The Need for a New Economics

John Mauldin

Sep 17, 2013



In today's Outside the Box, my good friend George Gilder, the well-known techno-utopian, attempts with some success to turn economics on its ear. "The economy is not chiefly an incentive system," he asserts, "it is an information system." And information, truly understood, is about the introduction of novelty, or "surprise," into a system. In the case of the economy, it's about invention and entrepreneurship. The new information that is injected gets converted into knowledge; and thus, says George, it is accumulated knowledge, rather than money or material, that constitutes true wealth.

And thus the economy is driven not so much by powerful people and institutions wielding the levers of the economic machine as it is by the ever-increasing power of information and knowledge. Economists and the governments they work for often appear to prefer a deterministic, no-surprises (and too-big-to-fail) economy, but that way lies economic stagnation. If determinism worked, socialism would have thrived.

Knowledge is centrifugal: it's dispersed in people's heads, and that has never been more true than in the Age of the Internet. And it is this universal distribution of knowledge which feeds back to the economy through the creative insights and entrepreneurial efforts of people worldwide that constitutes our chief hope for economic growth in the era opening up before us, where the limits of monetary manipulation and material extraction are becoming painfully apparent.

Here is a telling sentence from George:

Whether fueled by debt or seized by taxation, government spending in economicstimuluspackages necessarily substitutes state power for knowledge and thus destroys information and slows economic growth.

The writing is on the wall: either we reinvent ourselves and our global economy, or the noise that is obviously building in the system will overwhelm the creation and transmission of knowledge, and the great human quest for the democratization of wealth will fail. But, as George says, "Capitalism is not a system of equilibrium; it is an engine of disruption and invention. A capitalist economy can be transformed as rapidly as human minds and knowledge can change." So we do have plenty of grounds for hope.

For the young among my readers, George Gilder wrote the seminal work Wealth and Poverty (which has been recently updated) back in the early '80s, selling over 1 million copies and influencing a generation. He was Ronald Reagan’s most-quoted living author. He has written many books since then, but his latest book, Knowledge and Power, is in my opinión even more important.

When you combine Gilder’s work with Nassim Taleb’s Antifragility, along with the ideas that appeared in the recent Outside the Box piece by Charles Gave on the natural rate of interest, you can begin to get a real sense of why the design of the current monetary system is so flawed. Gilder’s work is foundational to that understanding. We have given our central banks a mandate far outside their actual capabilities: we’ve made them responsible for employment. With their limited tools, they have set about to improve employment but are disseminating corruption in their communications to the markets, in ways they neither intend nor understand. The framework that dominates the thinking of current central bankers simply does not encompass the new paradigm being advanced by Gilder, Taleb, Gave, and others.

Once you grasp the futility of the current structure, you can begin to make sense of the direction of the economy and understand how to position portfolios for continuing periods of exceptional volatility. In one of the great human ironies, the drive to reduce the fragility of the system in fact creates an even more fragile system, until we have a Minsky Moment on steroids.

But that’s a topic for yet another book. I have talked George into writing a summary of Knowledge and Power for today OTB, but it does no more than skim the surface. His books should be included in your fall reading.

George and I have spent many hours talking about new technologies and their implications. Longtime readers know I have a deep fascination with technology and creativity. I have recently been able to get my great friend Pat Cox (who knows more about such things than I have forgotten) to agree to come and write for Mauldin Economics. We will shortly be launching a newsletter focused on technologies that have the potential to transform our society — and ways to invest in them. Pat Cox should be a familiar name to readers of Outside the Box, and I can’t tell you how thrilled I am to be able to work together with him, exploring the fascinating new world that is being created all around us.

I am still thinking through the implications of what I saw on my recent trip to North Dakota. There was just so much positive energy and potential everywhere that it makes you want to come up with ways to transfer that process in every area of the economy.

Ironically, if it was up to the federal government as currently comprised, the Bakken oil play wouldn’t exist. It is messy and chaotic and not at all capable of being directed by a central planner. In short, it is massively successful, without one dollar of government money funding the individual businesses. There are no Solyndras in North Dakota. I’m sure there are lots of small failures here and there, but they haven’t cost taxpayers any equity money.

It is a busy week for me here in Dallas, with lots of meetings and research and writing piling on top of one another, plus family, gym, and other personal commitments. Tomorrow I get to have lunch with my friend Kyle Bass and go from there to spend a few hours with Dr. Woody Brock, who is in town for a speech. However much time I have with Kyle or Woody is not enough, as there are just too many ideas to capture in a few hours. But we all talk fast and try to get in as much as possible. I live for these times.

