The rediscovery of classical economics adaptation complexity and growth

The point is that conventional equilibrium theory provides policy makers with a poor understanding of how a market economy actually works.. As we shall see in Chapter 10, the present sta

The Rediscovery of Classical Economics

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Preface vi

Bibliography 195

Index 206

A book so long in the making generates many debts of gratitude Among

those who have provided me with help and encouragement at various

stages of its writing are Fessal Bouaziz, Asa Briggs, Ian Byatt, Phoebe

Clapham, Michael Fry, Gavin Kennedy, Brian Loasby, Alan Peacock,

Colin Robinson, Jim Stretton and John Thomson, as well as an

anony-mous researcher at the Royal Economic Society There are many others

whom I may have overlooked I thank them all most warmly for their

individual contributions, moral as well as intellectual I should also like

to thank my editors, Matt Pitman, Jo Betteridge, Sarah Cook and Jane

Bayliss, as well as the staff of the Reading Room at the National Library

of Scotland

A special word of thanks must go to Neil Menzies who read some early drafts and tirelessly prodded me whenever my concentration wavered I

am particularly grateful to Jim Walker, once my student, now my teacher

He is living evidence that classical economics really works Above all, I

am deeply indebted to my wife Judy for her forbearance during so many

absences of mind and for her active support at critical times Without that

support, this book could not have been written

Tyninghame, East Lothian

January 2013

This book is for Judy, who made it possible.

Two roads diverged in a wood, and I,

I took the one less traveled by, And that has made all the difference.

Robert Frost The Road Not Taken

economics, the paradigm that has dominated the mainstream of economic

thought for the best part of a century.2 That alternative is what may be

called classical economics, namely the intellectual tradition that began

with Adam Smith, evolved in the nineteenth century, was continued in the

twentieth century by Marshall and the Austrians amongst others, and is

today represented by theorists of complexity

The hallmarks of the classical tradition are principally three The first

is the belief that the growth of the economy, rather than relative prices,

should be the principal object of analysis Coupled with that belief is

an understanding of the market economy as a collection of processes of

continuing change rather than as a structure, and that the nature of this

change is self-organising and evolutionary Finally there is a conviction

that economic activity is rooted in human nature and the interaction of

individual human beings Many people might suppose from the similarity

of the terms ‘classical’ and ‘neoclassical’ that the one school of economic

thought is closely related to the other In fact, as this book will try to show,

they are more nearly exact opposites.3

We need an alternative to conventional equilibrium economics because

it does not provide us with a good understanding of how the economy

works Equilibrium theory is essentially a mechanistic metaphor.4 The

progressive refinement of the theory during the twentieth century was

intended to deliver determinacy of solutions together with simplicity of

structural form This has been achieved in principle, but at the cost of

such drastic simplification of assumptions and the exclusion of so many

important elements of economic activity that the resulting theory has little

correspondence with reality It is not surprising therefore that it has been

useful neither for prediction nor for explanation

This is particularly harmful for policy makers The importance of real

world phenomena that cannot be accommodated within the structure of

static equilibrium analysis is frequently overlooked or downplayed The

arrival of the recession of 2008‒2010 took Treasury officials and central

bankers on both sides of the Atlantic by surprise They had been almost

unanimously agreed that, thanks to their policies, from around 2000

onwards the Western world had entered a new era of stability and growth

that would last indefinitely Furthermore, recovery from the recession has

proved unexpectedly resistant to orthodox policy measures It is difficult

to separate these policy failures from the conventional equilibrium theory

on which they were based.5 Surely it cannot be a coincidence that the

study of business cycles was displaced from the academic curriculum by a

version of static equilibrium theory called macroeconomics? Although a

return to sustained economic growth is desperately sought by politicians

throughout the Western world as they struggle to balance their books and

provide their voters with jobs, little is heard about the contribution that

capturing increasing returns might make to this objective, perhaps because

increasing returns do not fit easily into the static equilibrium model

Such basic issues as free trade and protection and the market versus state

management appear to divide opinion in the profession as much as ever

Competing solutions to these and other policy questions remain

intellec-tually not much further advanced than Adam Smith left them (Kennedy

2008: 2) Many other examples can be cited The point is that conventional

equilibrium theory provides policy makers with a poor understanding of

how a market economy actually works

Equilibrium theory has focused the attention of academic economists

on issues surrounding the efficient allocation of a given set of resources

amongst a number of competing uses at a single moment of time While

such questions have engaged the best brains of at least two generations in a

number of intellectual conundrums,6 it has diverted them from an analysis

of those features of a market economy that have impressed themselves on

human history

There is first of all the ability to sustain growth in aggregate tivity over long periods of time This is a unique feature of the market

produc-economy: no other form of economic organisation has been able to deliver

sustained increases in living standards for masses of people The poorest

citizens of a rich country today are materially better off than their

wealthi-est compatriots of a hundred years ago, and immeasurably better off than

mediaeval kings and princes

Another characteristic feature of market economies is the periodic tuations in total output and employment that have been apparent since

fluc-at least the beginnings of industrialisfluc-ation A third fefluc-ature is the system

of markets itself, with its associated sets of prices But perhaps the most

striking feature of the market economy, distinguishing it from other forms

Introduction 3

of economic organisation, is the fact of incessant change New goods in a

bewildering variety are added every week to the shelves of our

supermar-kets We have come to expect continuous improvement in the quality and

technical specification of both producer and consumer goods We take for

granted constant novelty in the various forms of communication,

comput-ing and entertainment services that we are offered

For economists, it should be important to be able to explain these

phenomena: the process of growth in productivity that has brought about

our rising living standards, the origins and development of the business

cycle, the nature of markets and the processes of change But on all these

questions, equilibrium theory is silent.7 It is difficult to exaggerate the

inappropriateness of using the concept of ‘equilibrium’ to try to analyse

a market economy.8 Equilibrium means being at a state of rest A market

economy is never at a state of rest It is essentially restless, as Marshall

understood (Metcalfe 2006: 651)

As we shall see in Chapter 10, the present state of equilibrium theory is

the culmination of a century long digression in the academic teaching of

economics from the classical tradition, using linear algebra in pursuit of

the illusion of becoming a ‘hard science’ (Mirowski 1989), accompanied

by the marginalisation of important cognate disciplines like economic

history and the history of economic thought Equilibrium theory has

dif-ficulty in either explaining or predicting movements in a market economy

These difficulties arise from the limitations imposed by its assumptions

and omissions, limitations that make equilibrium theory ‘difficult, if not

impossible, to relate to empirical reality’ (Colander 2009: 416) There are

three critical assumptions

The first assumption made by equilibrium theory is that the economy is

static The configuration of the economy is analysed at a single moment

in time If change is to be investigated the most that can be hoped for

is a comparison between two static equilibria A and B, before and after

the notional change The path by which the economy moves from A to

B cannot be analysed The implication is that adjustment is

instantane-ous and costless To put it another way, the question of how resources

became allocated the way they are is resolved before the analysis begins

Equilibrium theory ignores the market process by which the state of affairs

is brought about that it simply assumes to exist

The logic of choice may be appropriate for the analysis of individual

action The preferences of one individual together with their knowledge

of the relevant facts determine a unique solution But the analysis of

individual choice cannot legitimately be extended to a market process

in which the decisions of several individuals influence one another, their

actions and reactions succeeding each other in time Once we allow for the

behavioural interdependence of individual consumers and producers, the

inadequacy of the static equilibrium model of the market process becomes

clear (Samuelson 2006: 244) The problem then becomes one of how the

data for each individual, on which they base their different plans, are

adjusted to the actions of other people It is precisely this process of

adjust-ment on which complexity analysis focuses its attention It is a dynamic

self-organising process whose nature and characteristics are assumed away

by static analysis Market equilibrium assumes that the data for different

participating individuals have been fully adjusted to one another, but does

not tell us how this was brought about (Hayek [1948] 1980: 93‒94)

