Broken Symmetry

Why Libertarians Should Stop Worrying and Learn to Love Intellectual Property

Toward a Libertarian Theory of Intellectual Property

We libertarians, being libertarians, are seldom to be found in agreement on first principles when it comes to anything, especially legitimate roles of government.  But if there were one principle to which all libertarians might agree, it would be this: That government, in carrying out its legitimate roles, should minimize costs.  The costs of government include not only the more obvious direct costs in the form of taxes and redistributions of property, but more importantly the much larger and more pernicious indirect costs of distortions to private institutions and organizations. (I follow the convention of some economists in distinguishing between the rules that define activity among a group of people ("the institutions") and the group of people itself ("the organization").) When government intervenes to benefit a particular group in society, even for noble of reasons, it can also undermine private institutions that have evolved to bring order, private institutions that may reflect a broader and more stable consensus than can be achieved even by a representative democracy.  At the margins of government reach, communities can and do by consensus ignore legal norms, thereby avoiding the distortions caused by the undermining of locally stable cultural norms.  We Americans should be as proud of the ranchers in Shasta County, California who ignore California trespass law as we are of the Founding Fathers who disobeyed the laws of a more ancient and powerful sovereign.

But true to libertarian form, I mean to challenge this most basic of libertarian principles.  For through my study and practice of intellectual property and antitrust law, I have come to the view that a broader proposition should be embraced: That all institutions in society, in carrying out their legitimate roles, should minimize costs.

Why the need for this broader proposition?  In short, because great benefits may be gained by keeping the same skeptical and minimalist eye, which libertarians naturally keep on government, on all institutions in society, whether public and private.  By focusing on government costs alone, libertarians have been blind to the costs of private institutions.  In the end, what difference does it make whether an oppressive institution is called public or private?  What libertarians are in favor of is more freedom, not less government.

Some readers might object: How can a private institution be costly like government?  The cost of government -- so these readers might say -- is coercion.  And by definition, no private institution can be guilty of coercion. 

My answer is that this objection begs the question.  Both public and private institutions interfere with individual liberties.  The constraints that parents place upon the liberties of their children -- mental, emotional, and physical -- are not different in kind from the constraints that governments place upon their citizens.  Parents' rules are not just because parental; governments' rules not unjust because governmental.   

A stubborn reader might nonetheless persist: If not different in kind, then in degree.  Government coercion is at a scale (of millions of people) and to a degree (of taking life) beyond private coercion.  A glance at twentieth century history confirms it. 

There can be no doubt that twentieth century history put a stink on government.  But did it leave private institutions smelling like a rose?  More importantly, the stubborn reader has already conceded my point by acknowledging that the scale and degree of coercion -- rather than public or private status per se -- is what makes government costly.  By this reasoning we can dismiss libertarians who argue against intellectual property simply because it is a government institution.

Having cleared away distractions, the more difficult question can be addressed:  Does intellectual property play a legitimate role at minimal cost relative to alternative institutions?  The question has both moral and economic dimensions.  Whether the role played by a given institution is legitimate is moral.  Whether there is not a better institutional form for accomplishing a given legitimate role is economic.  Intellectual property law should be favored by libertarians both for its moral and economic merit.

The Moral Case

The best argument ever made for the moral and economic merits of intellectual property was made very close to 150 years ago in Jacksonville, Illinois, where Abraham Lincoln gave a lecture (one in a series; multiple versions of which are available online).  Lincoln's lecture "On Discoveries and Inventions" concludes with famous words: "Before [the patent system], any man might instantly use what another had invented; so that the inventor had no special advantage from his own invention. The patent system changed this [by securing] to the inventor, for a limited time, the exclusive use of his invention; and thereby added the fuel of interest to the fire of genius, in the discovery and production of new and useful things."

What did Lincoln consider the moral case for patents?  To punish theft.  Without a property right in an invention, anybody who devoted the time and effort at inventing would be at the mercy of any dishonest character who managed to learn enough about the invention to copy.  To Lincoln, that seemed unamerican.  To Lincoln, the great difference between the United States and the nations of Europe was the result of "Discoveries, Inventions, and Improvements," which in turn "are the result of observation, reflection, and experiment."  In the United States, inventors earn rewards.

Some are skeptical of Lincoln's premise.  Wouldn't people spend time in "observation, reflection, and experiment" even without the rewards of intellectual property?

Some people, yes.  But for Lincoln the question was not whether inventing could go on without intellectual property.  Clearly it had in Europe, Greece, and Egypt.  (Although interestingly, the first patent system emerged from renaissance Venice.)  For Lincoln, the question was whether we ought to protect the livelihood of people who spend their time in "observation, reflection, and experiment."  Lincoln never worried, as did Thomas Jefferson, that ideas wouldn't spread fast enough if intellectual property punished copyists.

The Economic Case

The economic case for intellectual property is the most difficult.  The economic theory taught in law schools relies heavily on the principles of neoclassical economics, emphasizing equilibrium and the allocative efficiency of markets.  The recent paper by Bessen and Maskin provides an illustration.  A careful mathematical model is made of the net present value of patenting given a stream of innovations and the costs of licensing intellectual property.  But no theory or model is given for the source of the stream.  Many neoclassical economists seem to assume that inventions are an inevitable consequence of market competition.  No particular attention need be paid to inventors.  If the invention is efficient, an inventor will invent.  Even F.A. Hayek seems to have fallen into this circular reasoning.  More careful observation and reflection on inventing results in a calculus of costs and benefits in clear favor of intellectual property.