I think I’ll hit the send button and turn back to my Reading. I just had a huge database of over 500 city pension plans pop into my inbox, and that is going to capture my attention for the next few hours. You gotta love having readers who can access just about anything and get it to you. When I come up for air I’ll write about what I learned this week. And speaking of weeks, you have a good one.

Your finding out that yoga hurts analyst,

John Mauldin, Editor
Outside the Box



The Need for a New Economics

By George Gilder


Why is it that so many Americans seem to believe that government spending, fueled by debt or taxes, can drive economic growth and wealth creation? Why do they believe that low interest rates, enforced by the Federal Reserve, can somehow spur business and investment? Why do they imagine that money and consumer demand impel the economy forward?

The reasons, I believe, are rooted in an economic confusion between knowledge and power. Many economists believe that growth is impelled by the exercise of power, represented by money creation and by government spending and guarantees. By manipulating the so-calledlevers of the economic machine,” government power can enlarge demand, inducing businesses to invest and consumers to spend. This process is seen to generate the demand that fuels economic growth.

These images of the economy of power are part of the very creation story of economics in an era of new machines and sources of energy. The first economic models were explicitly based on the dynamics of the steam engine then impelling the industrial revolution. Isaac Newton’s physicalsystem of the worldbecame Adam Smith’sgreat machine” of the economy, an equilibrium engine transforming coal and steam into economic growth and progress.

Exploring technology investments over recent decades, however, I found myself preoccupied less with sources of power than with webs of knowledge in a field of study called Information Theory. On one level this theory was merely a science of networks and computers. Its implications, however, would change our deepest concepts of the nature of wealth. It would show that wealth is not money or power or demand. It is essentially the accumulation of knowledge.

Information theory effectively began with Kurt Godel’s demonstration in 1930 that all logical systems, including mathematics, are intrinsically incomplete and depend on axioms that they cannot prove. This epochal finding is often obscured by elaborate explanations of the intricate mathematics he used to prove it. But as John Von Neumann in his audience was first to recognize, Godel’s proof put an end to the idea of the universe, or the economy, as a mechanism. Godel’s proof, as he himself understood, implied the existence of autonomous creation.

Godel’s proof led directly to the invention by Alan Turing of a universal generic computer, a so-called Turing machine. By this abstract conception, which became the foundation for all computer science, Turing showed that no mechanistic computer system could be complete and consistent. Turing concluded that all logical systems were intrinsically oracular.

Computers could not be Smithiangreat machines” or Newtoniansystems of the world.” They inexorably relied upon human programmers or oracles and could not transcend their creators. As Turing wrote, he could not specify what these oracles would do. All he could say was that “they could not be machines.” In a computer, they are programmers. In an economy, they are entrepreneurs.

In 1948 a rambunctiously creative engineer, Claude Shannon, from Bell Labs and MIT, translated Godel’s and Turing’s findings into a set of technical concepts for gauging the capacity of communications channels to bear information.

Shannon resolved that all information is most essentially surprise. Unless messages are unexpected they do not convey new information. An orderly and predictable mechanism, such as a Newtonian system of the world or Smithian great machine, embodies or generates no new information.

Studying information theory for decades in my exploration of technology, I finally found the resolution to the enigmas that currently afflict most economic thought. A capitalist economy is chiefly an information system, not a mechanistic incentive system. Wealth is the accumulation of knowledge. As Thomas Sowell declared in 1971: All economic transactions are exchanges of differential knowledge, which is dispersed in human minds around the globe. Knowledge is processed information, which is gauged by its news or surprise.

Surprise is also a measure of freedom and criterion of creativity. It is gauged by the freedom of choice of the sender of a message, which Shannon termedentropy.” The more numerous the possible messages that can be sent, the more uncertainty at the other end about what message was sent and thus the more information there is in the actual message when it is received.

In Knowledge and Power, I sum up information theory as the treatment of human communications or creations as transmissions down a channel, whether a wire or the world, in the presence of the power of noise, with the outcome measured by its “news” or surprise, defined as entropy and consummated as knowledge.

Since these communications or creations can be business plans or experiments, information theory supplies the foundation for an economics driven not by equilibrium and order but by surprises of enterprise that yield knowledge and wealth.

Information theory requires that such a process be experimental and its results be falsifiable. The businesses conducting entrepreneurial experiments must be allowed to fail or go bankrupt. Otherwise there is no yield of knowledge and thus no production of wealth. Wealth does not consist in material capital that can be appropriated by the greedy or the government but in learning processes and knowledge creations that can only thrive in freedom.