From the perspective of equilibrium theory, the essential economic problem consists in allocating the scarce resources of society amongst

consumers as efficiently as possible, given everyone’s preferences and the

available technologies and resources To make possible a determinate

solution to this problem, it is assumed that there is a single global stock of

knowledge that is freely accessible to all participants in the economy This

stock includes knowledge of all prices, future as well as present, of all

tech-nologies, and of all possible investment opportunities and their outcomes

The prior problem of how all this knowledge can be known to one mind or

can somehow be collected in one place is simply assumed way This is the

second critical assumption of equilibrium theory

In practice, the knowledge that is put to work in a market economy

is widely dispersed Different people know different things, and what

they know is largely subjective and incomplete, and often tacit or

con-tradictory.9 The progress of the economy means that new commercial

knowledge is constantly being discovered The real economic problem

is therefore this: how can all this dispersed knowledge, new as well as

existing, be discovered and communicated to all the different participants

in an economy? To put it another way, how can the range of diverse and

specialised economic activities that make up a market economy be

coor-dinated in a tolerably effective manner? The actions of every participant

in a market economy are guided by a common set of prices, prices being

signals that abridge knowledge of what is happening in different markets

If they are to be reliable guides to action, prices must be generated by

markets.10

There is a fundamental difference between the way prices are determined

in equilibrium theory and in classical theory In equilibrium theory

pro-ducers and buyers are assumed to know in advance the lowest cost at which

a commodity can be produced Classical theory believes this information

will only be discovered by a market process of competition Likewise, in

equilibrium theory producers are assumed to be fully informed about the

preferences of consumers, including the kinds of goods they would like

Introduction 5and the prices they would be willing to pay for them Classical economists

would regard this kind of knowledge not as given data, but as facts that

can only be ascertained through competition (Hayek 1948: 95)

The distinction between the two approaches to the nature of knowledge

in a market economy is more than academic It came to have immediate

practical importance with the establishment of a planned economy in the

Soviet Union in the 1920s Marx and his immediate followers had shied

away from the question of how economic activity in a socialist state would

be coordinated Early critics argued that without market prices it would

be impossible to achieve any remotely rational allocation of resources

Socialist economists like Oskar Lange argued to the contrary that a central

planning authority could gather enough information to compute prices

centrally for handing down to factory managers, and that once sufficiently

powerful computers became available the problem would be solved This

was disputed by Hayek, Mises and others who argued that the dispersed,

subjective and fragmentary nature of economic knowledge meant that the

problems of acquiring, centralising and communicating it in a command

economy could not be overcome A vigorous debate, now known as the

socialist calculation debate, ensued in the academic journals in the 1930s

(Hayek [1948] 1980: 119‒209) The debate was definitively resolved by the

collapse of the Soviet Union in 1989, the political system being brought

down by the inability of the planned economy to deliver either the

increas-ingly sophisticated range of goods desired by consumers or the advanced

defence equipment required by the military Given the similarity of the

assumptions made about the nature of economic knowledge by

equilib-rium theorists and by the proponents of central planning, the implications

of this episode are significant

The third critical assumption of equilibrium theory is that of rational

behaviour It is assumed that consumers and businessmen use the perfect

knowledge that is believed to be at their disposal in a consistent and

calculating manner to make optimising choices It is implicitly assumed

that their brains have the power to absorb and process all the available

information, unclouded by cognitive biases Even stronger assumptions

are required to justify the so-called ‘rational expectations’ approach that

dominates equilibrium macroeconomics Here, it is additionally required

that every market participant shares a ‘true’ model of how the economy

works and is able to use that model to form identical expectations about

the future path of the economy All other participants have identical

beliefs and information and therefore share the same view of the future

It is self-evident that such assumptions do not reflect the reality of a

world of conflicting opinions The assumptions need to be relaxed in one

or both of two directions One is to allow different agents to form different

expectations, and the other is to allow agents to form their expectations

over time in the light of experience It seems plausible that people form

their own understanding of how an economy works through a

learn-ing process involvlearn-ing the social transmission of information and ideas

However, the most casual observation suggests that people do not share a

common view of the working of the economy, whether that is a true one

or not We live in a world of conflicting opinions and forecasts, where

individuals act differently Only after actions have been taken do we learn

who was (more nearly) right, and who was (more nearly) wrong Despite

this, ‘rational expectations’ remains the predominant assumption about

expectations formation in the contemporary literature of equilibrium

theory Why is this so? Presumably for reasons of analytical convenience

Choosing assumptions to fit a model rather than the facts does not seem

to be a scientifically satisfactory procedure.11

Many other restrictive assumptions are commonly made by equilibrium theory in order to achieve determinacy, an important one being the con-

vexity assumption that effectively rules out increasing returns, but these

three are the important ones

Also important in understanding the limitations of equilibrium theory is

an awareness of what is left out Institutional, social and political factors

are generally excluded The result is that those who interpret economic

events from the perspective of equilibrium theory will typically give undue

weight to those factors that are quantifiable, and underestimate the

influ-ence of unquantifiable ones The historical context of events is likewise

frequently discounted in equilibrium analysis, general influences being

emphasised at the expense of the particular

Even more damaging than the omission of institutional factors is the omission of the human factor The absence of change and uncertainty in

equilibrium economics means that there is no scope for entrepreneurship

Likewise, there is no place for human emotions like fear and greed that

play their part in forming expectations and levels of confidence Nor for

the emotions that drive economic growth like ambition, curiosity, or an

altruistic desire to serve humanity (Mokyr 2006: 311)

Many economists recognise that equilibrium theory is remote from the practical issues that confront them, but they are reluctant to let go of it

because they value its logical rigour, and cling to the principle of

determi-nacy Their standard defence is familiar:

1 A market economy behaves ‘as if’ the assumptions of equilibrium

theory were true

2 Only predictions matter, not explanations Therefore it doesn’t matter

if assumptions are unrealistic

Introduction 7

3 Evolutionary selection will eventually drive outcomes to the optimal

equilibrium, because good outcomes will drive out bad ones

The rejoinder to these points is straightforward (1) There is no persuasive

evidence in favour of this proposition On the contrary, most markets are

evidently out of equilibrium most of the time (2) The purpose of theories

should be to explain, rather than to predict Even if we were to accept the

criterion of prediction, economic forecasts based on equilibrium models

have invariably performed badly (3) Simulations show that only with

certain parameter values do complex systems converge to equilibrium

There is no guarantee that that equilibrium will be an optimum The

con-clusion must be that equilibrium theory is irrelevant to an understanding

of how a market economy works (Kaldor 1972)

The story of the development of economic theory since Adam Smith is

seen by equilibrium theorists as a search for an ever more formal structure

The search was so keenly pursued that the formal structure became an

end in itself, and its ultimate purpose was lost sight of The story has two

aspects In the first, society looking for a theory of growth was fobbed off

with a theory of value (Robinson 1966) In the second, the achievement of

formality, simplicity and elegance of theoretical structure was bought at

the cost of making such drastic omissions and such simplistic assumptions

that all connection with empirical reality, that which is to be explained,

has been lost The theory cannot explain anything of importance about the

contemporary market economy, nor does it contribute to an

understand-ing of how that economy works

Equilibrium theory has got away with this because, until quite recently,

there was no other competing theory of comparable formality and

sim-plicity Now there is The rival theory has greater explanatory power,

and offers new insights into how the economy works It has the great

advantage that it is not a static theory but a dynamic theory, it deals with

processes not structures, and it is does not require assumptions about

states of equilibrium It is therefore well-suited to addressing questions of

growth and fluctuation, the big questions of a market economy

None of the foregoing criticisms of equilibrium theory is original It has

been necessary to rehearse them in this introductory chapter in order to

clear the ground for the alternative that is expounded in the main part of the

book If the present work has any originality it lies in emphasising the

con-gruence of the economic applications of complexity theory with many of

the strands of thinking represented by the Austrian school, itself a

continu-ation in the twentieth century of the older classical tradition in economic

thought Taken together, these three apparently disparate schools form a

single continuous line of thought that can justly be termed ‘classical’.12

While the earlier Classical School is usually said to have ended with J.S Mill, I shall apply the term ‘classical’ to an intellectual tradition that

has been continued up to the present day by a number of economists of

whom I shall single out Marx, Menger, Marshall and Allyn Young as

well as Schumpeter and Hayek More recently, the classical tradition has

been continued in the writings of Boulding, Kaldor, Shackle and Loasby,

amongst others Let me repeat the three principles that can be said to

characterise this tradition:

