many books and movies and art, and probably have time to enjoy them too.

We love being at the center of things, I suppose - where history is happening, where there is always something new, where you feel energized just by looking around. We love living next to the greatest art galleries, the wonderful concerts and opera and restaurants - although sometimes when we are tired we have to make an extra effort to go out and take advantage of them. Energy is in short supply on Saturday mornings after the week too. You need energy to take advantage of all the opportunities.

We evidently have an extra need for stimulation and experience. We are curious and love books and travel as well. We want to know things and experience things. It is our instinctive view of the good life.

We have often discussed as a couple the fact that experiences make you more happy than more money. So it makes sense we live where peak experiences crash in like ocean waves. New York is the capital of experience, gushing and cascading and flowing in great torrents. Tranquility would just seem to...slow, too much the same.

We like having good careers. We are well paid and successful, although we haven't been willing to make huge sacrifices of time and freedom to get to the very top.

But it isn't primarily the career at is the attraction to living here. Neither of us have changed jobs in a long time. In some ways in that sense we might be better off in Washington or Boston or London. We like to spend time together rather than more time in the office.

Why here? It is the connection, the networks and cross-fertilization - but most people in cities have their own circles and don't mix quite as much as urban theorists think.

It is the ability to walk to the Metropolitan Museum - but in some ways the most interesting art is not here in expensive Manhattan.

Maybe talking about the future of the economy is a bit like talking about different places to live. The world may evolve to become more like San Francisco is now - or Lagos. People used to believe the future happened in California first. Not so much any more.

There is such variety of lives just based on place: between New York and Barcelona's Eixample, houses on Oahu's North Shore, North Vancouver, medieval central Siena. Or rural Vancouver Island out towards Port Renfrew. Or upstate New York near the Andirondacks. Why do people choose to live where they do, and why do they choose to move?

A lot of it must be inertia. Some, particularly in older societies, is a sense of rootedness, of belonging to a community - which is not really a New York thing at all. Some of it is nostalgia, personal history and meaning in this place where we have lived much of our lives. Places are lived stories, our own stories and stages and props and poems.

Some of the limits are obviously about money - attractive places cost more to live, and can become prohibitive. But what makes attractive places? Everyone agrees Paris is more attractive than Cleveland, but after that there is plenty of room for disagreement.

Some of it is avoiding commuting, certainly for us. We don't want to spend three hours a day on I-95 and the Merritt Parkway, like some people we know.

You come to love the things that ARE good about where you are. We don't think about our small apartment, but do thrill at walking home in SoHo after an excellent meal. Still, the material circumstances are more and more similar over time. If you live in the country, you are glad to escape the noise and the lack of fresh air and crowds of the city.

We certainly yearn sometimes at this time of year for our own backyard and grill. but for today at least I can sit here in the park at lunchtime.

Until I have to go back inside to my desk.

The limits of exchange value

This point about deflation in the prices of valuable goods raises a whole new set of issues, though. There is a difference between exchange value, what something can be sold for in the marketplace, and use value. There is a long history of discussion over this point. Marx argued for a labor theory of value, the amount of work which went into a good. And so he argued that if the good was sold for more than the labor value, workers were being exploited.

But what if the manufactured goods are being produced by robots - capital goods - in any case, as in the Foxconn story below?

Still, the point remains that market value or exchange value is not the only motivating economic force or measure. For one thing almost half our economies are already state-owned, and therefore not subject to market forces in the same way. We give out many valuable services like grade-school education free at the point of delivery, funded by taxes.

Historically, most people relied on subsistence production for themselves in any case. The market had little role to play in their lives, apart from occasional trade for things that could not be produced locally, like iron or salt.

Value is a knotty thing.

The reason we rely on markets so much is they are a very good coordination device. Price signals can be remarkably efficient at allocating resources. Money prices also solve the 'revealed preference' problem to a large extent. That means people can say or believe or claim they want something. But what they are willing to pay for it in relation to other things in offer is much more of a concrete fact.