It is supremely ironic that Hayek opposed intellectual property because it was Hayek who founded the economic theory of institutions and organizations that reveals the economic case for intellectual property.  In particular, it was Hayek who first wrote about the problem of coordinating dispersed bits of information held by individuals in society.  It was Hayek who first explained why decentralized institutions should be favored over central planning.  What Hayek understood was that the costs of information gathering and processing increased with scale much faster than even the most well-run central planning could handle.  At best, the result of central planning at scale are institutions badly adapted or poorly timed to resolve disputes.  At worst, central planners are corrupted by incumbent authorities or vocal minorities into serving an elite group in society.  

By contrast, decentralized institutions in the form of privately adaptable rules provide a scalable, accessible mechanism for resolving competing claims to scarce resources.  The archetypal Hayekian decentralized institution is market price.  By looking at market price signals, a dispersed group of individuals through society can coordinate a variety of activities associated with production and consumption without a single meeting, much less an election.  The story has been told of Nixon being introduced to a central planner in China who simply could not grasp how there was no need for his job in the United States.  Those days seem ancient!

But what is it exactly that makes decentralized institutions superior to central planning?  Is it the fact that central planning is done by government?  Consistent with the analysis given above, the answer is no.  First, whether public or private, central planning is less efficient than decentralized institutions.  Institutional religion, for example, is not exempt from the problems of central planning that plague governments.  Governments simply limit the damage that can be done by the central planning of institutional religion.  The Founding Fathers struck a unique balance through the First Amendment, permitting the United States a unique equilibrium between religious and government institutions.  (But maybe it's better to say that the First Amendment was a consequence of the unique equilibrium that existed rather than its cause.)  Conversely, decentralized institutions are not perfectly private.  There can be little doubt, for example, that a threshold level of government is necessary to markets for insurance, much less complex derivatives. 

What makes decentralized institutions superior is their structure and dynamics.  Decentralized institutions comprise a set of rules that underdetermine the outcome of competing claims to scarce resources.  In many cases, the rules are mutable -- i.e., subject to renegotiation among parties and counter-parties.  As a group, the individuals subject to constraint by decentralized institutions get feedback earlier and more often than do the individuals subject to rule by central planners.  Moreover, the process of variation, selection, and retention of rules that seem to work well for subject individuals means that decentralized institutions actually learn and adapt to changing circumstances.

Intellectual Property as Complex Adaptive System

The most compelling economic case for intellectual property is that it provides a decentralized alternative to centrally planned alternatives, such as prizes, grants, or even tax credits.  Intellectual property does not determine economic outcomes.  Rather, like other systems of property and contract law, it constitutes a market whereby outcomes are determined through repeated private interactions.  Intellectual property law is a substrate on which a network of inventors, entrepreneurs, and established companies coalesces into an ad hoc organization formed with a particular social goal.  The cooperation of legally separate NFL teams to license the NFL brand on an exclusive basis to Reebok -- now on appeal to the Supreme Court in the American Needle case -- provides only a hint of what can be accomplished when dispersed organizations band together through intellectual property rights to accomplish specific goals.  The formation of patent pools for the licensing of drugs developed for treatement of HIV/AIDS are another.

Although Lincoln would not have chosen these terms, we can be sure that he nevertheless had this decentralized network of intellectual property rights in mind when he argued in favor of the patent system 150 years ago.  In his extended argument, he identifies the patent system as the fourth major stage in the progress of civilization.  Lincoln identified speech, writing, and printing as the first, second, and third stages.  What all four stages have in common is their status as decentralized institutions.  All are subject to renegotiation over time through an evolutionary process.  As I have noted elsewhere, had he anticipated their invention, Lincoln almost certaintly would have added internet protocols as a fifth stage.  Perhaps intellectual property should be called the fifth and internet protocols the fourth.

Elsewhere I have made the argument that the patent system should be understood as an evolving complex system, and that important problems with current system could be solved by understanding patents in those terms.  In the terms presented here, my argument is that decentralized institutions constitute a complex adapative system, although to avoid the somewhat unfortunate terminology I often abbreviate this to "systems theory," a moniker embraced by a diverse group of venerable authorities including Mihalyi Csikszentmihalyi, Douglas McGregor, and W. Edwards Deming.

In this post I cannot provide an appropriate introduction to systems theory.  I must instead assert that a comparative institutional analysis conducted within the framework of systems theory strongly suggests that a decentralized institution like intellectual property is constitutive of innovation in ways that alternatives such as prizes or grants could never be.  Whereas prizes or grants are made (in a best case scenario) when the prospective value of an invention comes in view for the central planners, intellectual property permits a dispersed group of private individuals and organizations to invest in new technology.  Whereas the internal rate of return to investment in new technology would be negative (for easily copied technology) or too small to incur opportunity costs (for almost any technology), the security of intellectual property rights promises the possibility of outsize rewards for a limited time.  We are all gamblers in view of the uncertain future.  Intellectual property simply encourages a gamble on investments that promise even larger social benefits over the longer term.  In this limited regard, anaologies to secured credit, derivatives, and insurance markets are not inapt. All of these institutions facilitate the creation of wealth -- in a literal sense -- by facilitating divisions of labor and voluntary exchange that would otherwise be impracticable.

