Some Thoughts On Economics

My instinctive entry point into economics is through business. What is called the “Theory of the Firm” plays a key role in shaping what I see, think, and try to explain. Business, of course, gets frequent mention throughout economics, with most varieties of general theory claiming to place it somewhere inside the theoretical constructs. But pick up almost any textbook and the treatment of business is at best a weak caricature and at worst a laughable display of ignorance. Economics as it exists today in its mainstream form is of no use whatever to anyone seeking to understand the reality of business. Our extant theories of the firm are failures in that they attempt to see the world through a neoclassical lens whilst that lens obscures anything remotely real from view in an effort to retain the equilibrating perfection of the closed system envisaged by Walras. The contradiction between the pursuit of equilibrium explanations and the open ended nature of the real world defeats neoclassicism at the starting gate and dooms it to subsequent nonsensical irrelevance.

But it must mean something to someone since it is still, despite its evident silliness, the most preferred theory within the profession.

In this context I have to attribute a great honor to the Arrow-Debreu effort to complete the Walrasian episode. Arrow-Debreu deserves our constant indebtedness. It shows, definitively, how the Walrasian tradition cannot be an explanation for a real economy. It achieves completion by imposing such horrendously, and obviously, unreal constraints on itself that it proves Walras wrong. It is thus great science. It is the falsification of a tradition shown to be worthless.

On another matter: mainstream economists have never adequately, in my opinion, responded to Coase’s challenge of 1937. He asked simply: if markets do what classical economists and their followers say they do, why do firms exist? They ought not. That they do suggests something is very wrong at the heart of orthodox thinking. So I add the ‘Coase conundrum’ to Arrow-Debreu as adding weight to the critique. Mainstream economics is alchemy.

I am aware of the post-Coase tradition of ‘transaction costs’. Williamson represents the clearest version of this tradition. He seems, though, to be more concerned in not upending neoclassical thought than in explaining why firms exist. Asset specificity, cheating, agency issues and the like are nice ideas. Important ones. But they sit ill at ease within a theoretical world where everything is neatly defined and all information equally available. Such things cannot exist in the weightless world of neoclassical thought. So all Williamson and his ilk have done is to redefine the Coase conundrum. Instead of the original ‘why do firms exist’ we now have ‘why do transaction costs exist’. Nothing fundamental has been explained.

Then there is the problematic relationship of economics with information. References to information abound. Reputations have been made discussing it or its absence. Asymmetrical information is another challenge to orthodoxy that is too often ignored. Information about things is patchy in the real world. Very patchy. It is non-existent with regard to the medium and long term future. Yet this never deters the neoclassical theorists. They march along as if asymmetry was an inconvenience that can be assumed away for simplicity’s sake, rather than a dagger in the heart of their work.

Uncertainty and complexity characterize the real world. Certainty and simplicity characterize neoclassical economics. Hence it irrelevance. It is complicated though, as Arrow-Debreu shows. It has to be. Its epicycles weigh it down. But no amount of clever formalism can turn unreality into reality, just as lead is pretty tough to turn into gold. This doesn’t mean that neoclassical economist aren’t very bright. They are. They have to be to to tend to those epicycles. Newton, after all, spent more time on alchemy than on recognizable physics. No indeed, they are very bright. Just wrong.

There are, of course, other forms of economics. I find particular relevance in anything that considers evolution as a guideline. The economy seems to act in a very Darwinian way: variation, inheritance, and selection help explain the apparent paradox of both persistence and change within the same system.

Then again, learning seems paramount. Perhaps the economy is a giant learning device in the mode of Popper. Trial and error. Falsification of hypotheses. The adoption of successful routines, and then their replication, is exactly what goes inside business. Firms then can be viewed as search engines exploring the space of possible combinations of ideas. They grope around on the edge of our knowledge looking for new things to combine, and whenever they succeed they expand that space of the possible. They move our boundary deeper into the infinite. In this view growth is limitless, constrained not by resources, but by our imagination and thus our ability to make and do more with less. It is an optimistic rejection of Malthusian and neo-Malthusian gloom. Although Malthus was onto something. He saw dynamics and change. He had processes in mind. So I am with Keynes and his disappointment that economics followed Ricardo and not Malthus.

This thought leads me to another: firms covet information. They actively prevent its spread. They use all sorts of institutional methods to prevent information leaking out beyond their borders. Economics thus has to be institutional in some way, as Veblen well knew. Firms rely on them.

