You use an analogy to biological evolution, so let me continue with this analogy. In biological evolution, every progress is based on mutations and natural selection. So it would seem the more mutations, the higher selection pressure, the more progress, right?
Try this in reality. Take a lot of organisms, perhaps the whole ecosystem, expose them to high radiation (more mutations) and remove many resources (more selection pressure). Will you accelerate the evolution and get the superhumans soon? No. Most probably, all the higher organisms wil die, and you are left with some mutated insects. Unless those die too.
The problem is that to evolve, organisms need mutations and selection, but to survive, they also need... well, survivable conditions. Simple organisms can survive more extreme conditions, but the more complex organisms are more picky.
Back to the economy. Economy consists of humans and their organizations, and humans have limited time and cognitive power. If you have -- an extreme example, to emphasise the point -- thousand types of money, new ones appearing and old ones randomly disappearing every week... you spend all your time and brain power trying to deal with this; you can't get a lot of other stuff done. Yes, it's more experiments on the currency market, but the cost is less experiments on any other market, because all the remaining markets are now taxed by the uncertaintly about money. Perhaps the situation is not as bad as I describe it, and many people can deal with it efficiently. Okay, but even then... many people can't, and those people are prevented to do what they could do otherwise; again, you get less experiments on other markets.
For a complex society to function, you need some mix of freedom and stability. Sure, some people can survive any chaos, either by skills or by luck, but generally, uncertainly is a tax. -- This is not a general argument for any regulation; a regulation can also be stupid and harmful, and probably often is. Just that every change has a cost: other people who used the thing that changed, must now spend time and money just to keep up with the change. So it is good if some fundamental things, used by too many people, don't change too often or too dramatically.
Having read this and the other two related posts, I am downvoting. These are thinly veiled political screeds against central banking, and in my opinion do not contain significant new content. Posts of this caliber and type can be found by the thousands on the internet at large. They do not belong here.
(And so perhaps it’s not entirely surprising that central banking pre-dates economics itself, and is essentially an outgrowth of a feudal institution.
Your history here is weird. The First Bank of the United States (established 1790s) was wildly controversial, and its charter expired in 1811. The Second Bank of the United States (established 1817) was equally controversial and essentially ceased to function as a central bank some time in the 1830s. The modern Federal Reserve was not established until 1913.
If central banking was so established in status quo political thinking, this on-again, off-again political pandering is hard to explain.
Eh. It makes more sense to start the history of central banking with the Bank of England, which was explicitly set up by the government for the government, than in the US. I do agree that the history of central banking in America suggests that the respect that modern economists have for central banking is strange and needs to be explained somehow (but this is sort of the overall point, as I understand it).
There are many things a government might want from a central bank, such as: a place to actually hold the government's money, an entity to print the actual banknotes, an entity to manage the creation of fiat money, an entity to issue government debt, or an institution to manage the government's monetary policy (balancing inflation v. employment).
Explicitly managing monetary policy is the modern purpose of central banks, and many of the other functions I listed are powerful levers in monetary policy. I think one of the author's implicit conclusions from this mini-sequence thingie is that monetary policy need not be centralized in the government's hands.
Whatever else one might think of this conclusion, one should recognize (as the author apparently does not) that the historical usage of institutions of the form "Bank of Country" massively predates the concept of even trying to manage monetary policy. Further, lots of US government monetary policy was heavily debated in times when there was no central bank.
In other words, whatever erroneous monetary policy implicitly implemented by the actions of (say) the Bank of England in the 1700s or by the First Bank of the United States, those errors are not very strong evidence against the modern Federal Reserve as a centralized, government implementation of the balance between inflation and employment level. In short, the quote I challenged was overstating the value of the evidence.
In other words, whatever erroneous monetary policy implicitly implemented by the actions of (say) the Bank of England in the 1700s or by the First Bank of the United States, those errors are not very strong evidence against the modern Federal Reserve as a centralized, government implementation of the balance between inflation and employment level. In short, the quote I challenged was overstating the value of the evidence.
Mmmm. I'm not sure I agree with this, because many institutions have vestigial features, and it's difficult to imagine technological growth before it happens. When talking about the modern American educational system, it is worthwhile to compare the Prussian system to its contemporaries, even though the American system is only distantly related to the Prussian system, because many bad features about the Prussian system are 'in by default', and because the contemporaries may have good ideas that are useful now.