The first is that classical economists believe that economic growth, not the theory of value, is the primary issue with which economic analysis

should be concerned Since growth means change, classical economics

analyses processes of change, not structures or end states

The second principle of the classical tradition is recognition that the nature of change in a market economy is self-organising and evolutionary

Change is seen as beginning with individuals adapting their behaviour,

then spreading throughout the economy from the bottom up as a result

of further adaptation on the part of other individuals and businesses A

self-organising process is one where the interactions among the individual

elements of a group lead to patterns of behaviour at the aggregate level of

the group as a whole that are different from, and cannot be predicted by,

the behaviour of the elements themselves Self-organising processes are

pervasive in market economies In the classical view, economic activity

is an irreversible process that takes place in historical time: it involves

qualitative as much as quantitative change Change is determined largely

by factors occurring within rather than outside the economy, so a market

economy is also an evolutionary process

Thirdly, classical economists recognise that a market economy is an ever changing assembly of relationships among individual human beings An

understanding of human motivations and beliefs must therefore be central

to any economic analysis

The differences between classical theory and equilibrium theory can be summarised in the following terms Classical theory focuses on change and

growth within open, dynamic nonlinear systems that are normally far from

equilibrium Equilibrium theory, on the other hand, analyses the theory of

value13 within closed, static linear systems that are always in equilibrium

As to the essential nature of economic activity, classical economics makes

no distinction between micro- and macroeconomics Patterns of activity at

the macro level emerge from interactions at the micro level Evolutionary

processes provide the economy with novelty, and are responsible for its

growth in complexity In equilibrium theory micro-and macroeconomics

remain separate disciplines; there is no endogenous mechanism for the

creation of novelty or growth

Introduction 9The behaviour of human beings in classical theory is analysed individu-

ally People typically have incomplete information that is subject to errors

and biases, and they use inductive rules of thumb to make decisions and

to adapt over time Their interactions also change over time as they learn

from experience In equilibrium theory, individual behaviour is assumed

to be homogeneous and can be modelled collectively It is assumed that

humans are able to make decisions using difficult deductive calculations,

that they have complete information about the present and the future, that

they make no mistakes and have no biases, and therefore have no need for

adaptation or learning (Beinhocker 2006: 97)

In the following chapters we shall try to show that the classical

perspec-tive provides a better understanding of how market economies work than

does equilibrium theory We begin with human behaviour in Chapter

2 It is sometimes forgotten that all economic activity is the result of

human actions that depend in turn on the different and variable motives

and beliefs of millions of individual human beings Human knowledge

is at the root of the growth of output Human qualities like judgment,

perseverance and leadership lie behind every successful business, while

human weaknesses have brought about some spectacular market failures

Markets are moved by changes in expectations, while human emotions

like greed and fear drive cycles of prosperity and recession The way

humans interact with one another is different from the behaviour of other

animals and even more different than the behaviour of physical particles

when they collide with each other Human behaviour therefore needs

to be modelled differently from natural phenomena Within the broad

class of complex adaptive systems, there is a hierarchy of behaviours of

increasing complexity Biological phenomena are more complex than

physical phenomena, and human behaviour is more complex still A

market economy therefore needs to be distinguished from other types

of complex systems and treated as a separate class, namely as a human

complex adaptive system

It is the restless nature of human beings that is chiefly responsible for the

relentless and incessant change that we see manifested in every developed

market economy Novelty and continuous improvement in technology

and in the quality of consumer and capital goods is one of the

distinguish-ing features of a market economy, and it requires explanation This is the

subject of Chapter 3

Changes in economic activity originate from initiatives by

individu-als The changes their actions set in motion compel responsive changes

on the part of other people In other words, they adapt their behaviour

Individuals and businesses in market economies learn to adapt their

behav-iour largely by processes of trial-and-error; they learn from experience

They do this for the simple reason that they lack the knowledge to do

oth-erwise An important part of the changing environment to which they are

responding is simply the changing behaviour of other market participants

Adaptation leads to the emergence of new patterns of behaviour that

eventually permit a growth in total productivity From this perspective,

the benefit of a market economy may not be so much its efficacy in the

allocation of resources at a moment in time, or even their efficient

alloca-tion over time, but rather that, more than other forms of organisaalloca-tion, it

facilitates adaptability or adjustment to change Adaptation, emergence

and evolution are discussed in Chapter 4

The adjustments that take place in a market economy are mutual and voluntary There is no control exercised from the top down either

from within or from outside the economy From mutual adjustments

in behaviour at the micro level, there emerge, through intermediate

layers of similar actions, discernible patterns of activity, irregular but

persistent, at the level of the economy as a whole Those relatively stable

patterns, those  modest but apparently steady changes that we observe

on the surface of most economies are the outcome of incessant and

frequently disruptive, interactions taking place below the surface This

fits the description of a self-organising system, or, in modern parlance, a

complex adaptive system The vision of an economy as a self-organising

system can be traced back to the classical economists of the eighteenth

century, and even earlier.14 But it has been substantiated by some recent

advances in applications of nonlinear mathematics Chapter 5 reviews the

properties of self-organising systems and their implications for economic

analysis

In the next four chapters we use the concept of self-organisation to understand some of the characteristic features of a market economy In

Chapter 6, we show how markets themselves are best understood as

self-organising processes that perform the vital functions of price discovery

and product selection Only when markets are treated as processes can we

make sense of competition and entrepreneurship Markets have evolved

over a long period of time, and are still evolving

The sustained annual increments in total output per head that we associate with market economies are the result of another self-organising

process, the process of economic growth In Chapter 7 we show how trade,

a distinctly human characteristic, sets in motion a process of increasing

specialisation of economic activities that results in sustained increases in

productivity When the higher profits and wages accruing from those

pro-ductivity gains are spent they lead to an expansion of purchasing power

in the economy as a whole This increases demand somewhere which

will justify a further degree of specialisation in that part of the economy,

Introduction 11raising total productivity still further, and so on in a cumulative spiral of

growing productivity and incomes

Another distinctive pattern to be seen in industrialised market

econo-mies is that periodic fluctuation in total output and employment known

as the business cycle A recent study identified no fewer than 148

occa-sions since 1870 where a country experienced a cumulative fall in output

of at least 10 per cent (Barro and Usua 2008) Each of these episodes

differs from one another in several ways They are triggered by different

events, and the industries principally affected may be different Nor can

any statistical regularity be detected in the frequency, amplitude or

dura-tion of each cycle It may therefore be more appropriate to think of such

fluctuations as having a recurring pattern, rather than forming a cycle, a

term that perhaps implies too great a degree of regularity In Chapter 8 we

analyse the common pattern that is discernible in most economic

fluctua-tions It, too, has the characteristics of a self-organising process

Market economies, like the societies of which they are part, are often said

to operate within a ‘framework’ of institutions But the rules of behaviour

of societies including formal laws as well as social norms, together with the

organisations that embody them such as markets and governments, evolve

gradually over time Most of today’s business practices are the outcome

of a long and continuing process of cultural evolution The classical

economists were well aware that most of the important institutions of their

society were the product of evolution rather than design It might seem,

on the other hand, that contemporary institutions, such as banking laws,

owe their existence to acts of deliberate collective decision making Surely

they cannot be said to have evolved? On closer examination, however, it

turns out that legislation also evolves Like individuals and businesses,

governments progress by trial-and-error The functions of government are

the subject of Chapter 9

Chapter 10 traces the continuity of classical thought from the older

classical school through the work of Menger and his twentieth century

followers to contemporary theories of self-organisation as reflected in

the analysis of complex systems It is widely supposed that the analysis

of dynamic nonlinear systems originated quite recently in the natural

sciences, and in the mathematical sense that may be correct However,

the principles of self-organisation to which the mathematics gives

expres-sion were identified much earlier by social scientists When the results of

the first applications of the methods of complexity to economics became

available, it was recognised that they represented a rediscovery of

classi-cal economics For most of the twentieth century classiclassi-cal economics has

been marginalised, the mainstream of economic thought being occupied

by equilibrium theory in its neoclassical version Neoclassical economics

is now revealed to be not the mainstream but a backwater, a dead end in

the history of economic thought It is the Austrian economists and their

successors, the theorists of complexity, who are the true inheritors of the

classical tradition in economic thought

NOTES

1 Marshall ([1920] 1962: xiii).

2 Within the term ‘equilibrium economics’ I include neoclassical and neo-Keynesian

theories, and any others that use the static equilibrium framework of analysis.