Given the scope of its impact, even ten years is too short a time to evaluate the relative costs and benefits of a intellectual property. But historical evidence for the net benefits of intellectual property is not hard to find looking across the longer span of history.  As noted above, the patent system was born in renaissance Venice, and carried out across the European continent by artisans who sought a reasonable reward for time spent perfecting a particular skill.  Although the English and American patent systems got off to a bad start by failing to honor the basic quid pro quo of public disclosures of knowledge in exchange for limited exclusive rights, by the mid-nineteenth century (the Patent Act of 1836 to be precise), the patent system had taken on what is substantially its modern form.  Interestingly, the concept of trade secrets as intellectual property rights emerged around the same time.  The industrialization that took place in the United States subsequent to 1836 is at least comparable in scope to the fifteenth century renaissance in Italy.

In the past, libertarians have simply misunderstood intellectual property to be merely government-granted privilege. Libertarians should be in favor of intellectual property because it promotes freedom through private enterprise at a scale and to a degree anticipated only by speech, writing, printing, and the Internet.

FFFFFFFFBT!

That's the sound of inflation you're hearing:

In normal times, banks hold a bare minimum of funds in reserve to support their liabilities. But these bank reserves now exceed the U.S. Federal Reserve's regulatory floor by $1 trillion. Before the credit crisis intensified in September last year, excess reserves -- effectively cash banks hold above their regulatory requirements and usually hate holding -- totaled just $2 billion.

Where can that money go? One or more of the following must now occur: Fed raises rates to slow flow of money to banks; banks lend more at higher rates to increase flow to consumers; consumers spend more of newly available, more expensive credit.

An Op Amp with Positive Gain?

From the WSJ:

ETF Portfolio Management is using ETFs to create a twist on a hedge-fund strategy called "trend following," which bets on sustained price movements to make returns with low correlation to the broad market. Trend-following funds are part of a group managing $92 billion that returned 18% last year when broader markets plunged, according to Hedge Fund Research. ETF Portfolio Management's funds and the broad group of trend-following hedge funds have slightly negative returns in 2009.

What's new is the ETF implementation, not the strategy of course:

Analyses of rational speculation usually presume that it dampens fluctuations caused by "noise" traders. This is not necessarily the case if noise traders follow positive-feedback strategies--buy when prices rise and sell when prices fall. It may pay to jump on the bandwagon and purchase ahead of noise demand. If rational speculators' early buying triggers positive-feedback trading, then an increase in the number of forward-looking speculators can increase volatility about fundamentals. This model is consistent with a number of empirical observations about the correlation of asset returns, the overreaction of prices to news, price bubbles, and expectations. Coauthors are Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann. Copyright 1990 by American Finance Association.

Rick Bookstaber is on the right track suggesting that a central clearinghouse of information on the positions held is probably necessary to stablize the system, at least for now. There are probably stability criteria that can be defined for the market, but no amount of theory will be sufficient without an empirical foundation.

The Move to Direct Cash-Flow Accounting

The CFO blog reports on how CFOs have reacted to proposals for a change to direct cash-flow accounting. What is direct cash-flow accounting?

Basically, the direct method of accounting tracks cash changes from the bottom up to arrive at net income, rather than starting with net income and making adjustments.

In other words, you calculate profit and loss using a measure of actual dollars and cents flowing in and out of the company. Sounds sensible, right? Not if you know how things are done now!

"We don't collect this type of information [required by the direct method]," asserted Bond, a panelist at the conference. "That's not the way our ERP system is set up to do things." Steve Whaley, controller for WalMart, agreed, saying the enterprise-resource-planning system for the king of the box stores would also have to be reprogrammed to spit out financial results under the direct method.

Which begs the question, what the heck kind of information are we collecting right now?

See also the academic literature on this topic.

Flogging Tech Transfer? A Reply to David Schwartz

Tech Transfer Tactics provides a valuable service to the group of professionals active in the field, and I have often learned about something new from its pages. It's rare that the editor David Schwartz weighs in with any commentary, so I took a little extra time to digest what he had to say about a recent editorial piece in USA Today, titled "Lucrative inventions pit scientists against universities." The USA Today piece describes an internecine conflict, which is apparently still ongoing, between former faculty-member Renee Kaswan and the University of Georgia over the rights to a successful drug, which Kaswan invented while at the university.

Even without personal knowledge of Kaswan's case, I think it safe to say that something went wrong with the system for both her and the University of Georgia in this instance. Given that, I have had trouble seeing how or why David Schwartz should take exception to the fact that USA Today is calling attention to her case. If universities are doing right by their faculty, then there is nothing to worry about, and people like Dr. Kaswan are not likely to get much traction in arguing that faculty are not getting their due from universities. I certainly don't understand how Mr. Schwartz came to the conclusion that the piece was a "mass media flogging.":

I’m a little guy on the media stage. This e-zine will reach about 200,000 research commercialization professionals around the world — not millions. But I hope I reach a few that will make the effort to set things right, or balance this scorecard just a little bit. Tech transfer professionals have a hard enough job as it is, taking flack from both administrators and innovators while attempting to navigate valuable inventions through a maze of personal, political, legal, and financial hurdles. They are largely unheralded for this yeoman’s work, and don’t complain much about it. But damn it, they don’t deserve to be publicly flogged for their tireless work to bring technological solutions to global problems and help critical research from their labs become useful to the public, rather than sitting in a researcher’s beaker and lab notes.