To use the concrete example of free banking, it looks to me like free banks were mostly better for everyone except the government, and so the government outlawed them, and so they don't exist, and because of status quo bias, something that currently doesn't exist in practice can't exist in theory.
It's also difficult for us to imagine the amount of progress that would have happened had they existed. It's not quite fair to compare central banking in 2000 with free banking in 1700 (but several would argue that, even then, free banking in 1700 would win the comparison). We don't know what a free banking that had 300 years to mature would look like; the closest glimpse we have is the problems that were solved by a handful of econ professors thinking about them with more modern tools, whereas central banking has hundreds thinking about how to improve things.
Since I'm already going on the content of the issue, let me present my crude analogy for why I think free banking is better: it's a system of incentives, whereas central banking is a system of experts. Incentives make use of distributed computing like other markets, whereas experts make distributed mistakes. Particularly celebrated ones- like the Fed and the Great Depression- will probably not be made again, but then there's the risk of generals always fighting the last war.
And this is why the original post is not merely political diatribe against central banking. As is true with so much political diatribe, there are real and interesting questions suitable for science and engineering behind them.
Incentives make use of distributed computing like other markets, whereas experts make distributed mistakes.
It's common to find de-centralized dynamic systems displaying ordered behavior -- and sometimes that results in instability and positive feedback.
Markets often display correlated mistakes -- in the case of credit creation, that mistake looks like a bubble, and its [over]-correction can cause a financial panic. Credit bubbles can happen without fiat money or central banking -- consider the US Panic of 1873 or the other mid-19th-century panics that happened while the country lacked central banking and government-issued paper money.
It might be that some alternate banking system damps out such things, but financial instability -- large-scale coordinated mistakes -- happens routinely in systems without central authority.
It's common to find de-centralized dynamic systems displaying ordered behavior -- and sometimes that results in instability and positive feedback.
Agreed, but I don't think I agree with a possible implication of:
It might be that some alternate banking system damps out such things, but financial instability -- large-scale coordinated mistakes -- happens routinely in systems without central authority.
Financial instability is always possible under any system, and so I don't mean to claim that it won't happen under a free banking system. But it's not obvious to me that the potential for financial instability is an argument for centralized banking. One crude model people sometimes use is that there's a tradeoff between frequency and severity of instability, with central banking choosing more severe but less frequent crises.
One crude model people sometimes use is that there's a tradeoff between frequency and severity of instability, with central banking choosing more severe but less frequent crises.
This seems like an empirical question. I don't have any deep background in the history of economics but I had the impression that in the 19th century -- without a central bank -- the US had a number of financial crashes more severe than anything we've had since the Great Depression. Though obviously there are many confounding variables, so I'm not sure how meaningful this analysis is.
Is there relevant data to say that central banks worsen the severity of financial crises, when they happen?
I agree with what you wrote except this:
Explicitly managing monetary policy is the modern purpose of central banks, and many of the other functions I listed are powerful levers in monetary policy.
My understanding is that all the other functions of central banks still very much matter and it's a mistake to point to one aspect of what a central bank does and say "This is The Purpose of the bank!" I would have said that to some extent, the causality goes the other way -- the government needs a central bank even if there isn't a monetary policy or a fiat currency, and that bank then inevitably has powerful influence on monetary policy, and so we might as well be explicit that the bank will manage it.
To give a concrete example, the Eurozone countries have central banks, and those banks are important, even though they don't manage monetary policy.
I got the formatting right! (right?!)
In any case, let me offer a few comments:
So this doesn't fit in very well with the two downvoted-to-oblivion posts I tried before, and that's deliberate. I did the experiment, it failed, and now the thing to do is say oops and move on. I won't try to write an economics sequence here, or anywhere for that matter. Although I am in fact now convinced of the benefits of just forcing yourself to write--the post I have here was a chapter of my book I was struggling to write, and what I have here after a few hours of working from scratch is much better than the weeks I spent producing dreck--it's also clear that the idea of an economics sequence isn't a very good one and not just because I'm a terrible writer. I thought it might work because reading the sequences made me a better economist, and so I thought a sequence on economics might make people better rationalists, and that may well be true, but if it is I don't have anywhere near the ability to pull it off yet.
Still, I did in fact learn quite a lot, for example:
Get to the goddamn point.