3 ‘Hardly an author can be found, not even Keynes himself, who is so much the exact

antipode of Milton Friedman in every part of the economist’s theoretical vision as Carl Menger’ (Streissler and Weber 1973: 165).

4 Mirowski (1989) The term ‘equilibrium’ seems first to have been used in the context

of economic theory by Sir James Steuart It was never used by either Smith or Hume

Its modern usage appears to have originated with Cournot in 1838, gaining currency in the English-speaking world with Mill ten years later (Milgate 2008: 22) The term has two broad meanings First, a point at which there is no incentive within a system to change behaviour, e.g a steady or stationary state, and second, a stationary position in

a dynamic process The former interpretation is commonly associated with economics, whereas the latter is the sense in which the term is most often used in the natural sciences (Winter 2008: 57).

5 ‘The typical graduate macroeconomics and monetary economics training received

at Anglo-American universities during the past 30 years or so may have set back by decades serious investigations of aggregate economic behaviour and economic policy- relevant understanding.’ Willem Buiter, ‘The Unfortunate Uselessness of most “State

of the Art” Academic Monetary Economics’, Financial Times blog 3 March 2009,

avail-able at www.ft.com/maverecon.

6 See, for example, Harcourt (1972).

7 It might be thought that the equilibrium theory of value would be able to explain at

least the workings of markets But so restricted is its construct of ‘perfect’ competition, that it excludes almost all the activities that the verb ‘to compete’ describes (Hayek 1948: 92).

8 ‘[T]he limitations of the concept [of equilibrium] in dealing with conditions of persistent

and imperfectly predicted change will not be removed until economics possesses a developed theory of change’ (Stigler 2008: 57).

9 The extraordinary volumes of trading observed in financial markets arise in large part

from the fact that different people know, or think they know, different things.

10 Classical economists believe that market economies have evolved over time to meet

the need to coordinate dispersed commercial knowledge, in much the same way that language has evolved to meet human needs to communicate with one another, and law has evolved to meet society’s need to resolve disputes.

11 It may not be surprising to find that economic models based on rational expectations

have difficulty in explaining such robust stylised facts as the trade-off between inflation and unemployment (Carroll 2006, p.6).

12 See Chapter 10.

13 Macroeconomic theory has extended the theory of value into the topics of growth

and fluctuations, but, as we shall see in Chapter 10, such extensions are fraught with difficulties.

14 For example, Mandeville ([1732] 1988).

2 Human behaviour

Economics is a study of men as they live and move

and think in the ordinary business of life.

Alfred Marshall 1

We have become so accustomed to economies being described by statistics

of output, exports, stocks of capital and so on, that we often forget that all

these things are simply the outcome of human activity, and that a market

economy is a collection of relationships between human beings That

being the case, we should not be surprised to discover that the way that

economies work is determined by human behaviour Human behaviour

is rooted in individual human values, and individual human values are

subjective, heterogeneous and changing

Classical economists from Smith to Marshall and Schumpeter have put

human beings at the centre of their vision of economic activity Marshall

defined Economics as being a study of humans in the ordinary business of

life Schumpeter noted that the essence of the economy lay not in paper

securities or production equipment but in the psychological relations

between people and in the mental state of the individual For Smith, the

three great drivers of economic activity, the psychological constants of

his model of the economy, were ‘the [human] propensity to truck, barter

and exchange one thing for another’, ambition, and the urge to procreate

Another basic human motive to which he drew attention is the individual’s

need for the approval of others (Kennedy 2008)

TRADING

From the point of view of an economy perhaps the most important human

trait is the disposition to exchange goods and services with one another

The significance of trading is that it leads to specialisation, a form of

cooperation that is the key to economic growth Adam Smith asserted that

what he called ‘the propensity to truck and barter’ was a uniquely human

activity, remarking that ‘No man ever saw a dog make fair and deliberate

exchange of a bone with another dog’2 (Smith [1776] 1937: 13) Was Smith

right in thinking that cooperation through trade is uniquely human? There

are some species, like ants, where individuals live together in colonies with

specialisation of tasks and trade But this tends to take place among

rela-tives In other species, there is evidence of limited cooperation between

nonrelatives around specific tasks, within very small groups and for short

periods Extensive cooperation among large numbers of nonrelatives

persisting over long periods of time does indeed appear to be unique to

human beings (Beinhocker 2006: 7; Seabright 2004)

AMBITION

Ambition, ‘the desire of bettering our condition’ (Smith [1776]1937: 341)

or ‘[the] universal, continual and uninterrupted effort [of men] to better

their own condition’ (ibid: 345) has been a key driving force for change

and growth in the economy throughout history:

it is this effort, protected by law and allowed by liberty to exert itself in the manner that is most advantageous, which has maintained the progress of England towards opulence and improvement in all former times, and which, it

is to be hoped will do so in all future times (Ibid.)Most of us have come across the ultra-ambitious type, the workaholic to

be found in all occupations According to Smith, those individuals who

are driven by the prospect of fame and fortune deceive themselves Even

when they realised their ambitions, this did not bring them personal

hap-piness or peace of mind; they ended their lives exhausted and unhappy

Although ambition may be damaging to the individuals afflicted by it, it

is a human motive of great, albeit unintentional, social benefit Smith puts

the argument eloquently:

The poor man’s son, whom heaven in its anger has visited with ambition, when

he begins to look around him, admires the condition of the rich With the most unrelenting industry he labours night and day to acquire talents superior

to all his competitors Through the whole of his life he pursues the idea of a certain artificial and elegant repose which he may never arrive at, for which he sacrifices a real tranquillity that is at all times within his power It is in the last dregs of his life, his body wasted with toil and diseases, his mind galled and ruffled by the memory of a thousand injuries and disappointments which

he imagines he has met with that he begins at last to find that wealth and greatness are mere trinkets of frivolous utility

And it is well that nature imposes upon us in this manner It is this deception which rouses and keeps in continual motion the industry of mankind It is this which first prompted them to cultivate the ground, to build houses, to found cities and commonwealths, and to invent and improve all the sciences and arts, which ennoble and embellish human life; which have entirely changed the

Human behaviour 15

whole face of the globe, have turned the rude forests of nature into agreeable

and fertile plains, and made the trackless and barren ocean a new fund of

sub-sistence, and the great high road of communication to the different nations of

the earth The earth by these labours of mankind has been obliged to redouble

her natural fertility, and to maintain a greater multitude of inhabitants (Smith

[1759]1976: 181)

PROCREATION

The universal urge to procreation meant, according to Smith, a constant

tendency for population in every society to increase The resulting pressure

of population growth on resources was responsible for driving societies

through successive stages of development, as each sought new ways to

relieve the pressure Increased food supplies might temporarily allow

income per head to rise, but sooner or later population would catch up

through reduced infant mortality or extended longevity (Kennedy 2008:

65) This theme was taken up by Malthus, but it dropped out of

main-stream academic discourse once equilibrium theory had replaced the old

classical factor supply functions with the simplifying assumption of fixed

supplies of resources (Blaug 1997)