Now it's true that a good journalist would have taken the time to get the other side to the story here. And it's true that tech transfer professionals have a hard job, and don't get enough recognition for the important work that they do. But I just don't see how this article could be the scourge that Mr. Schwartz makes it out to be. If anything, I think it's useful for calling attention to the important issues of IP ownership that are not even on the table in current debates over patent reform. Who gets what, at the end of the day, is often what matters most in getting people to cooperate toward our ultimate goal of more innovation. Some universities have been more generous than others with their faculty. The jury is still out as to what balance is right for promoting progress.

But there's another definition for "flogging" in English, which seems to fit better the circumstances: "To sell something." Everybody wants readers -- USA Today, Mr. Schwartz, and even I. We all need to be careful about falling into the trap of catering too much to our favorite audience. Even though I agree that USA Today did a poor job of researching its article, I think Mr. Schwartz has gone too far in dismissing the relevance of the Stanford v. Roche case, or of Dr. Kaswans's story. It's true that these are just one case, just one story. But these are cases worth considering. In tech transfer, everybody has a story to tell, and few are formulaic.

For the record, I don't agree that any publicity is good publicity. Bad publicity is indeed bad... but only when it's true.

Reply to Robert Pozen on "Inventing a Better Patent System"

Pozen makes good observations that generally fit well with what I see as necessary to reforming the patent system. In particular, he seems aware that damages apportionment is a red herring for those interested in reform. It might save a few stakeholders some money at the margin, but amending the damages portion of the statute isn't going to fix the systemic problems.

In addition, Pozen observes:

One root of the problem is that patent examiners, many of whom are young or lack practical experience, are not qualified to evaluate whether complex claims in biotech or physics meet the most critical tests: whether the claim is novel relative to prior art, and whether this would be obvious to a person skilled in the art. To help fix this, Congress should pass an amendment allowing experts in the field to submit explanatory or critical comments on patent applications. Currently, most such evaluations are prohibited “without the express written consent of the applicant.” But academic scientists and industry researchers are the best judges of an application’s novelty. Their input would help federal examiners better understand the merits of claims. True, outside comments would likely elicit disagreements from the applicant — but it is better to have this debate first rather than waiting until after patents are granted and taking it to the courts, as we do now.

This observation and suggestion -- which I do not endorse -- are nonetheless motivated by a view I share with Pozen, a view articulated in a letter comment submitted to the FTC earlier this year. In particular, I agree that the system should be reformed so that engineers and scientists doing applied work have an actual incentive to refer to patent office filings for information on what's new in their field. The quid pro quo of the patent system is premised on the notion that scientists and engineers could learn something from the disclosures of issued patents. That is a pure hypothetic for most fields right now because of how poorly the information in disclosures is organized and presented to the public.

The idea of making the patent system more relevant to practicing engineers and scientists is a good one in principle, even if Pozen's specific suggestion of permitting engineers and scientists from competitors to take potshots during prosecution is a total mess in practice.

The rest of Pozen's suggestions more or less track the harmonization proposals that have already been made by a number of interested groups. I don't think most of them would have a huge impact on how well the system runs. Oppositions are not the end-all-be-all here because some potential defendants will choose to fight in district court instead, where procedures are more familiar, as shown by the history of inter partes reexamination. Publication after 18 months happens already for most claims because markets are now global.

The one I strongly disagree with is the proposal to let companies that choose to keep their inventions trade secret be exempt from patent infringement. Would this exempt follow-on inventors from paying for original blocking patents? Why should companies that choose not to share their ideas with the public be exempt from paying for what public knowledge they have used? Either we hang together or we hang apart. Implementing this type of reform would simply render the patent system irrelevant -- both as a cost to the companies that Pozen is sympathetic to and as incentive to innovation.

For what it's worth, I noted today also that Google Scholar now includes patents and legal opinions. That's an example of a private solution to the current systemic problems that could make a bigger difference over time than any amendment to the statute.

Do animals cooperate with non-kin?

From Nature:

Since Robert Trivers' seminal paper on reciprocal altruism in 1971, models of reciprocity and the Prisoner's Dilemma resource-sharing game have provided the dominant theoretical framework for explaining cooperation between unrelated individuals. Yet there is little evidence that, under natural conditions, animals other than man commonly exchange either resources or services. In a Review, Tim Clutton-Brock examines the case for reciprocal altruism in natural populations of non-human animals. The evidence is thin, he concludes, and many examples of apparent cooperation between non-kin are probably cases of mutualism or manipulation.

Thanks to Tyler Cowen for pointing out both this and the last post. We seem to be tuned into a similar wavelength today!

Homophily and Mimetic Desire

From Rene Girard:

My work has often been presented as a discussion of archaic religion through comparative anthropology. Its goal is to shed light on the process of hominization: the fascinating passage from animality to humanity that occurred thousands of years ago.

In all of this, my hypothesis has concerned mimesis: Because humans imitate one another, they have had to find a means of dealing with contagious similarity, which could lead to the pure and simple disappearance of their society. The mechanism by which they have done that is sacrifice, which reintroduces difference into a situation in which everyone has come to resemble everyone else.

Seemed topical given the recent post on homophily and influence.

See also this earlier post relating mirror neuron's to Girard's theory of mimesis.

Co-opetition by Nalebluff and Brandenburger

A blurb on the jacket to Information Rules by Shapiro and Varian leads me to the website for this book by Nalebluff and Brandenburger:

Q. How does someone put this idea of CO-OPETITION into practice?

A. The key is looking at business as a "game." Once you do, you can much more easily spot both the competitive and cooperative aspects of what's going on. Then, after you have a more complete picture of what's going on, there are some simple concepts from game theory that allow you to change the game so you'll do better.