Self-taught 20 year-olds cannot just claim to have found a gaping flaw in a centuries-old science and not expect to provoke quite a lot of skepticism
Start with less controversial claims, establish some groundwork and shared background information (while getting to the goddamn point, in a way that appeals to the interests of the audience and their purpose for gathering), then move on to pointing out the gaping obvious holes in a science.
Here's why I decided to post this article to here:
It's a unique, original argument (Well, it's an old argument that belongs to someone else, but the application is new), and without the sequences at LessWrong I probably wouldn't have come up with it. So after my attempt to start a new sequence aborted rather quickly, this is still a way I can share something cool with this site as a way of giving something back to the sequences (oh god that sounds weird). That's why I spend every weekend harrassing Ronald Coase's secretary, trying to get him to read my refutation of the first fundamental theorem of welfare economics (oh yeah that's a thing I did and also I kind of have a history of being like, "I found a gaping obvious hole in economics!")
It's another example of Bayes beating Science (not nearly as good, admittedly, as MW vs CI, but it still is one)
If I persuade you guys (and I so will) it can be another one of those obviously right things LWers believe that makes everyone else think they're a pseudoscientific phyg.
Where else am I going to get smart, quick, highly critical feedback?
I was running out of karma and decided to go for the gusto.
That's why I spend every weekend harrassing Ronald Coase's secretary, trying to get him to read my refutation of the first fundamental theorem of welfare economics (oh yeah that's a thing I did and also I kind of have a history of being like, "I found a gaping obvious hole in economics!")
Given this, you should be more cautious about claims like:
If I persuade you guys (and I so will)
I am willing to bet against that one if we operationalize it with a poll.
I am willing to bet against that one if we operationalize it with a poll.
Microeconomics suggests that if such a bet is to be made it would be advisable to only count votes that also check "make this public" and only count votes from those accounts that meet basic criteria regarding creation date and/or minimum karma.
I found this comment much more interesting than your posts on economics :)
Start with less controversial claims, establish some groundwork and shared background information (while getting to the goddamn point, in a way that appeals to the interests of the audience and their purpose for gathering), then move on to pointing out the gaping obvious holes in a science.
I think you need to decide whether you want to
or
... because people who don't know much about the topic won't be qualified to judge your claims (even with your explanations), and people who know about economics will be annoyed at your low-level explanations.
You could just write one post (in an open thread) about "I have this crazy idea, you need to know about X, Y and Z to understand, I'm not going to bother writing a tutorial, what do you think?". It would be less work for you, and less boring for the audience.
This reminded me of Dennett's review of Penrose's The Emperor's New Mind, in which he mentions that Penrose seems to be doing both these two things at the same time (in physics and computer science, not economics), as a strategy to argue about fundamental points with his colleagues:
This raises a perplexity about Penrose's intentions in writing this book. He repeatedly acknowledges that his colleagues, who already understand the difficult materials he is teaching us much better than we ever will, do not yet accept his idiosyncratic vision. But if he can't convince them, pulling out all the stops, what good will it do if he convinces us with a relatively elementary version? What then? Are we supposed to join in a Children's Crusade to persuade his colleagues to get in step? This cannot be his intention.
I suspect he has a more subtle strategy in mind. When experts talk to experts, they are careful to err on the side of underexplaining the fundamentals. One risks insulting a fellow expert if one spells out very basic facts. There is really no socially acceptable way for Penrose to sit his colleagues down and lecture to them about their oversimplified and complacent attitudes about fundamentals. So perhaps educated laypeople are only the presumptive audience for this book, hostages to whom he can seem to be addressing his remarks, so that the experts--his real target audience--can listen in, from the side, without risk of embarrassment. I think this is a wonderful strategy, perhaps the only way of getting experts who are talking past each other to refresh their mutual understanding of the fundamentals. (It is especially valuable in philosophy.) It may leave the non-experts in the role of spectators, but at least it gives them ringside seats.
A respected insider like Penrose can get away with this strategy (and even so, he failed to persuade almost anyone of his claims) but an unknown outsider cannot. The ideas of this sequence should be presented to economists, at the non-basic level they expect, to seek their criticism and feedback.
Self-taught 20 year-olds cannot just claim to have found a gaping flaw in a centuries-old science and not expect to provoke quite a lot of skepticism.