SOCIAL NORMS

When the human need for approval is combined with another human trait,

a concern for the well-being of others, together they give rise to a social

convention or norm in society that limits the tendency for an individual to

act in a purely self-regarding way.3 In other words, in developed market

economies there exists a social norm of what we might call ‘fairness’ that

makes certain kinds of selfish behaviour unacceptable

Generally speaking, individual human behaviour is shaped by the

norms and values, customs and habits of the society in which it takes

place Different norms can produce very different outcomes The ‘wrong’

norms can provide insuperable obstacles to economic progress, or at least

dampen its prospects Even in the most advanced economies examples can

be found of communities where personal achievement is frowned upon,

and those who want to ‘get on’ have to leave In the absence of a norm

like trust, trading activity becomes impossible or very difficult, so that it is

hard to imagine a market economy developing without it

When managers of large corporations are discovered to have been

acting in bad faith in the conduct of their businesses, they are punished

by society If such wrongdoing is suspected, rightly or wrongly, to be

widespread, then trust in the whole economy is shaken (Akerlof and

Shiller 2009: 26) When the major US banks stopped trusting each other

in late 2008, they became unwilling to lend to each other and the supply of

inter-bank credit dried up.4

Some cultural norms are conducive to change and growth They include

a spirit of enterprise – the ‘can-do’ attitude – a sense of identity, a

com-mitment to the common good, a willingness to work hard, thrift, honesty,

patience and tenacity together with an ability to transmit these values

from one generation to another (Landes 1998: 217‒18) Bowles and Gintis

(2006) suggest that adherence to social norms is underwritten not just by

the expectation of future reciprocity, but by such emotions as shame, guilt,

pride, regret and joy They believe that these feelings play an important

role in sustaining cooperative relations within societies

Other human emotions have varying influences on economic ity Self-confidence, a willingness to take risks and a desire to ‘keep up

activ-with the Jones’s’ all work in favour of change and growth On the other

hand, states of mind coloured by unwarranted feelings of optimism or

pessimism, envy, resentment and temptation can amplify fluctuations

in economic activity As Kindleberger observed, ‘There is nothing so

disturbing to one’s well-being and judgment as to see a friend get rich’

(Kindleberger 1996: 13) At certain times, people allow their normal

judg-ment to be unbalanced by greed How else can one explain in the run-up to

the financial crisis of 2008 the spectacle of bankers eagerly buying bundles

of securities whose value they did not know

Human weaknesses of a slightly different kind are at work in the public sector If we were all saints, there might be no need for government at

all But the fact that it is notoriously difficult to get publicly controlled

organi sations to operate efficiently may be attributable to the fact that

their employees, like the rest of us, can’t resist pursuing their own private

agenda.5

‘RATIONAL’ ECONOMIC BEHAVIOUR

In the Preface to the First Edition of Principles of Economics Marshall

wrote: ‘Attempts have indeed been made to construct an abstract science

with regard to the actions of an “economic man”, who is under no ethical

influences and who pursues pecuniary gain warily and energetically, but

mechanically and selfishly But they have not been successful’ (Marshall,

[1920] 1962: v) Sadly, this judgment turned out to be incorrect In the

fol-lowing hundred years equilibrium theorists were singularly successful in

capturing the mainstream of economic thought

Human behaviour 17The conventional equilibrium theory found in textbooks and academic

journals today treats human beings as if they were no more than

desic-cated calculating machines whose choices are uncontaminated by feelings,

and who are driven by a single motive –what John Kay has called

self-regarding materialism (Kay 2004), and others call selfishness or greed

Rational economic man is a creature whose only method of attaining his

objectives is by rational calculation based on perfect information One

justification for such a simplistic assumption is the claim that it works.6

Another, perhaps more compelling, reason for making this stark

assump-tion is that a single quantifiable variable can conveniently be fitted into a

linear mathematical model

It may be true that an assumption of self-regarding materialism is a

better predictor of people’s behaviour than is an assumption of altruism It

is also true that one of the factors that distinguishes human behaviour from

that of other animals and from inanimate objects is the use of reasoning

But of course human beings are not one-dimensional Their behaviour is

driven by a range of motives and feelings, and if we are to understand how

an economy works we need to recognise that More importantly, the type of

calculating behaviour assumed by equilibrium theory is simply not possible

in a market economy, for at least three reasons First, most of the facts

nec-essary for such calculations are absent Even if they were present, it would

be beyond the limited computing power of the human brain to process

them Second, uncertainty is pervasive Third, we interpret such facts as we

are able to discern through the distorting lens of our emotions We do not

see the world as it really is Let us consider each of these difficulties in turn

THE FACTS ARE MISSING

When human beings act they usually act purposefully When we engage in

economic activity we are normally trying to improve our circumstances as

we see them The problem is that the information we use to understand the

circumstances in which we operate is always fragmentary and incomplete,

often partly erroneous and sometimes just plain wrong

We may lack the simplest facts If I want to know which new computer

to buy I need to know the prices as well as the specifications of the

avail-able range of models Such information can usually be obtained by a

search of online or printed catalogues But for someone starting a new line

of business, there are prices of materials and services he needs to know that

cannot so easily be looked up He may get estimates of current prices, but

information about future prices will be unavailable or uncertain And he

can only guess at the volume of demand for his product

The problem is that no matter how complete and accurate is the mation we collect about yesterday’s or even today’s circumstances, the

infor-information that really matters concerns the future, because all the choices

we make today will play out in the future The profitability of an

invest-ment made now will depend not on today’s prices of the product and the

materials used, but on future prices – and these are generally unknown As

Keynes put it:

Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible If we speak frankly,

we have to admit that our basis of knowledge for estimating the yield of an

investment some ten years hence of a railway, a copper mine, a textile factory,

the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence

(Keynes 1936: 149‒50)

UNCERTAINTY

Various attempts have been made to overcome this handicap of the

unknowability of the future One such approach is to pretend that

uncertainty is measurable, by specifying all the outcomes of an event and

attaching a probability to each of them In fact, an objective calculation

of probability is only possible if one is in possession of a large number of

observations of an event that has been repeated over and over again For

example, the repeated rolling of dice or the spinning of a roulette wheel

or a lottery urn allows the results to be tabulated so that reasonable

infer-ences can be made about the probability of future outcomes

The circumstances in which uncertainty is actually measurable in nomic life are very limited indeed A rare example is the calculation of the

eco-risks of mortality at different ages, a calculation usually made by actuaries

employed by life insurance companies In this case, an approximate

calcu-lation of the probability of an individual’s death at a certain age is made

possible by the existence of an historical record of the deaths at particular

ages of the population of which the individual is a member, and by

assum-ing that the life expectation of the individual concerned is the same as that

of the population as whole Uncertainty that is measurable in this way is

known as risk Unfortunately, the word ‘risk’ has come to be used in a

wide range of circumstances where uncertainty is either not measurable

at all, or can only be made quantifiable by arbitrarily assigning subjective

values to probabilities The currently fashionable practice in both business

and the public sector of what is misleadingly called ‘risk management’

provides an example

Human behaviour 19The word ‘risk’ is also widely used in financial markets It is true that

in some markets it is possible to take out insurance against the risk that

an investment will fail to return a profit But this can only be done when

and if a calculation of probabilities is possible Otherwise, the person or

organisation providing the insurance is not providing an insurance

con-tract at all, but is simply taking a gamble.7

In general, human affairs are not at all like a lottery or a game of roulette

History is marked by unique events, not repeated events To put it another

way, history consists of a single sequence of events rather than the set of

independent observations that the laws of probability would demand

Those financial analysts who enter stock market data into their forecasting

models and pretend that they are using thousands of separate and randomly

distributed numbers are deceiving themselves and their clients The size of

a sample of stock market observations is effectively one (Bernstein 2007)

So the uncertainty that pervades human affairs, including human

eco-nomic activities, cannot be dispelled by pretending that uncertainty can be

measured It cannot We must accept the unavoidable uncertainty of our

knowledge of future events As Keynes said: ‘About these matters there is

no scientific basis on which to form any calculable probability whatever

We simply do not know’ (ibid.)