Control of its boundaries is critical to a firm. Information beyond its borders cannot accrue profit. Only information within its boundaries can add value. Setting those boundaries correctly is a major task of management. Insourcing versus outsourcing is the common parlance. Understanding the boundaries and calibrating against the market is what goes on.

But is this correct?

What do firms do with the knowledge they acquire?

They in-form. By this I mean they impose order. They tease order from prior disorder. And by so doing create value. For it is order that we seek. Ordered resources. Only resources that have been accumulated and ordered can satisfy our needs – basic or otherwise. When we consume we extract those resources by destroying the order. This is the entropy that Georgescu-Roegen mentioned. From this persecutive an economy is a fight against entropy. The physical world is dominated by an incessant tendency towards disorder. Things dissipate. They depreciate. Useful resources are scattered and become useless. Only creativity – the creativity embodied in all life – can stave off entropy. Then only locally. Then only temporarily. There is no equilibrium in such a system, only a perpetual fight, a dynamic against disorder.

Think it through: the iron in a motor car is not lost when it rusts in a scrap yard. The iron remains. It just isn’t in a useful form. The in-forming has become dis-formed. The order lost. Thus the value destroyed.

So economics is about learning new ways of imposing order. And it does this in the face of uncertainty. So as our learning produces more complex ways to impose order the economy becomes more fragile, more entangled, more interdependent, and in need of more control to offset those things. Imposing order takes time and space. It takes energy. It takes planning. It requires ever greater control over the process of ordering.

Thus the need for firms.

They are spaces, both physical and logical, within which our practical knowledge is deployed to impose order on resources. This imposition requires energy and skill. Energy can come from labor or it can come from more basic sources. Skill can come from current labor or it can come from the embodiment of past labor. For current capital is simply the ordering – the inheritance and selection of – past learning in the form of useful machinery or equipment. The substitution of labor for capital or vice versa tells us that neither if fundamental. The energy and skill are.

Energy and knowledge deployed to order resources for subsequent disordering. That’s the economic process.

The apparent smooth surface of an economy – the supposed matching of supply with demand – has beguiled us long enough. It is emergent. It belies the seething below the surface. It cannot be predicted by understanding the lower levels. It just is. It is illusory to think otherwise. Building upwards from below does not necessarily end up with the whole. Nor does decomposing the whole necessarily end up with the constituent parts. Supply and demand are an accounting of the contest between creativity and entropy. The artifacts associated with them are important to our understanding of allocation, but not at all to the more fundamental issue of growth.

That is a question of knowledge. Of the institutions and culture needed to exploit that knowledge. And of the way in which we solve problems and add order to our environment.

One last thought: primary and secondary knowledge. They are my way of parsing the total knowledge. Primary knowledge is the replicated and selected part. It is coded. It is thus easily re-used. It is also thus reliable. It is the source of efficiency. Or rather I should say pseudo-efficiency, since in the face of open ended discovery and uncertainty there can be no such thing as certain efficiency. Primary knowledge is what firms embody into the routines that constitute production. Either a machine or labor can perform the routine. It is the routine that is paramount. And a routine is simply a discovered or learned solution to a problem. Firms prefer primary knowledge because of its ease of replication and its reliability. It gives them control within their space over the outcome of the in-forming process.

Secondary knowledge, in contrast, is inefficient. It is more complex. It is the intelligence to solve problems ad hoc. It is thus essential for learning. New problems negate the validity of old knowledge. Novelty – exploring the edge or our possibilities – cannot be discovered, shaped, and made useful without intelligence. And this is where evolution does not help. Our exploration of novelty is directed. It is not random. Chance may play a role, but our exploration is highly contingent on what came before. Innovation is never ex-nihilo. It builds on the foundation. It moves outwards from the center. Nor does innovation take place only at the edge or our knowledge. It can take place deep inside. For discovery is not just of new knowledge, but of new applications for old knowledge. Having a store of intelligence – what I call secondary knowledge – is essential to both forms of discovery. But is is expensive. This is because there is no certainty of outcome.

Primary knowledge replicates old order. Secondary knowledge creates novel order. Business translates novelty into processes consisting of routines based upon innovation. It thus translates secondary into primary knowledge and extracts value by so doing. As long, that is, as the primary knowledge is not superseded by novelty.

Creativity fending off entropy. Knowledge and learning at the heart of it all. Problem solving. Dynamic, constant, unpredictable, and fraught with uncertainty. No direction. No equilibrium. Riven through with asymmetries. The temporary imposition of order on our surroundings so that we can survive and enjoy life.

Economics in the real world.

Or at least that’s what I think.