This post has "Bayes" right in the title and yet it didn't occur to you to think about the prior here? Also, the font's off.
That's why I spend every weekend harrassing Ronald Coase's secretary, trying to get him to read my refutation of the first fundamental theorem of welfare economics (oh yeah that's a thing I did and also I kind of have a history of being like, "I found a gaping obvious hole in economics!")
Not to say you are a crank, but the bit I've quoted reads to me like something a crank would say. If I explain why it might help you present yourself in a less cranky-sounding way.
Refuting a theorem usually means doing one of three things: showing the theorem's invalid (its conclusion doesn't follow from its premises); showing that the theorem, although valid, is unsound (at least one premise is false in practice); or showing that the abstract objects the theorem refers to don't map onto specific things in the real world we care about.
The first fundamental theorem of welfare economics pretty obviously suffers from the last two problems: wholly competitive markets are rare, and the idea of Pareto optimality doesn't capture most people's intuitions of what counts as a very good economic outcome. Chances are, either your refutation is along the same lines, in which case it's true but trivial, or you're taking the alternative route of claiming the theorem's mathematically incorrect, in which case you're probably wrong. Either way it's unlikely your idea is so novel it's worth harassing someone's secretary. Were I in your shoes I'd probably talk in person with economists I know to see what they think of my idea, then try publishing a paper about my idea, and only then make unsolicited contact with famous academics (by sending them the paper, or a pointer to the paper).
Repeatedly trying to get an academic's attention after they've rebuffed you is another warning sign of crankery. (It's not a perfect sign by any means. Sometimes tugging on an academic's coattail until they acknowledge your criticism is the right thing to do; a common example would be when an academic loudly promulgates a theory that's obviously incorrect. But I wouldn't say that's the case here, since Coase didn't co-invent the theorem and I haven't seen him shoving it in people's faces.)
Also, Coase is 102 years old. Trying to monopolize the attention of someone so close to the end of their life is a bit presumptuous.
More generally, if you have "I found a gaping obvious hole in economics!"-type thoughts on a regular basis, they're probably less earth-shattering than they feel on the inside; if a hole is obvious there are likely to be many other people who've noticed it already.
Coase is 102 years old. Trying to monopolize the attention of someone so close to the end of their life is a bit presumptuous.
Although I didn't realize he was that close to the end of his life when I wrote that! RIP.
Maybe I am missing something, but it seems to me that the first half of your post is a celebration of the efficiency of free markets, which would not be controversial at all to most economists. Then you jump straight from that to the superiority of free banking to central banking. If proving the superiority of free banking was so simple, then it would be utterly incomprehensible that most economists do not agree with you. This should give you pause and make you consider that you might be missing something.
(I know you argued in the first post that economists are biased in favor of central banking because it gives them status and power, but I find this explanation extremely implausible. First, only a tiny percentage of economists work for the central bank; second, the same hypothesis predicts that economists should favor centralized government regulation over free markets on other spheres as well, and yet they don't, at least not by the same overwhelming margins they favor central banking.)
As a non-economist, I don't find it difficult to imagine that money, a universal medium of account and exchange, might be different than other goods and work best in a centralized way, even if I do not have the knowledge to articulate why.
Say two firms compete with each other: one sells tulips, and the other roses. Which, if either, is profit maximizing--which is ideal for the current economic environment? Probably neither, but it doesn’t matter; the economy will promote the firm that makes more money and kill the firm that makes less.
This isn't true, any more than nature selects for the best bacteria and eliminates the others. Being pushed into a smaller niche is much more common than dying out.
Here's the quote from Alchian: "those who realize positive profits are the survivors, those who suffer losses disappear."
It's not survival of the fittest, it's approximately the non-survival of the least fit. The reason I'm saying "approximately" is that it's too easy for people to think about fitness as though it's a thing that can be known in specific detail separate from the organism and its environment.
Thanks for the link to Alchian-- I hadn't heard of him, and he does a good job of hammering down hard on the limits of knowledge. I wonder if there are ill effects to the extent that people are trying to do the impossible task of maximizing profit-- I mean not just that they're defecting in some way, but that trying to do something impossible is very wasteful.
Cool, so that's three strikes and you're out. I actually learned a lot in a really short amount of time here, which was the primary goal. I'll be presenting my arguments on this and another project of mine to professional economists in about two months time, something I've never done before, so I'm really glad I got some practice in and got some really big errors out of the way.