COGNITIVE BIASES

Despite the pervasiveness of uncertainty in economic affairs, each of us is

constantly obliged to make choices All the decisions we make in our daily

lives are based upon our beliefs about the future, however incomplete and

uncertain our knowledge of that future may be Unfortunately in making

choices we face a further set of difficulties Our perception of the future is

distorted by some very human weaknesses that psychologists call

‘cogni-tive biases’

In forming a view about the future, we generally tend to believe that

it will look rather like the present This is sometimes termed ‘myopia’

Likewise, we tend to assume that the existing state of opinion correctly

sums up future prospects, and we often go along with majority opinion

about the future, believing it to be better informed than our own

indi-vidual judgment Experience shows that these quite understandable

ten-dencies all impart a bias to the expectations we form about the future

We may also from time to time suffer availability bias, hindsight bias, the

‘affect heuristic’ and many more biases All this leads to the conclusion

that the view of the future formed by the average human being is likely to

be seriously defective (Yudkowsky 2008)

Further biases may be imparted by our state of mind at a particular moment, which may give us either an overly optimistic or an excessively

pessimistic view of the future When such feelings are widely shared among

a group of people participating in a particular market or set of markets,

they are described as ‘the state of confidence’ Sudden mood swings from

unwarranted optimism to unwarranted pessimism and back again are

often seen in financial markets, and can contribute to movements in the

rest of the economy (see Chapter 8) But it is not only in financial markets

that collective psychology plays a part Keynes asserted that one of the

major determinants of the level of investment in a market economy was

the state of business confidence, a factor to which he said practical men

always play the closest attention, but which economists neglected (Keynes

1936: 148‒49)

Then there is wishful thinking, which leads us to disregard some kinds of evidence For example, we tend to play down a gradual accretion of small

changes, and to attach more importance to bigger and more noticeable

changes, simply because the latter fit better with our own preconceptions

of how things happen There is furthermore widespread money illusion,

where we respond to nominal monetary values rather than to real values

Adam Smith noted a widespread human tendency to overrate our own abilities, and a disposition to underestimate risks He deplored the exces-

sive popular demand for lottery tickets in his time, and the infrequency

with which buildings in the eighteenth century were insured against fire

Today the insurance of commercial and residential property against fire

is almost universal in developed market economies So far as lotteries

are concerned, governments have taken over from private promoters the

exploitation of the gullibility of the general public

When a tendency to overestimate our own abilities is combined with a disposition to underestimate risk, then the result is a tendency to overvalue

our chances of gain in any business venture While this ‘spontaneous

optimism’ may be a misfortune for the individual, it is perhaps, like

ambi-tion, a blessing for society as a whole Keynes believed that without this

particular form of cognitive bias, business investment would be much less

than it is:

[A] large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation Most of our decisions to do something positive can only be taken as the result of animal spirits – of

a spontaneous urge to action rather than inaction, and not as the outcome

of a weighted average of quantitative benefits multiplied by quantitative probabilities Thus if the animal spirits are dimmed and the spontane- ous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die (Keynes 1936: 162)

Human behaviour 21

He concludes that:

We are merely reminding ourselves that human decisions affecting the future,

whether personal or political or economic cannot depend on strict

mathemati-cal expectation, since the basis for making such mathemati-calculations does not exist;

and that it is our innate urge to activity which makes the wheels go round, our

rational selves choosing between the alternatives as best we are able, calculating

where we can, but often falling back for our motive on whim or sentiment or

chance (Ibid: 163)

Faced with these difficulties of incomplete, inaccurate and uncertain

infor-mation, how do people make the choices that confront us all in our daily

lives? The answer, according to psychologists, seems to be that we fall back

on hunches and rules of thumb (Kahneman and Tversky 2000) Where do

such rules of thumb come from? Our expectations about the future tend

to be formed on the basis of our experience of the past Marshall did not

think of human nature as given, but as being influenced by the experience

of the individual; poverty was a cause of physical and mental suffering

He believed that human knowledge and character are moulded within the

economy and society, and co-evolve with it What is thought depends on

what is done, and conversely (Metcalfe 2006: 653) Loasby agrees: ‘In the

absence of perfect cognition, perfect rationality and perfect foresight, we

must have recourse to the dialectics of evolutionary processes As well as

knowledge, these processes develop preferences and character; and the

working environment in which most people spend much of their time is a

major influence on all three’ (Loasby 2006: 372)

HOW EXPECTATIONS ARE FORMED

In the conventional equilibrium model, ‘rational’ expectations are

gener-ally assumed This means that every participant in a market knows the

‘correct’ model of how the economy will work in the future, and everyone

believes that everyone else also knows what it is and will use it If this

happens, then the outcome will be consistent with these common ‘rational’

expectations

But what happens if, as is rather more likely, expectations differ between

individuals, and they do not know what the expectations of others are? This

was the problem addressed by Arthur in 1994, when he created a simple

simulation model to try to answer it (Arthur 2009: 16‒18) He imagined

a bar attended by up to 100 potential customers Each week they decided

independently whether to attend or not The simple rule was that if an

individual expected that more than 60 people would attend he or she would

stay at home, whereas if they expected fewer than 60 to attend then they

would go How will the potential attendees predict the numbers showing

up, and what will be the resulting actual pattern of attendance over time?

One key feature of the problem is that individuals will soon realise that their predictions of how many people will show up depends on other peo-

ple’s predictions of the attendance, but others’ predictions will depend in

turn on their predictions of other people’s predictions There is no ‘correct’

expectational model that can be assumed to be common knowledge, and

so, as in real world markets, the problem from each individual’s

perspec-tive is ill-defined

Arthur simulated the way the problem might work out by starting with

a range of subjectively chosen expectational models Thereafter each

indi-vidual acts inductively: they act on their experience, and choose the model

that has proved most accurate for them Computer simulation over 100

notional weeks showed that the mean attendance soon converged to 60,

with an average ratio of 40 per cent of forecasts predicting above 60 and

60 per cent below 60 appearing as an emergent phenomenon

This simple model was later extended by Arthur and some colleagues to the formation of expectations and the realisation of prices in a hypotheti-

cal financial market As in the bar problem, individual expectations cannot

be assumed or deduced but must be discovered from experience Market

participants continually create and use multiple hypotheses of what moves

the market price and dividend within an artificial stock market The

‘investors’ are individual artificially intelligent computer programs that

can generate and discard expectational ‘hypotheses’ and can make bids

or offers based on the currently most accurate of these The stock price

forms endogenously from the bids of the agents, and thus ultimately from

their expectations (Arthur et al 1997: 18) So individual expectations are

competing in a world that these expectations jointly create, a characteristic

feature of complexity

The results of the simulation were interesting There were two phases:

(1) If the parameters of the model were set in such a way that the artificial

agents updated their hypotheses only very slowly, then the diversity of

expectations collapsed into homogeneous ‘rational’ expectations ones,

that is those that were consistent with the continuation of an equilibrium

price (2) But when the rate of updating of hypotheses is increased, the

artificial market behaves differently There is a pattern of divergent beliefs

that do not converge over time The market exhibits periods of high price

volatility followed randomly by periods of low price volatility brought

about by changes in beliefs rippling through the market There are also

periodic bubbles and crashes These are features of real world markets not

captured by equilibrium models

Human behaviour 23Stock market data, which are now copious in their availability, appear

to show numerous examples of power law behaviour Such statistical

behaviour is usually interpreted as evidence of the existence of complexity,

in the sense that these stable and recurring aggregate patterns are the

unin-tended result of lower level individual interactions What is interesting is

that purposive human behaviour at the micro level can produce aggregate

patterns that are stable and recurring in the same way that can be observed

in non-human systems

Whereas equilibrium theory assumes that all agents have a complete

knowledge of their environment, and use all available knowledge of

economic theory to compute a rational forecast, it seems more natural to

believe that a market economy is made up of a population of

heterogene-ous agents with limited knowledge (boundedly rational), using different

forecasting rules When the economy is seen as a complex adaptive

system with many interacting agents, rational expectations theory would

require each to share the same beliefs about the future as all other agents

Experiments by Hommes suggest that heterogeneity of forecasting rules

may be required to be consistent with stylised facts observed in the

labora-tory (Hommes 2009: 116)