After all, the Neanderthal in his cave had all the material resources and physical appetites that we have today. The difference between our own wealth and Stone Age poverty is not an efflorescence of self-interest but the progress of learning, accomplished by entrepreneurs conducting falsifiable experiments of enterprise.

The enabling theory of telecommunications and the internet, information theory offered me a path to a new economics that could place the surprising creations of entrepreneurs and innovators at the very center of the system rather than patching them in from the outside as “exogenous inputs. It also showed that knowledge is not merely a source of wealth; it is wealth.

Summing up the new economics of information are ten key insights:

1) The economy is not chiefly an incentive system. It is an information system.

2) Information is the opposite of order or equilibrium. Capitalist economies are not equilibrium systems but dynamic domains of entrepreneurial experiment yielding practical and falsifiable knowledge.

3) Material is conserved, as physics declares. Only knowledge accumulates. All economic wealth and progress is based on the expansion of knowledge.

4) Knowledge is centrifugal, dispersed in people’s heads. Economic advance depends on a similar dispersal of the power of capital, overcoming the centripetal forces of government.

5) Creativity, the source of new knowledge, always comes as a surprise to us. If it didn’t, socialism would work. Mimicking physics, economists seek determinism and thus erroneously banish surprise.

6) Interference between the conduit and the contents of a communications system is called noise.

Noise makes it impossible to differentiate the signal from the channel and thus reduces the transmission of information and the growth of knowledge.

7) To bear high entropy (surprising) creations takes a low entropy carrier (no surprises) whether the electromagnetic spectrum, guaranteed by the speed of light, or property rights and the rule of law enforced by constitutional government.

8) Money should be a low entropy carrier for creative ventures. A volatile market of gyrating currencies and grasping governments shrinks the horizons of the economy and reduces it to high frequency trading and arbitrage in a hypertrophy of finance.

9) Wall Street wants volatility for rapid trading, with the downsides protected by government. Main Street and Silicon Valley want monetary stability so they can make long term commitments with the upsides protected by law.

10) GDP growth is fraudulent when it is mostly government spending valued retrospectively at cost and thus shielded from the knowledgeable judgments of consumers oriented toward the future. Whether fueled by debt or seized by taxation, government spending in economicstimuluspackages necessarily substitutes state power for knowledge and thus destroys information and slows economic growth.

11) Analogous to average temperature in thermodynamics, the real interest rate represents the average returns expected across an economy. Analogous to entropy, profit or loss represent the surprising or unexpected outcomes. Manipulated interest rates obfuscate the signals of real entrepreneurial opportunity and drive the economy toward meaningless trading and arbitrage.

12) Knowledge is the aim of enterprise and the source of wealth. It transcends the motivations of its own pursuit. Separate the knowledge from the power to apply it and the economy fails.
 
The information theory of capitalism answers many questions that afflict established economics. No business guaranteed by the government is capitalist. Guarantees destroy knowledge and wealth by eliminating the precondition of falsifiability.

Unless entrepreneurial ideas can fail or businesses go bankrupt, they cannot succeed in creating new knowledge and wealth. Epitomized by heavily subsidized and guaranteed leviathans, such as Goldman Sachs, Archer Daniels Midland, Harvard and Fanny Mae, the crisis of economics today is crony statism.

The message of a knowledge economy is optimistic. As Jude Wanniski wrote, “Growth comes not from dollars in people’s pockets but from ideas in their heads.” Capitalism is a noosphere, a domain of mind. A capitalist economy can be transformed as rapidly as human minds and knowledge can change.

As experience after World War II when US government spending dropped 61 percent in two years, in Chile in the 1970s when the number of state companies dropped from over 500 to under 25, in Israel and New Zealand in the 1980s when their economies were massively privatized almost over-night, and in Eastern Europe and China in the 1990s, and even in Sweden and Canada in recent years, economic conditions can change overnight when power is dispersed and the surprises of human creativity are released.

Perhaps the most powerful demonstration that wealth is essentially knowledge came in the rapid post world war II revival of the German and Japanese economies. Nearly devoid of material resources, these countries had undergone the nearly complete destruction of their physical plant and equipment. As revealed by decades of experience with unsuccessful ministrations of foreign aid, the mere transfer of financial and political power is impotent to create wealth without the knowledge and creativity of entrepreneurs.

Information Theory is a foundation for revitalizing all the arts and sciences, from physics and biology to mathematics and philosophy. All are transformed by a recognition that information is not order but disorder. The universe is not a great machine that is inexorably grinding down all human pretenses of uniqueness and free will. It is a domain of creativity in the image of a creator.