Anyway, thanks for the feedback, y'all. This will probably be the last article related to economics I put up for at least for a couple of months, when I should be finished with a different project of mine, something that I would be very amused to share here. Just a little foreshadowing.
You may also want to consider spending some time on Less Wrong discussing issues that aren't about economics. It may help matters to have discussions that don't focus as much on your own particular area of deep interest.
You didn't get to the point by the time I stopped reading the wall of text. Also I believe that empirical studies have shown that factories (or maybe it was mines) with five times the production cost of their competitors stay in business.
t factories (or maybe it was mines) with five times the production cost of their competitors stay in business
For mines, that's very unsurprising: as long as the mineral resources sell for more than production costs it's worth producing. Saudi Arabia produces oil at much lower cost than the marginal well, but it still makes sense to dig new wells. By the same token, small subsistence farmers who have land but can't sell it just earn less than less productive farmers elsewhere.
But you're probably thinking of this post by Robin Hanson, and the 5:1 result is for developing countries undergoing fast catch-up growth (vs 2:1 for developed countries). And it's the worst decile of competitors vs the best, not the worst vs the average.
If you imagine that a 25% cost advantage would let your firm quickly displace all rivals, think again. Yes more efficient firms and plants eventually displace less efficient ones, but it is easy to overestimate the strength and speed of this effect. For example, in a US manufacturing industry with five plants in use, the best plant will typically produce about twice as much with the same inputs (including materials, land, labor, etc.) as the worst plant. In India and China, it will make five times as much: - See more at: http://www.overcomingbias.com/2011/06/selection-is-slow.html#sthash.WfmND8Gj.dpuf
Another robust finding in the literature—virtually invariant to country, time period, or industry—is that higher productivity producers are more likely to survive than their less efficient industry competitors. …
Aggregate productivity growth in the U.S. retail sector is almost exclusively through the exit of less efficient single-store firms and by their replacement with more efficient national chain store affiliates. …
One thing to remember about this is that sometimes lower labor productivity is rational in light of legacy capital investments. E.g. new power plants and factories might require fewer workers, but if you already have the old factory built, you can avoid spending a huge amount of labor building a new factory for a while.
I'm not sure that is what I'm thinking of; I seem to recall something more pessimistic than that, challenging the assertion that the less efficient factories really went out of business. "More likely to survive" != "Much more likely to survive", it may just be a statistically significant 'difference' (was it)?
I'm not sure that is what I'm thinking of; I seem to recall something more pessimistic than that, challenging the assertion that the less efficient factories really went out of business. "More likely to survive" != "Much more likely to survive", it may just be a statistically significant 'difference' (was it)?
What I got from Hanson's post was that people overestimated the speed of selection acting on profitability. Even though one person might be able to produce widgets half as cheaply as the next person, it might take a much longer time than people think for the first person to displace the second person, especially if the first person's lower costs per unit are due to their particular size (such that expanding would increase their costs).
Basically, you need to be actually losing money to go out of business, and even if you're making more money than the next guy, that may not translate to you making him lose money.
It's not clear to me that in a world of free banking, the banks would have incentives to do what's good for the economy. It seems like people would try to get their hands on the most deflationary currency, which may or may not be the one with the best monetary policy.
Oh, the formatting is still wrong, isn't it? Bugger me, I'll try again in 8 minutes I GET IT I'M TRYING TO FIX IT DON'T MAKE THIS DISAPPEAR.
Okay, there is no way that whoever already moved this down to -2 actually read the whole thing. If you guys really hate economics, or me, or talking about anything remotely political even though it's really all very scientific (it's not my fault people build political ideologies and policies around bad economics), JUST TELL ME and I'll stop doing this. My goal isn't to cause distress to the LessWrong community, but without someone explaining how I got downvoted to -2 before anyone could have read the article then I won't know how to stop doing it (whatever "it" is.)
Seriously, I get why you guys didn't like the first two (I didn't either), but you couldn't have even read this one yet.
I did not downvote this post without reading it. However, here are some reasons why people might be downvoting:
In the beginning, before people had quite understood how economics worked, they'd gone around thinking crazy ideas like “Businessmen choose so as to maximize profits” and “Firms set the marginal cost [pay] of their workers equal to the marginal product revenue [output] of their workers.”