THE HUMAN MIND

Only a few years after Marx had re-stated Ricardo’s labour theory of value

(‘garbled Ricardianism’ according to Mises), Menger proposed that the

value of a commodity is not established by its cost of production, nor is it

intrinsic Its value is established by a subjective appraisal based on its

mar-ginal utility to the would-be user The economic value of a commodity is a

relationship between an object and an appraising human mind Different

human minds will come up with different valuations, and the same human

mind will value the same object differently in different circumstances

Thus Austrians look at economic activity from the perspective of the

individual agent ‘They want to be sure that all the things their theories say

about how individuals act are reasonable things to say about real people’

(Koppl 2009: 393).8 Complexity theorists would agree; what Austrians call

subjectivism complexity theory calls agent-based reasoning

Hayek’s theory of complex phenomena was rooted in his

understand-ing of the human mind (Hayek 1952) He recognised that the operations

of the central nervous system are too complex to be captured in a simple

stimulus-response framework Complex living systems must understand

their environment in order to adapt successfully to it Living organisms

must ‘sense, classify and act’ upon their environment (Koppl 2009: 393)

In other words, before learning or adapting they have to make sense of

their problems In order to do this, they use experience to convert

informa-tion about the world into categories or cognitive props.9 Agents inhabit

an environment that they must cognitively interpret, an environment that

is characterised by the actions of other agents, and is therefore always

changing.10

There are strong links here between modern cognitive theory that underlies complexity theory and the traditional Austrian approach to

human decision-making in an economic context Not only does Hayek’s

work unify the two approaches, but the idea of human agents having

to make sense of the particular circumstances they face – to cognitively

structure their problems – is very similar to the concept of ‘verstehen’ or

understanding emphasised by Mises ([1949] 1963: 51‒58)

This is a very different picture of human behaviour than the one adopted by equilibrium economics Instead of a plurality of cognitive

processes, there is just one: human economic agents are all assumed to be

rational optimisers This is usually interpreted to mean that they

evalu-ate uncertainty probabilistically, revising their evaluations via Bayesian

updating and choosing the course of action that maximises their expected

utility They are generally assumed to share a stock of common knowledge

and to have ‘rational’ expectations about their environment However,

common knowledge cannot simply be assumed into existence Any such

knowledge must be attained from specified cognitive processes operating

on experiences obtained through concrete interactions But in order for

equilibrium economics to achieve its aim of becoming a ‘hard’, ‘exact’

or ‘real’ science like physics, it cannot treat human agents as unique or

creative individuals, but as homogeneous bits of data whose behaviour is

always predictable

Equilibrium theory treats human beings as if they behaved no ently from inanimate particles But stones and atoms do not make plans

differ-and act upon them, they do not act purposefully, they do not evaluate

means and ends Unlike physical particles responding ‘dumbly to their

magnetic field’ (Arthur 2009: 12), human agents consider outcomes that

might result as a consequence of actions they might undertake, that is,

their behaviour is predicated on the use of foresight and strategy If we

exclude from our analysis peculiarly human considerations like intentions

and motives because they do not fit easily into the formal mathematical

reasoning required by classical mechanics, then we risk leaving out

infor-mation that may be essential for understanding human behaviour

Hayek’s study of the mind led him to the conclusion that not only vidual mental processes but also the mind as a whole are phenomena of a

indi-special kind that cannot be explained in terms of the laws of physics alone,

Human behaviour 25even although mental phenomena are physical processes The human

mind adds a layer of complication to the behaviour of human beings that

does not exist in the behaviour of physical particles or even biological

organisms Therefore additional theorising is required to explain human

economic behaviour.11 This led him to the concept of a hierarchy of

complex phenomena

A HIERARCHY OF COMPLEXITY

Hayek was the first to suggest that the different branches of science can be

ranked in a hierarchy according to the complexity of the phenomena that

they study (Hayek 1967: 22‒42) He proposed that the sciences could be

arranged in a hierarchy of increasing complexity with physics, being the

simplest, at the bottom, with biology in the middle, and the social sciences

at the top.12 Those classes higher up the hierarchy exhibit an additional

level of complexity that requires the formulation of separate laws of

behaviour and justifies distinctive methods of analysis The principle that

governs the ordering of the classes in the hierarchy is that, at any given

level, a member of a particular class will observe the laws of behaviour of

their own class as well as all the laws governing the behaviour of

phenom-ena in all lower classes So the behaviour of human beings conforms to the

laws of biology, physics and chemistry as well as to the ‘laws’ of human

cultural behaviour This means that the methods of analysis appropriate

for physics are unlikely to be appropriate for economics or any of the

social sciences

Consider what happens when a stone is thrown into the air A stone

obeys only the laws of physics, and its behaviour is therefore quite

predict-able If a bird is thrown into the air, it is subject to exactly the same

physi-cal forces as the stone, but additional forces, chemiphysi-cal and biologiphysi-cal, are

at work, which account for its more complex behaviour If a remotely

con-trolled vehicle is launched into the air then, being concon-trolled by a human

mind, it may be capable of even more complex behaviour than a bird.

CREATIVITY

Human beings are uniquely creative, and they are creative in lots of

dif-ferent ways We usually associate creativity with endeavour in the arts

and crafts; it is generally overlooked that people can be equally creative

in business activity It might even be argued, as some Austrians do, that

almost all human action is creative But the term ‘creativity’ is generally

reserved for an action that results in some discernible novelty When

someone launches a new product on to a market, brings a new type of

production process on stream for the first time, or experiments with a

new channel of distribution, in short tries anything new, they are being

genuinely creative

So too are those who start up new businesses Entrepreneurs are the type of people who prefer to start their own new businesses rather than

to pursue the less risky job of managing them for others once they have

been established When an entrepreneur starts a new business he or she

will discover whether their innovation is successful, whether it has to be

modified and, if so, in what way, or abandoned altogether There is

there-fore a close connection between creativity and discovery The role played

by the unforeseen element in an act of creation was expressed by Picasso

when he said ‘I do not seek: I find.’ The same idea was expressed by the

architect Antonio Gaudi when he wrote ‘Man does not create, he

discov-ers’ (Casanelles 1967: 13)

Creative acts are not ‘add-ons’ to normal economic activity On the trary, creativity implies novelty, and novelty, that is to say change, is at the

con-very heart of the market economy As we shall see in the next chapter, the

market economy is always and everywhere in a state of change; it is never

at rest for a moment It is constantly being swept by the perennial gale of

creative destruction

NOTES

1 Marshall ([1920] 1962: 12).

2 It has also been suggested that it was this propensity of Homo sapiens to trade that

enabled our species to survive while other hominid species became extinct.

3 It is therefore quite wrong to identify Adam Smith with a morality of selfishness or with

arguments of the ‘greed is good’ variety.

4 After these banks had been supported with the aid of capital supplied by the US

tax-payer, there was widespread and deeply felt anger amongst the population when, 12 months later, the same banks’ managers insisted on paying themselves large bonuses

This was seen to violate a widely held norm of ‘fairness’.

5 See Chapter 9.

6 ‘People do what they get paid to do; what they don’t get paid to do, they don’t do’

(Easterly 2001: xii).

7 This would appear to have been the position of many providers of credit default swaps

and other contracts in the recent financial crisis.

8 This is a point of view that appears to be endorsed by Arrow when he writes: ‘It is

a salutary check on any theory of the economy or any other part of society that the explanation makes sense on the basis of the individuals involved’ (Arrow 1994: 3).

9 Arthur points out that it is not necessary that these cognitive props should fit together

coherently to generate effective actions (Arthur et al 1997: 5).

10 This is a further reason for believing that the rational optimising behaviour assumed by

equilibrium economics is not possible Not only does the human mind have a limited

Human behaviour 27

memory and finite processing capability, the concept of an optimal course of action cannot in general be defined.

11 ‘It is a gratuitous pastime to apply to the description of the behaviour of man the same

methods the natural sciences apply in dealing with the behaviour of mice or of iron’

(Mises 1978: 37).