The question comes down to where the borderline of the market is. And not in the old sense of where the limits of the state are, either, though that is becoming very sensitive again as Washington is close to gridlock over the size of government. It is about which areas the market is most useful for as a social technology (which I'll talk more about soon.) If most daily needs are becoming cheaper and cheaper, then will the same market allocation devices work as well for the new needs or demands which open up, and which will drive the evolution of the economy?

Deflation and value

Picking up the returns to scale strand, there is one complication with all of this. I said that a lot depends on whether the main growth areas in the economy can be provided at low marginal cost.

If they can, then growth is likely to produce deflation. The gains come not so much in employment gains as falling prices, so they can be more readily available to society at very low cost. The music industry may not be as healthy as it was twenty years ago, but society has an immeasurable wealth of music available at a mouse click at no cost. Some things of great value cost next to nothing. Tyler Cowen discusses this in passing in his book The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will(Eventually) Feel Better.

Strands

I was talking about returns to scale in a post just below. I'm going to refer from now on to picking up different strands of argument or discussion. Here's some I now have going currently:

- Evolution and the economy
- the Edge of Markets and Returns to scale
- Relative price changes and what they mean for daily life. I'm going to call this 'deeper shifts in structure.'
- What people need and want
- Productivity
- Purpose, Motivation and Satisfaction

I'll add labels for these different strands.

How are cities and companies like ecologies?

Here's an interesting TED talk looking at the relationship between size and success of animals - and cities. There are advantages to scale, he says, but problems like crime also scale up as well.

He also talks about the sigma-shaped growth of companies. They tend to grow rapidly, level off for some time, and then almost without exception disappear and die as well. It is interesting stuff both from an evolutionary perspective and a returns to scale perspective.

Chinese workers are being replaced by robots

The West used to shudder at the thought of the vast low-cost labor pool in China, and dreaded the undercutting of its own manufacturing firms. It still bought the lower cost imported goods at Walmart, though.

Now one of the largest employers in China of all, Taiwanese-based Foxconn, announces it intends to replace a large proportion of its 1.2 million workers in China with robots.

This is potentially one of those stories that turn out to be historic marking points.

It shows the downward pressure on manufacturing employment applies everywhere. And it has implications for China's future. If you have an automated plant with few or no labor costs, a location six thousand miles from your main markets becomes more unattractive. There are fewer reasons not to put the plant in New Jersey or Turin.

"Medium Chill" and Happiness

This article argues many, if not most Americans would like a 'medium chill' life, looking for just enough in terms of material  stuff and housing space. Instead they would have more time to spend on relationships. 

http://tinyurl.com/6zxa8al

Sent from my iPad

At the edge you can see the future

The future could depend on whether marginal costs rise or fall.

Economists often talk about marginal costs. That is the cost of producing one more additional item for sale, as opposed to the average cost of all the items together. A classic example is a seat on the Delta shuttle flight between LaGuardia and National airport Washington leaving tomorrow. The cost of operating the flight so you can fly the first passenger runs into tens of thousands of dollars. But the extra cost of flying the fiftieth passenger is tiny, a few dollars extra to cover fuel expended carrying the extra weight, and any extra ticketing costs. The average cost to fly the fiftieth passenger is hundreds of dollars, but the marginal cost could be ten or twenty dollars. (This is why airline ticketing systems are so complicated).
What does this mean for the economy as a whole?

A lot depends on whether the growing areas of your economy have rising or falling marginal costs. Most classic manufacturing or energy production has rising marginal costs, at least in the short run. If you want to produce more at the margin, you have to run your factory harder, pay more overtime, get closer to capacity limits. If you want to expand production further, you may have to invest hundreds of millions in a new plant. And if there are economies of scale, there may only be room for two or three large plants in the world, or there will be oversupply and producers will not recover their costs. Over time, costs may fall because of new technology or techniques, but you still need more resources to produce more.
For much of our new information economy, on the other hand, marginal costs are zero, or close to it. You can sell a hundred million copies of Mac OS Lion for much the same cost as one million, or a hundred. You can write an app and overnight scale up to worldwide availability in the millions.
Clearly you have a very different economy if the new needs that evolve have rising or falling marginal costs. In the later case you can scale up to almost universal, ubiquitous satisfaction of the wants very quickly for little additional money. It is the big rock candy mountain.