Of course people noticed the problem right away: people observably don’t make decisions to do things like maximize profits or set MC equal to MR. Economists responded by saying that people somehow implicitly used rules like “maximize profits” or “set MC equal to MR” as guidelines for behavior.
Then in 1939 a group of Oxford economists decided to test the theory: do firms use “set MC equal to MR” as a rule for setting the pay of workers? They sent out questionnaires to firms asking them how they set their workers’ pay.
The responses they got back were highly disturbing. Firms didn’t know what this marginal cost and marginal revenue business was and they didn’t much care. They used a kind of pricing called “full-cost pricing” which...didn’t make much sense and it’s not very important. What is important is that the results of the questionnaires struck a huge blow to marginalism. Firms aren’t using marginal cost to make decisions!
And so the full-cost pricing controversy was born.
There was a huge debate in the profession. Was marginalism wrong? Were firms not profit-maximizing entities? Some of the greatest economic minds of that generation took part in the debate. But for all their effort there didn’t seem to be any satisfactory way to explain the data that would also preserve most of the advances in economic theory since the 1870s.
Then Armen Albert Alchian, the 1000 year-old vampire of economics, entered the fray. In eleven elegant pages he ended the debate and changed economics forever.
Alchian pointed out that it is only in a world of certainty and perfect foresight that people can choose to maximize profits or set MR equal to MC. Neither of those things are actions, they are outcomes--there is no button you can press to maximize profits or set MR equal to MC. In the world of certainty and perfect foresight, however, there may as well be a button--you can just look down all the paths your different actions lead to to see which path leads to the highest profits. It’s easy, for someone with certainty and perfect foresight.
But in reality, there is uncertainty and imperfect foresight. Imperfect foresight means that the button pressing-equivalent of looking down all the different paths you can take to see which one leads to the highest profits is not possible.
Uncertainty means that when you consider the consequences of your choices, you don’t face a single potential outcome but rather a distribution of outcomes, and furthermore, that distribution overlaps with the distribution generated by other actions. Uncertainty is a consequence of the immense complexity of the economy, which is made of an uncountable number of ever-changing parts. And in that case, “maximize profits” or “set MR equal to MC” is in no way a useful guide to action. There is a single maximizing outcome but you can’t choose that. You can only choose different distributions, and because the distributions overlap, there is no maximizing distribution. There is an optimal distribution, whichever distribution you happen to prefer, but maximization is out as a guide to action.
So what is to become of economic theory if firms can’t choose to maximize profits and set MR equal to MC?
Not to worry, Alchian said. That’s what the economy is for.
The economy is competitive. That means there is a set of criteria which the economy selects for. Firms with that criteria are promoted and firms without that criteria go out of business. Yes, just like evolution by natural selection; the economy is evolutionary.
Alchian pointed out that what the economy selects for is realized positive profits. Basically, that means the economy promotes the firms that make more money than their competitors. Firms that make less money than their competitors go out of business--they die.
Those realized positive profits are achieved by the firm that is best adapted to its environment, in exactly the same way that those organisms which reproduce successfully are best adapted to their environments. Therefore the competitive economy, by directly selecting for realized positive profits, indirectly selects for the firms which do the best job of solving the economic problem they are presented with.
What that means, Alchian realized, is that you don’t need any individual in the economy doing anything particularly “economic” like trying to maximize profits or set MR equal to MC for the economy itself to achieve exactly that. You can have people with zero foresight, and as long as they can just try all kinds of things, the economy will select for the firms that do the best job of approximating the characteristics best suited to the environment.
Say two firms compete with each other: one sells tulips, and the other roses. Which, if either, is profit maximizing--which is ideal for the current economic environment? Probably neither, but it doesn’t matter; the economy will promote the firm that makes more money and kill the firm that makes less. The plans and rationales of the two different firms for their actions are irrelevant.
Two more firms go at it: one tries to somehow achieve “full-cost pricing” and the other tries to somehow set MR equal to MC. Alchian’s point is that neither firm actually knows that it can accomplish its goal with its chosen strategy. The economy will choose the firm which makes more money, which is the firm better suited to the environment, and the economy will kill the firm that makes less money.