12 More recently, the American physicist Murray Gell-Mann extended Hayek’s

clas-sification to include chemical (between physical and biological) phenomena He also recognised the existence of artificial (i.e computer-generated) phenomena, although it

is not clear where he thinks they belong in the hierarchy See Gell-Mann (1994).

3 Qualitative change and quantitative

growth

Capitalism is by nature a form or method of economic change, and not

only never is but never can be stationary.

J.A Schumpeter 1Classical economists have observed that the market economy is a process

in historic time characterised by incessant and irreversible change Its most

important characteristic, the one which distinguishes it most clearly from

all other economic systems2 is that it continuously changes from within as

it grows As Marx put it, in his typically polemical style:

The bourgeoisie cannot exist without constantly revolutionising the ments of production, and thereby the relations of production, and with them the whole relations of society Conservation of the old modes of production

instru-in unaltered form was, on the contrary, the first condition of existence for all earlier industrial classes (Marx and Engels [1848]1955: 37)

At the opposite end of the political and analytical spectrum from Marx

stands the great English economist Alfred Marshall Writing in the early

part of the twentieth century, his view was the same:

The main concern of economics is thus with human beings who are impelled, for  good and evil, to change and progress [T]he central idea of economics  must be that of living force and movement (Marshall [1920]

1962: xiii)

At the same time he remarked on our lack of understanding of the nature

of the process of economic growth: ‘how little we know of the causes by

which progress is being fashioned, and how little we can forecast the

ulti-mate destiny of the industrial organism’3 (ibid: 39)

Following Marshall, Mises wrote that:

The characteristic feature of man is action Man aims at changing some of the conditions of his environment in order to substitute a state of affairs that suits him better for another state that suits him less (Mises 1978: 34)

Qualitative change and quantitative growth 29

Joseph Schumpeter reminded his readers that: ‘The essential point to

grasp is that in dealing with capitalism we are dealing with an evolutionary

process’ (Schumpeter 1942: 82)

Accordingly change is incessant, and there are few if any constants that

can be observed in a market economy Nevertheless, from the first quarter

of the twentieth century onwards the focus of attention amongst

main-stream economists shifted decisively from change and growth towards

the determination of prices,4 and hence to the use of equilibrium methods

of analysis Since then questions of change and growth in the economy,

despite their urgency for voters and politicians, have generally been

ignored in the mainstream academic literature.5

Then, some 25 years ago natural scientists began to notice the

perva-siveness of evolving self-organising systems (Prigogine 1996) One of the

scientists in the forefront of this revolution was John Holland, a

psycholo-gist who has pioneered studies of adaptation in both natural and human

systems (Holland 1992) He and others recognised the market economy to

be an example of such a system

Looking at the economy of New York City as a microcosm of the larger

US economy, Holland was struck by what he called its ‘kaleidoscopic’

nature While to the casual observer there was an appearance of

continu-ity and even constancy on the surface of the economy, underneath there

was a ‘perpetual flux’ of people and structures Over a number of years,

particular buyers, sellers, buildings, roads and even bridges changed, but

these incessant changes of detail did not disturb a discernible, continuing

and coherent pattern of economic activity He said that the pattern

mani-fested by economic activity is like ‘the standing wave in front of rock in a

fast-moving stream’.6

THE EMERGENCE OF STEADY GROWTH AT THE

TOP FROM INCESSANT CHANGE AT THE BOTTOM

When we look at a market economy we find orderly patterns of behaviour

on the surface, at the aggregate level, that are the outcomes of millions of

independent interactions that take place between individuals and

busi-nesses Hundreds of thousands of companies and millions of people are

continuously interacting with each other by buying and selling goods and

services Individuals are generally trying to improve their standard of

living To do that they may need to look for better-paying jobs, or even

set up their own businesses Companies, meanwhile, are trying to survive,

to make profits and, if possible, to increase them To do this they need to

discover what new products consumers will buy, what new production and

distribution processes might be profitable, and what steps they might take

to fend off real or potential threats from their competitors

All participants in the market economy are continuously adapting to the changing environment in which they operate And the most important

part of that environment is the behaviour of other businesses and of other

people However destructive change may be to the individual business or the

individual household at the bottom of the economic process, what emerges

at the top is not chaos or anarchy but relatively stable and orderly patterns

of growth of output per head, and therefore of real average incomes

At the top level, the market economies of different Western countries show remarkably similar patterns of growth In most advanced econo-

mies, the level of aggregate output grows more or less steadily, at a long

term annual average rate over the last half century of between 2 and 3 per

cent, despite the fact that in any given year the output of some industries

may be rising fast while in others it is falling Likewise, total employment

grows steadily, although there will be substantial losses of jobs over time in

some industries and gains in others Patterns of relative prices and wages

are normally quite stable at the aggregate level While prices of primary

products may be volatile, it is unusual to find large annual fluctuations in

aggregate indices such as the consumer price index.7

What we observe on the surface of a market economy, modest but steady annual increments in total output, population and output per head

and relatively stable patterns of prices do not represent exact regularities,

but recurring and persistent patterns of behaviour These are the result of

incessant and often disruptive changes going on in innumerable

interac-tions below the surface The adjustment of the individual elements is

mutual and voluntary There is no control exercised either from within or

from outside the system

This is a description of a self-organising system What self-organisation means, and how it works, is explained in Chapter 5 Meanwhile, in this

chapter we begin with an examination of the actual ‘surface’ experience

of growth in Western economies as it has been observed by historians We

ask why economic growth happened where and when it did In the second

half of the chapter we look at the changes in behaviour that have brought

that growth about

WHAT ACTUALLY HAPPENED: CHANGE AND

GROWTH IN THE WEST

First, some definitions: we use the term ‘the West’ to refer to that group

of countries in Western Europe and North America, as well as Australia,

Qualitative change and quantitative growth 31New Zealand, Japan and a few others, whose economies are the most

advanced.8 The economic systems of these countries are sometimes

referred to as ‘capitalism’ Such a term suggests as well as an ideology an

unchanging set of institutions As we shall see, the institutions of a market

economy are continuously changing We use the term ‘market economy’

to refer to the economic institutions, that is the rules and organisations,

that have evolved in Western Europe over many centuries, and which

continue to evolve at the present time (Rosenberg and Birdzell 1986: xi)

The earliest forms of these institutions were in place, and economic growth

was well under way, before the first systematic and comprehensive analysis

of a market economy appeared in 1776 The Wealth of Nations was written

at a time when the market economies of the West were still predominantly

agricultural and commercial The huge changes associated with

industri-alisation lay ahead

When economists talk about ‘economic growth’ they mean the rate of

growth of total output, or of total output per head, in a particular country

or region These concepts have the advantage of being both

comprehen-sive and measurable in principle and often in practice (Maddison 2007)

However, there are formidable difficulties of interpreting the resulting

statistics Any measure of total output not only means adding together

very different things, but it also disguises the changing composition of that

total over time and its differing composition between countries Aggregate

numbers conceal the underlying processes of change Furthermore, little

or no account is taken in these data of the dramatic changes in the quality

of goods and services that have taken place, thus underestimating very

seriously the extent of the growth and, above all, of the changes that have

occurred within market economies over the last 250 years

From the earliest times down to about a thousand years ago, the

over-whelming majority of people in the world lived a thoroughly miserable

existence Their lives were a struggle just to stay alive and to ward off the

ever-present threats of hunger and disease In Hobbes’ memorable phrase,

human life ‘was nasty, brutish and short’ The freedom of ordinary people

to trade, to own property, or even to change their occupation was severely

restricted Their working lives were directed by their superiors in the social

hierarchy Then from about 1000 AD onwards, in Western Europe things

very slowly began to improve

At the beginning of the second millennium the average standard of

living, that is, total output per head of population, in Western Europe was

about what it had been at the time of the birth of Christ a thousand years

earlier, namely a bare subsistence level But between then and the end of

the eighteenth century average standards of living rose almost threefold

(ibid: 70) This transformation was brought about almost entirely by the