In the same way, capitalism is not a system of equilibrium; it is an engine of disruption and invention. All economic growth and human civilization stem from the surprises of creativity and the growth of knowledge in a domain of constitutional order.

The great mathematician Gregory Chaitin, inventor of algorithmic information theory, explains that to capture the surprising information in any social, economic, or biological science requires a new mathematics of creativity imported from the world of computers. He writes: “Life is plastic, creative! How can we build this out of static, eternal, perfect mathematics? We shall use post-modern math, the mathematics that comes after Godel, 1931, and Turing, 1936, open not closed math, the math of creativity

Entropy is a measure of surprise, disorder, randomness, noise, disequilibrium, and complexity. It is a measure of freedom of choice. Its economic fruits are creativity and profit. Its opposites are predictability, order, low complexity, determinism, equilibrium, and tyranny.

Predictability and order are not spontaneous and cannot be left to an invisible hand. It takes a low-entropy carrier (no surprises) to bear high-entropy information (full of surprisal). In capitalism, the predictable carriers are the rule of law, the maintenance of order, the defense of property rights, the reliability and restraint of regulation, the transparency of accounts, the stability of money, the discipline and futurity of family life, and a level of taxation commensurate with a modest and predictable role of government. These low entropy carriers bear all our bounties of surprising wealth and progress.


The Armageddon Looting Machine: The Looming Mass Destruction From Derivatives
             

Increased regulation and low interest rates are driving lending from the regulated commercial banking system into the unregulated shadow banking system. The shadow banks, although free of government regulation, are propped up by a hidden government guarantee in the form of safe harbor status under the 2005 Bankruptcy Reform Act pushed through by Wall Street. The result is to create perverse incentives for the financial system to self-destruct.

Five years after the financial collapse precipitated by the Lehman Brothers bankruptcy on September 15, 2008, the risk of another full-blown financial panic is still looming large, despite the Dodd Frank legislation designed to contain it. As noted in a recent Reuters article, the risk has just moved into the shadows:
Banks are pulling back their balance sheets from the fringes of the credit markets, with more and more risk being driven to unregulated lenders that comprise the $60 trillionshadow-banking sector.

Increased regulation and low interest rates have made lending to homeowners and small businesses less attractive than before 2008. The easy subprime scams of yesteryear are no more. The void is being filled by the shadow banking system. Shadow banking comes in many forms, but the big money today is in repos and derivatives. The notional (or hypothetical) value of the derivatives market has been estimated to be as high as $1.2 quadrillion, or twenty times the GDP of all the countries of the world combined.

According to Hervé Hannoun, Deputy General Manager of the Bank for International Settlements, investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), although most are not generally classed as SBS institutions themselves. At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks.


The Hidden Government Guarantee that Props Up the Shadow Banking System
 
 
According to Dutch economist Enrico Perotti, banks are able to fund their loans much more cheaply than any other industry because they offerliquidity on demand.” The promise that the depositor can get his money out at any time is made credible by government-backed deposit insurance and access to central bank funding. But what guarantee underwrites the shadow banks? Why would financial institutions feel confident lending cheaply in the shadow market when it is not protected by deposit insurance or government bailouts?

Perotti says that liquidity-on-demand is guaranteed in the SBS through another, lesser-known form of government guarantee: “safe harborstatus in bankruptcy. Repos and derivatives, the stock in trade of shadow banks, have “superpriorityover all other claims. Perotti writes:

Security pledging grants access to cheap funding thanks to the steady expansion in the EU and US of “safe harbor status." Also called bankruptcy privileges, this ensures lenders secured on financial collateral immediate access to their pledged securities ...
Safe harbor status grants the privilege of being excluded from mandatory stay and basically all other restrictions. Safe harbor lenders, which at present include repos and derivative margins, can immediately repossess and resell pledged collateral.

This gives repos and derivatives extraordinary super-priority over all other claims, including tax and wage claims, deposits, real secured credit and insurance claims. Critically, it ensures immediacy (liquidity) for their holders. Unfortunately, it does so by undermining orderly liquidation.

When orderly liquidation is undermined, there is a rush to get the collateral, which can actually propel the debtor into bankruptcy.

The amendment to the Bankruptcy Reform Act of 2005 that created this favored status for repos and derivatives was pushed through by the banking lobby with few questions asked. In a December 2011 article titled “Plan B – How to Loot Nations and Their Banks Legally,” documentary film-maker David Malone wrote:

This amendment which was touted as necessary to reduce systemic risk in financial bankruptcies ... allowed a whole range of far riskier assets to be used ... The size of the repo market hugely increased and riskier assets were gladly accepted as collateral because traders saw that if the person they had lent to went down they could get (their) money back before anyone else and no one could stop them.
 