What Alchian’s analysis shows is that you can have an economy full of people who just make silly decisions for no rational reason and still have rational economic outcomes if the competitive economy selects for those outcomes. What economists had thought is that firms adapt themselves to the economy, but Alchian showed that it is more like the economy which adapts firms to it. And thus, “consistent success cannot be treated as prima facie evidence against pure luck!”
Marginalism is saved! The full-cost pricing controversy has ended. People don’t need to maximize profits or set MR equal to MC as long as the economy selects for realized positive profits and having MR set equal to MC a characteristic of a firm ideally suited for the given economic environment.
What no one realized at the time, not even Alchian, who was soon busy using the stock market to figure out which materials are used to make nuclear bombs, is that Alchian’s argument destroys the case for central banking.
Let’s consider central banking versus free banking from this angle: which system has greater science power, i.e., if we think of the economic environment as posing a problem to the two systems, which system is more likely to solve that problem?
The power to solve a problem comes in two steps: generating hypotheses, and testing hypotheses.
Free banking generates hypotheses by, well, letting people try whatever they please. But it’s not quite as random as that, or nothing would ever be accomplished. Just as in evolution by natural selection, as long as the environment has not changed too dramatically, using what already exists as the starting point allows you to cut a long way through the search space to a hypothesis not extremely far from the most correct answer.
But people are smarter than evolution. They don’t just have to stop with what they are currently experimenting a mutation on. They can look at the past or at other industries for inspiration. They can also use their own insight to cut even farther past the answer the economy has already produced. This results in failures, certainly, but also in brilliant innovations at a rate and scale evolution by natural selection cannot match.
That is how free banking generates hypotheses: dozens, hundreds, or maybe even thousands of hypotheses, some big, some small, are constantly being proposed, where proposed means the number of hypotheses submitted for testing. They use the given answer as a starting point and use their own knowledge of changing economic conditions, past and parallel evidence, and their own insight to go even further. This is a very different and superior system to evolution by natural selection, which simply takes the current hypothesis and tries a small random change. It can’t look at past or parallel hypotheses and the change is random since no intelligence is applied.
Now compare this to how central banking generates hypotheses. Central banking, like free banking, can only propose as many hypotheses as it is able to test, which is much smaller than what free banking can do both because central banks want to experiment less and because there are fewer of them to begin with.
Central banking can’t match free banking’s rate of hypothesis generation, but if central banking can generate hypotheses as good as the best free banking hypotheses with fewer hypotheses, that’s actually a point in central banking’s favor--it’s more efficient with its hypotheses. But central banking probably can’t do that. That’s simply because central banking, like free banking, can’t go much farther in its hypotheses than by looking at what it is already doing, what it has done, and what other central banks are doing parallel to it. But the range of hypotheses attempted by the central bank is much more limited than free banking. You simply can’t try as many different kinds of things with a central bank. The consequences of a central bank filled with experimental spirit would be disastrous. Central banking could only outperform free banking if it started out much closer to the most correct hypothesis than free banking did. But that is extremely implausible. To see why we have to go back to Alchian.
In the real world of uncertainty and perfect foresight, central banks can’t just press a button setting inflation, unemployment, and economic growth at the desired levels.
(Although you might wonder if something like the Mind Projection Fallacy doesn’t occur when economists play at being central bankers. The individuals in the model might not know everything about their small world but the modeler, the economist certainly does, and so in his model the solution will be obvious to him, and if he doesn’t realize that that’s a fact about his mind and not about the world, then he would be overconfident in the central bank’s foresight and ability to achieve its goals by the decision-equivalent of button pressing)
What central banks actually face is a set of overlapping distributions of outcomes with no maximizing distribution due to the extreme complexity of economy. There is no certain or clear path to the goals of the central bank.
Free banking also faces this problem, but there are two key differences.
The first key difference is that free banking is much more decentralized than central banking. A more decentralized system means that the problems the individuals are trying to solve are much smaller and simpler (although still possibly very large and complex), and the problem-solvers have more information about the problem. It’s a smaller problem and they are closer to it. The more centralized system faces a more complex system and has less information to solve it with. Free banking is thus more likely to generate some hypotheses that are better than what central banking produces.
The second difference has to do the relative ability of free and central banking to test their hypotheses, the second aspect of scientific power.