I came to this view through Csikszentmihalyi's version of systems theory. Game theory has always seemed to static. But I liked Nalebluff's Thinking Strategically. Another book for the reading list...

How Persuasive Are You?

When you recommend a new product to your friend and she tries it out, is it because you've persuaded her, or because she shares your preferences? If you're like me, you don't generally bother recommending things to people unless you know they happen to share your tastes along some dimension. Yet in principle there are some people out there whose opinions are "influential" -- coaxing otherwise disinterested people to try new things despite having different tastes. In principle, that's part of why professional athletes and celebrities are paid to endorse products. But teasing out exactly how much of the adoption of a new product is due to influence and how much is due to shared characteristics (i.e., "homophily") in the network can be difficult.

One cut at this question is forthcoming in PNAS in an article titled, "Distinguishing Influence Based Contagion from Homophily Driven Diffusion in Dynamic Networks" by Sinan Aral, Lev Muchnik,and Arun Sundararajan (as noted on the OrgTheory blog) (try emailing Aral for a copy):

In the context of product adoption, peer influence is associated with the presence of adopters in one‟s local network... However, identification of causal peer influence effects is complicated by the unobservability problem. Each user either has adopter friends or not, making it impossible to observe whether those with adopter friends ... would have adopted had they not had adopter friends. Homophily in this case creates a selection bias because treatments are not randomly assigned: adopters are more likely to be treated due to similarity with their neighbors. Thus, frequently used methods such as regression analysis, which can only establish correlation, are insufficient. Causal treatment effects can on the other hand be estimated via matched sampling, which controls for confounding factors and overcomes selection bias by comparing observations that have the same likelihood of treatment.

Toward this end we adapt matched sample estimation for use in dynamic networked settings. Conditioning matches on a vector of observable characteristics, behaviors and attributes yields influence estimates that account for the homophily that may make product adoption decisions cluster in the network even if no influence exists. This procedure establishes upper bounds on the degree to which influence (rather than homophily) explains assortative mixing and temporal clustering in networks. Since influence can vary over time, our framework provides estimates of its evolution. We can also assess the marginal influence of having an additional adopter friend for any arbitrary number of friends.

The upshot of this work is that shared characteristics among individuals accounts for almost all of the "viral" spread of new product adoption -- i.e., that preferences are largely fixed within the time-scale of weeks or months after a new product is introduced. There exists, nonetheless, a small group of people who are "influenced" into adopting a new product -- i.e., whom adopt the product through social interactions with other adopters with whom few characteristics are shared.

At least on its face, the work seems to affirm the use of fixed preferences as an approximation in this context. This validates the use of this approximation by economists. It also demonstrates, however, that the approximation is not without exception. Also of interest to economists.

One question I had on considering the work is whether it would be possible to single out the "influenced" and "influencers" in this survey, and determine whether or not such people occupy a position as bridges or "weak-tie" links within the social networks. Along the lines of Granovetter, the idea is that influence here is largely a function of whether or how often individuals come into contact with others with characteristics far different from their own. It would be interesting to know whether these individuals could be identified using this approach, which isolates "influence" from homophily.

The Good, the Bad, and the Ugly

From Dan Primack at peHUB:

The secondary market’s stickiest wicket continues to be the gap between buyside and sellside pricing expectations. Rather than trying to bridge the divide, it would appear that both sides are calcifying – believing that the other will cave.

For buyers, that means banking on a theory that increased capital call volume will push some LPs over the line from liquidity-parched to liquidity-desperate. Sellers, on the other hand, counter that an increase in capital calls is likely to be coupled with an increase in distributions, which could help them maintain an even keel.

The detente among LPs, buy-side GPs, and sell-side GPs recalls a classic spaghetti western:

One cannot help observing that the same groups that before the crisis were actively engaged in buying and selling have undergone a sort of phase transition to passive standoffs in which the biggest concern is with being the last man standing.

What will break up this "calicified" state, and get the volume of transactions flowing again? Government interventions seem not to be enough. Only restored trust and confidence will do the job. And these take time.

Rolfe Winkler Looks Like a Major New Blogging Talent

From his post "Markets need rules":

Anyone in business knows how much trust matters on both sides of any transaction. When trust disappears, transactions stop. The market breaks down and individuals are forced to rely on themselves. In a perfectly free market, where economic Darwinism means competition always trumps cooperation, trade quickly grinds to a halt.

No one wants this. As economist Russell Roberts has argued, “self-sufficiency is the road to poverty.”

Laws align incentives so that cooperation can be more profitable than competition. So that individuals in the free market don’t have to worry about the market eating them alive.

Winkler's take is slightly different than mine. What I would (and did) say is this:

What Adam Smith taught us is that cooperation is the source of endogenous growth within an economy. Voluntary exchanges and divisions of labor literally create wealth within society. When it's money rather than goods or services that are exchanged, residual income (i.e., profit) is an excellent proxy for cooperation and endogenous growth. In fact, it's the best the world has ever known.

Crucially, the argument is that cooperation creates wealth, and that laws (or social norms) promote wealth creation to the extent that they facilitate and encourage cooperation. This claim may be quite counterintuitive to competition regulatory authorities, in particular, because much of competition regulatory theory is premised on the notion that competition is the engine of growth, with a few recognizing exceptions for temporary and otherwise limited monopolies (for example, for intellectual property). Winkler falls into the same trap by treating cooperation and competition as dichotomous. Competitions are simply one way to get people to cooperate.