Burning Down the Barn To Get the Insurance


The Barn Safe harbor status creates the sort of perverse incentives that make derivativesfinancial weapons of mass destruction,” as Warren Buffett famously branded them. It is the equivalent of burning down the barn to collect the insurance. Says Malone:
All other creditors bond holdersrisk losing some of their money in a bankruptcy. So they have a reason to want to avoid bankruptcy of a trading partner. Not so the repo and derivatives partners. They would now be best served by looting the companyperfectly legally – as soon as trouble seemed likely. In fact the repo and derivatives traders could push a bank that owed them money over into bankruptcy when it most suited them as creditors. When, for example, they might be in need of a bit of cash themselves to meet a few pressing creditors of their own.

The collapse of . . . Bear Stearns, Lehman Brothers and AIG were all directly because repo and derivatives partners of those institutions suddenly stopped trading and ‘lootedthem instead.

The global credit collapse was triggered, it seems, not by wild subprime lending but by the rush to grab collateral by players with congressionally-approved safe harbor status for their repos and derivatives.

Bear Stearns and Lehman Brothers were strictly investment banks, but now we have giant depository banks gambling in derivatives as well; and with the repeal of the Glass-Steagall Act that separated depository and investment banking, they are allowed to commingle their deposits and investments. The risk to the depositors was made glaringly obvious when MF Global went bankrupt in October 2011. Malone wrote:

When MF Global went down it did so because its repo, derivative and hypothecation partners essentially foreclosed on it. And when they did so they then looted’ the company. And because of the co-mingling of clients money in the hypothecation deals the "looters" also seized clients money as well ... JPMorgan allegedly has MF Global money while other people’s lawyers can only argue about it.

MF Global was followed by the Cyprusbail-in” – the confiscation of depositor funds to recapitalize the country’s failed banks. This was followed by the coordinated appearance of bail-in templates worldwide, mandated by the Financial Stability Board, the global banking regulator in Switzerland.


The Auto-Destruct Trip Wire on the Banking System


Bail-in policies are being necessitated by the fact that governments are balking at further bank bailouts. In the US, the Dodd-Frank Act (Section 716) now bans taxpayer bailouts of most speculative derivative activities. That means the next time we have a Lehman-style event, the banking system could simply collapse into a black hole of derivative looting. Malone writes:

The bankruptcy laws allow a mechanism for banks to disembowel each other. The strongest lend to the weaker and loot them when the moment of crisis approaches. The plan allows the biggest banks, those who happen to be burdened with massive holdings of dodgy euro area bonds, to leap out of the bond crisis and instead profit from a bankruptcy which might otherwise have killed them. All that is required is to know the import of the bankruptcy law and do as much repo, hypothecation and derivative trading with the weaker banks as you can.
 
... I think this means that some of the biggest banks, themselves, have already constructed and greatly enlarged a now truly massive trip wired auto-destruct on the banking system.

The weaker banks may be the victims, but it is we the people who will wind up holding the bag. Malone observes:

For the last four years who has been putting money in to the banks? And who has become a massive bond holder in all the banks? We have. First via our national banks and now via the Fed, ECB and various tax payer funded bail out funds. We are the bond holders who would be shafted by the Plan B looting. We would be the people waiting in line for the money the banks would have already made off with ...

... The banks have created a financial Armageddon looting machine. Their Plan B is a mechanism to loot not just the more vulnerable banks in weaker nations, but those nations themselves. And the looting will not take months, not even days. It could happen in hours if not minutes.

Crisis and Opportunity: Building a Better Mousetrap
 
 
There is no way to regulate away this sort of risk. If both the conventional banking system and the shadow banking system are being maintained by government guarantees, then we the people are bearing the risk. We should be directing where the credit goes and collecting the interest. Banking and the creation of money-as-credit need to be made public utilities, owned by the public and having a mandate to serve the public. Public banks do not engage in derivatives.

Today, virtually the entire circulating money supply (M1, M2 and M3) consists of privately-createdbank credit” – money created on the books of banks in the form of loans. If this private credit system implodes, we will be without a money supply. One option would be to return to the system of government-issued money that was devised by the American colonists, revived by Abraham Lincoln during the Civil War, and used by other countries at various times and places around the world.

Another option would be a system of publicly-owned state banks on the model of the Bank of North Dakota, leveraging the capital of the state backed by the revenues of the bank into public bank credit for the use of the local economy.

Change happens historically in times of crisis, and we may be there again today.