Alchian showed that even if individuals want to maximize profits and set MR equal to MC, in a world of uncertainty and imperfect foresight the idea of choosing to maximize profits simply doesn’t make sense. The economy is simply too complex for people to adapt themselves to it very effectively. But that doesn’t matter, because the economy adapts people to it. The economy selects for the firms with realized positive profits, which is to say, firms which are relatively well-suited for the given environment, and the economy kills the firms which are relatively unsuited for the given environment.
In other words, the market economy tests hypotheses. All those hypotheses constantly generated by free banking are subject to a brutal, merciless test: the test of survival in the marketplace. It is this constant, terrible series of tests that allows market economies to produce outcomes that economics can explain and predict when economics has very little ability to explain or predict individual behavior.
This is free banking’s greatest advantage over central banking, because central banking does not test its hypotheses. The central bank does not profit for generating a good hypothesis and it does not die for generating a bad one. The central bank does not face the trial, the test, the selection.
Imagine a group of biologists who created a few types of organisms which they intended to be well-suited to some environment, and then never released those organisms into the environment to subject them to evolutionary pressures. They would have no way of knowing which organisms were better suited to that environment and which weren’t. Scientific power depends strongly on whether you can do the test. People who can’t test their hypotheses don’t get very far with them.
The different quality of the tests free and central banking subject their hypotheses too brings us back around to their relative ability to generate quality hypotheses. Both rely on looking at what they are already doing and have done to serve as a starting point for new hypotheses, but the difference is that free banking’s starting point is a starting point forged in the furnaces of scientific testing, and central banking’s starting point is pretty much whatever central banks happen to be doing, which may appear to be working or not. If it does appear to be working, uncertainty means there is no way of knowing whether that is sheer luck or if the hypothesis is actually a good one. Free banking has a powerful test, however, for determining its surviving hypotheses and so can be more confident that its surviving hypotheses are actually good.
The verdict is clear: the scientific power of free banking is dramatically superior to that of central banking. Free banking generates a larger quantity of hypotheses, the most accurate of which are more accurate than the hypotheses central banking generates, and then goes through a much more exacting testing process which kills off the bad hypotheses and rewards the good ones with profits. Central banking, on the other hand, is left wondering if any success it is seeing is because of the good hypothesis or sheer dumb luck, because there is no trial, no test to distinguish.
You might notice, at the end of all this, that the process free banking goes through to adapt and be adapted to the environment closely resembles the scientific method. People come up with hypotheses that seem smart to them based on what they know about past results, and then they do the experiment. The hypotheses that pass the test are promoted and the hypotheses that fail are discarded.
Central banking, on the other hand, more closely resembles armchair philosophy of the sort that science rebelled against centuries ago. A small number of very smart people are supposed to figure the world out largely by thinking about it. Sure, they have reams of data and theory, but so did Aristotle (hey, every time he looked outside he was receiving all kinds of data). Aristotle’s weakness was that he didn’t do experiments, not a lack of access to data or raw intelligence. By the same token, central banking’s weakness is its inability to test its hypotheses.
(And so perhaps it’s not entirely surprising that central banking pre-dates economics itself, and is essentially an outgrowth of a feudal institution. Whereas in every other industry there were significant movements in the past several centuries towards the ending of privilege and monopoly, the freeing up of competition and trade, central banks maintained their monopolies and privileges and even were established in countries that had previously lacked them. And so the methodology of central banking is still essentially pre-scientific.)
This isn’t the end of the argument, of course. There are all kinds of obstacles to successful coordination in a free banking regime (for example externalities, predatory pricing, information asymmetry), but then again the same is true in a central banking regime (for example terrible incentives, lack of Hayekian information, political interference). At best for the case for central banking, these kinds of problems on net wash out.
Which means, given how much stronger free banking is as a scientific process than central banking, that free banking wins outright, even though I can’t do the experiment to prove it. It’s simply a much more plausible hypothesis.
(This is not a defense of free banking. Nothing in this argument establishes that free banking is the best banking regime, and I do not intend to present that argument. It isn’t interesting to me. But this argument does show that if you want an alternative to free banking, that alternative can’t be central banking.)
And it’s so ironic, that for all the desire economists and laypeople have expressed over the years for a scientific alternative to capitalism, that a competitive market economy is the embodiment of the scientific method in the global economy, working on a scale beyond the current abilities of any scientist or team of scientist to solve problems that the world’s best economists cannot even begin to solve in their entirety.