Relative Prices and Different Lives

One of the most important things in economies is the deeper relative prices of different goods and services. We usually don't pay much attention to them, though, as they usually change slowly. It is a matter of the longue duree, as historian Fernand Braudel put it, rather than something which is evident in Friday's GDP number or the next CPI print.

We are conscious of the price of energy, for sure, as it can be volatile and move a great deal in a short period of time. And in economic theory we sometimes think about the price of traded goods versus non-traded goods - ie those things which are traded on world makets, like iPods, versus those which are local, like hairdressers.

But mostly we look at the overall price level - inflation - or treat the changing costs of different goods like an exogenous shock, something which lies outside our theories and just happens.

But it is also obvious that the price of most manufactured goods has fallen substantially in the last few decades. Clothing, electronic goods, food are all relatively cheaper. In fact, there is massive deflation happening in some parts of the economy.

Take Spotify, the legal Internet music service which launched in the US last week after success in Europe. It claims to offer instant access to over 15 million songs - for free. It is more permissive than other similar services like iTunes, napster or pandora. Music used to be very expensive, as anyone who bought a CD in the 1980s knows. You would get 8 or 10 songs for $20. All of the world's music is now available legally for free (or at least at a marginal cost of zero after you have bought the computer and the broadband access). You don't have to download it from the torrents illegally.

The same applies to most information services, which are plunging in price. Netflix delivers most of the world's cinematic history for less than $10 a month, more than you could ever watch. The world's great libraries are increasingly accessible online.

And it is not just things in the cloud. The range and quality of food available at so where like Whole Foods or Eataly would amaze people even twenty years ago, and for a lower proportion of take home pay. Yes, food prices are going up and can cause riots in developing countries. But as a proportion of people's spending, people can now eat better for less than ever before.

But other things have got more expensive. Property has generally got more expensive in the last few decades, although the great crisis has produced some correction, of course. Admittedly, the quality and living space people enjoy has generally gone up as well, and prices rose more in 'luxury cities' like New York or San Francisco or London than less exciting Cleveland or Sheffield. And much of the increase was because of looser credit and wide availability of mortgages, as well as more two-salary households. But in general, property still takes up as much of people's spending as several decades ago, and usually more.

Medical costs have risen. New technology has not reduced overall costs, as in media, because it has raised possibilities in an area where demand is potentially infinite.

Education has also risen in price, certainly at third level. This is in large part because of what is sometimes called Baumol's disease. Services with little or no productivity growth become relatively more expensive over time. There have been no productivity revolutions in education for a long time. A professor still stands in front of a class, in much the same way they did in Bologna or Oxford in the fourteenth century. But salaries keep up with the rest of society. Add to that it college degrees have become essential for most jobs and you have guaranteed demand.

All of these changes are actually well known, of course. But step back and think about what this means for people's lives and livings. It means huge material abundance, but limited living space. It means vast cultural access, but significant barriers to fully taking advantage of it because of educational limits ( at least so far). It means more and more of the wealth of society being devoted to medical expense, especially for the very old. These all mean a different kind of society and a different kind of life.

What if most goods and services we need in daily life can be produced by just three or four per cent of the workforce, as happened to agriculture? What happens if education and Medicine are hit with their own productivity revolutions before long, as may indeed happen? (Markets ARE good at ultimately finding productivity improvements if there is enough potential gain.)

We can already glimpse a society where most daily needs bar shelter, healthcare and education can be provided with a minuscule proportion of the workforce, at minimal cost. There will be new needs and demands over time, for sure. But will they need to employ laboring millions to provide? If not, it is not just a shift in demand to new goods. It is a revolution in society just as large as the invention of agriculture, or the Industrial Revolution. Much depends on the nature of the new needs.