Consider the facts of the American Needle case, for example. An unfettered market for NFL souvenirs is one form of private cooperation. The NFL IP licensing group is another. Both are procompetitive and anti-competitive, but among different stakeholders. NFL IP Licensing group promotes competition among professional leagues (MLB, NHL, etc.). A free market among manufacturers and distributors promotes competition among NFL teams, and probably lower prices and lower average quality in souvenirs overall. The question, which I think the Seventh Circuit got right, is what kind of cooperation/competiton we want to promote. The institution of market competition merely pushes people to differentiate or operate with more efficiency. When the market is already operating at peak technological efficiency and peak diversity, competition will be degrading and wasteful.

More fundamentally, the divisons of labor and voluntary exchanges that create wealth are acts of cooperation. In some cases, competiton is necessary to close the gap between bids and asks. In others, there are enough levers on the transaction such that competition isn't necessary to get overlap. In cases where transactions are occurring despite lack of competition, government should be careful not to destroy social capital -- often hard won over generations. That was Ellickson's central insight.

A Short Explanation of the Relationship Between Broken Symmetry and Systems Theory

W. Edwards Deming defines a "system" as follows:

A system is a network of interdependent components that work together to try to accomplish the aim of the system. A system must have an aim. Without an aim, there is no system. The aim of the system must be clear to everyone in the system. The aim must include plans for the future. The aim is a value judgment. (We are of course talking here about a man-made system.)

When Deming says, "[w]ithout an aim, there is no system," he is not saying (of course), that the people who would make up the system disappear. What he is saying is that the aim, by giving each of the people who accept it a shared purpose, modifies the behavior of the people such that activities are no longer random with respect to the aim, but ordered in a way believed best suited to achieve the aim.

In an earlier post on the Ising Model of consumption and savings, we identified individual agents as spins on a one-dimensional lattice. Spin up means consumption; spin down savings. With no magnetic field, the spins are randomly aligned according to the temperature (i.e., money supply) available to them. When a uniform magnetic field is applied, however, that lack of symmetry is broken, and a measurable magnetization (i.e., net savings or consumption) emerges. This broken symmetry is most dramatic when the system approaches the critical point at near zero temperature -- the system spontaneously orders into all savings or all consumption.

In other words, what Deming is saying is that a shared goal, an "aim," acts as field that breaks the symmetry of the system, giving rise to a finite order parameter. (Careful readers will note that my use of the term "system" in describing the Ising Model's behavior is inconsistent with Deming's, which requires an applied field.) In the case of the Ising Model of savings and consumption, the order parameter is aggregate savings or consumption. But other order parameters will emerge in response to other applied fields.

Functionalism and Systems Theory and the Supreme Court's Upcoming Review of American Needle

(If you need background on the case, skip to the * * * * * below.)

For proponents of functionalism and systems theory, there is no more important case before the Supreme Court right now.

Robert Ellickson is perhaps most famous for showing how the Coase Theorem does not hold among ranchers in rural Shasta County in California. His explanation is that shared cultural values are more important than legal rules in many particular social contexts. What the Seventh Circuit has done in American Needle is prevent antitrust law from interfering with privately evolved social norms of cooperation. The theory that individuals can evolve into groups with common norms is part of the sociological theory of functionalism.

In an earlier post on Robert Ellickson's Order Without Law, I pointed out how Ellickson's reasons and evidence for dismissing functionalism as a useful and valid part of systems theory are no longer sound. First, Ellickson rejected functionalism because of a fight among evolutionary biologists that was going on contemporaneous with his publication of Order Without Law. Functionalism is enjoying a resurgence among some evolutionary biologists, notably including E.O. Wilson, whom Ellickson cites in Order Without Law as an opponent of group selection theory. Wilson and Holldobler recently published, The Superorganism, which lays out a functionalist theory of group selection for how cooperation evolved among insects.

Second, there are now better theoretical tools for getting quantitative about functionalism. In particular, associating a group with a network, and individuals with nodes therein, permits evolution of group behavior to be modeled using mathematical models for network growth and decay, or phase transitions. Such models help to eliminate much of the conceptual circularity to which Ellickson objects in this passage.

The upshot is that social norms can evolve to facilitate group cooperation. These norms, in turn, can play a huge role in promoting health and economic growth. The case of IP licensing by the NFL is an easy example of the economic benefits of cooperation. Competition among the teams for licensing revenue -- which I understand is the norm among MLB teams -- leads to less social benefit for consumers and less revenue for the league. In many contexts, cooperation creates wealth that competition would destroy.

This is not to say that there is no role for antitrust regulation. The point is that regulators should not rely on the prescription of methodological individualists (including, most notoriously, neoclassical economists) that competition is a uniform good. Neither perfect competition nor perfect cooperation is optimal for a society. We must find a balance in which enough competition is permitted to allow existing relationships to be broken so that new experiments with resources, capital, and people can be tried. But we should remember that these experiments have an opportunity cost of stability and efficiency, which is too expensive when there is no theory tested by the experiments.

The Seventh Circuit's ruling on the "single-entity" doctrine should be upheld by the Supreme Court. It is a sophisticated answer to the question of how functional groups should be defined. The Seventh Circuit refuses to accept the oversimple definition of a group as a particular group of people. Rather, the group is defined (as W. Edwards Deming suggests it must be) by its shared purpose. Each individual has many goals, but a group of individuals will have only as many as are shared by each individual within it. This counterintuitive fact accounts, to a considerable extent, for the success of neoclassical theory -- only a handful of goals are shared by large groups of people over long periods of time, with the rational pursuit of happiness being the most obvious.

Long time readers will appreciate why I feel this decision is so important for the future prospects of our country. But to give just one illustration, refer back to the description of the effects of individual versus group competition described in this earlier post on executive compensation:

Chickens have always lived in groups, and in the modern egg production industry they are crammed inhumanely into cages usually containing nine to twelve hens. [Biologist William Muir] wanted to increase egg production by selective breeding, and he tried to do it in two ways. The first method involved selecting the most productive hen from each of a number of cages to breed the next generation of hens. The second method involved selecting all the hens from the most productive cages to breed the next generation of hens. You might think that the difference between the two methods is slight and that the first method should work better. After all, it is individuals who lay eggs, so selecting the best individuals directly should be more efficient than selecting the best groups, which might include some individual duds. The results told a completely different story.

When Bill presented his results at a scientific conference that I attended several years ago, he showed a slide of hens selected by the first method after six generations.The audience gasped. Inside the cage were only three hens, not nine, because the other six hens had been murdered. The three survivors had plucked each other during their incessant attacks and were now nearly featherless... What happened? The most productive individuals had achieved their success by suppressing the productivity of their cagemates.

By contrast, the second method resulted in higher production, and a cage that looked almost happy. If group selection could have such a dramatic impact on egg production, what impact might they have on the characteristics of individuals and groups in other situations in which group selection criteria are at work?

What kind of world do we want to live in? There is more at stake in how the Supreme Court decides this case than seems to be apparent to most people.

* * * * *

Here's how the Seventh Circuit summarized the facts and record on appeal (see here for links):

For those who do not know, the NFL is an unincorporated association of (now) 32 separately owned and operated football teams that collectively produce an annual series (or “season”) of over 250 interrelated football games. Each season culminates in a championship game—a game better known as the Super Bowl. As such, the product that the teams produce jointly—NFL football—requires extensive coordination and integration between the teams. After all, NFL football is produced only when two teams play a football game. Thus, although each team is a separate corporate entity or partnership unto itself, no team can produce a game—the product of NFL football—by itself, much less a full season of games or the Super Bowl. Likewise, the teams’ individual success is necessarily linked to the success of the league as a whole; to put it another way, it makes little difference if a team wins the Super Bowl if no one cares about the Super Bowl.

Realizing that the success of the NFL as a whole was in their best interests, in the early 1960’s the individual teams sought to collectively promote the NFL Brand—that is, the intellectual property of the NFL and its member teams—to compete against other forms of entertainment. With this promotional effort in mind, in 1963 the NFL teams formed NFL Properties: a separate corporate entity charged with (1) developing, licensing, and marketing the intellectual property the teams owned, such as their logos, trademarks, and other indicia; and (2) “conduct[ing] and engag[ing] in advertising campaigns and promotional ventures on behalf of the NFL and [its] member [teams].” Among other things, the NFL teams authorized NFL Properties to grant licenses to vendors so the vendors could use the teams’ intellectual property to manufacture and sell various kinds of consumer products that bear the teams’ logos and trademarks—products such as team jerseys, shirts, flags, and, as pertinent here, headwear, like baseball caps and stocking hats.

For a while after its establishment, NFL Properties granted headwear licenses to a number of different vendors simultaneously; one of those vendors was American Needle, which held an NFL headwear license for over 20 years. But then in 2000, the NFL teams authorized NFL Properties to solicit bids from the vendors for an exclusive headwear license. Reebok won the bidding war, and in 2001 the NFL teams allowed NFL Properties to grant an exclusive license to Reebok for ten years. NFL Properties thus did not renew American Needle’s headwear license, or the licenses of the other headwear vendors.

American Needle responded to the loss of its headwear license by filing an antitrust action against the NFL, NFLProperties, the individual NFL teams, and Reebok. As relevant here, American Needle claimed that the exclusive headwear licensing agreement between NFL Properties and Reebok violated § 1 of the Sherman Antitrust Act, which outlaws any “contract, combination . . . or conspiracy, in restraint of trade.” 15 U.S.C. § 1. As American Needle saw it, because each of the individual teams separately owned their team logos and trademarks, their collective agreement to authorize NFL Properties to award the exclusive headwear license to Reebok was, in fact, a conspiracy to restrict other vendors’ ability to obtain licenses for the teams’ intellectual property. American Needle also contended that, by authorizing NFL Properties to award the license to Reebok, the NFL teams monopolized the NFL team licensing and product wholesale markets in violation of § 2 of the Sherman Antitrust Act. See id. § 2.

And here's how the Seventh Circuit ruled on the question of whether the NFL can be considered a "single entity":

American Needle first contends that the district court erred by granting the NFL defendants’ summary judgment on its § 1 claim. Specifically, American Needle argues that the district court incorrectly concluded that the NFL teams constitute a single entity under Copperweld when collectively licensing their intellectual property. American Needle’s argument leads us into murky waters. We have yet to render a definitive opinion as to whether the teams of a professional sports league can be considered a single entity in light of Copperweld. The characteristics that sports leagues generally exhibit make the determination difficult; in some contexts, a league seems more aptly described as a single entity immune from antitrust scrutiny, while in others a league appears to be a joint venture between independently owned teams that is subject to review under § 1. See Brown v. Pro-Football, Inc., 518 U.S. 231, 248-49 (1996) (“[T]he clubs that make up a professional sports league are not completely independent economic competitors . . . . In the present context, however, that circumstance makes the league more like a single bargaining employer . . . .”); Bulls II, 95 F.3d at 597-99 (“To say that the league is ‘more like a single bargaining employer’ than a multi-employer unit is not to say that it necessarily is one, for every purpose.”); see also Super Sulky, Inc. v. U.S. Trotting Ass’n, 174 F.3d 733,741 (6th Cir. 1999) (“[T]he notion of concerted action liability in the field of professional sports is at best confusing.”). For instance, from the perspective of fans, a professional sports league can be seen as “a single source” of entertainment that produces “one product,” even though the league’s member teams are distinguishable. Bulls II, 95 F.3d at 599. Yet at the same time, individuals seeking employment with any of the league’s teams would view the league as a collection of loosely affiliated companies that all have the independent authority to hire and fire employees. See Brown, 518 U.S. at 249 (noting that professional football players “often negotiate their pay individually with their employers,” NFL teams); Bulls II, 95 F.3d at 599 (“[F]rom the perspective of college basketball players who seek to sell their skills, the teams [in the National Basketball League (NBA)] are distinct . . . .”).

That being said, we have nevertheless embraced the possibility that a professional sports league could be considered a single entity under Copperweld. Bulls II, 95 F.3d at 598. But see Fraser v. Major League Soccer, L.L.C., 284 F.3d 47, 55-56 (1st Cir. 2002) (citing Sullivan v. Nat’l Football League, 34 F.3d 1091, 1099 (1st Cir. 1994), to note that Bulls II has not yet been adopted by United States Court of Appeals for the First Circuit). But because of the many and conflicting characteristics that professional sports leagues generally exhibit, we have expressed skepticism that Copperweld could provide the definitive single-entity determination for all sports leagues alike. See id. at 599-600. This skepticism, in turn, has led us to opine that the question of whether a professional sports league is a single entity should be addressed not only “one league at a time,” but also “one facet of a league at a time.” Id. at 600. Thus, in reviewing the district court’s decision, we will limit our review to (1) the actions of the NFL, its members teams, and NFL Properties; and (2) the actions of the NFL and its member teams as they pertain to the teams’ agreement to license their intellectual property collectively via NFL Properties.

With this compartmentalization of Copperweld in mind, we turn to American Needle’s challenge to the district court’s single-entity determination. According to American Needle, the district court applied the wrong legal standard when concluding that the NFL teams were a single entity. As American Needle sees it, the district court concluded “that the NFL [t]eams are a single entity because they ‘act’ as a single entity in licensing their intellectual property.” American Needle asserts that this approach undercuts the Supreme Court’s central teaching in Copperweld: that the Sherman Antitrust Act was designed to combat the deprivation of independent sources of economic power in the marketplace. See 467 U.S. at 469-71.

Therefore, American Needle continues, instead of asking whether the NFL teams merely “ ‘act’ ” as a single entity, the district court should have inquired into whether the NFL teams’ agreement to license their intellectual property collectively deprived the market of sources of economic power that control the intellectual property. That question, the company contends, can be answered by looking to whether the teams could compete against one another when licensing and marketing their intellectual property. If so, American Needle posits, then it is the individual teams who actually control their intellectual property, meaning that they cannot be considered a single entity for the purposes of licensing their intellectual property.

We agree with American Needle that the Supreme Court in Copperweld was concerned about the anti-competitive effects that collective action might introduce into the market. We further agree that when making a single-entity determination, courts must examine whether the conduct in question deprives the marketplace of the independent sources of economic control that competition assumes.

But we are not convinced that the NFL’s single-entity status in the present context turns entirely on whether the league’s member teams can compete with one another when licensing and marketing their intellectual property. American Needle’s proposed approach is one step removed from saying that the NFL teams can be a single entity only if the teams have “a complete unity of interest”—a legal proposition that we have rejected as “silly.” Bulls II, 95 F.3d at 598. As we have explained, “Copperweld does not hold that only conflict-free enterprises may be treated as single entities”; “[e]ven a single firm contains many competing interests.” Id. at 598 (discussing Robert G. Eccles, Transfer Pricing as a Problem of Agency, in Principals and Agents: The Structure of Business 151 (1985)). Thus, though the several NFL teams could have competing interests regarding the use of their intellectual property that could conceivably rise to the level of potential intra-league competition, those interests do not necessarily keep the teams from functioning as a single entity. Id. at 597-98. We therefore cannot fault the district court for not considering whether the NFL teams could compete against one another when licensing and marketing their intellectual property.

And with that said, American Needle’s assertion that the NFL teams have deprived the market of independent sources of economic power unravels. Certainly the NFL teams can function only as one source of economic power when collectively producing NFL football. Asserting that a single football team could produce a football game is less of a legal argument then it is a Zen riddle: Who wins when a football team plays itself? See Nat’l Collegiate Athletic Ass’n v. Bd. of Regents, 468 U.S. 85, 101 (1984)(“‘[Some] activities can only be carried out jointly. Perhaps the leading example is league sports. When a league of professional lacrosse teams is formed, it would be pointless to declare their cooperation illegal on the ground that there are no other professional lacrosse teams.’ ” (quoting Robert Bork, The Antitrust Paradox 278 (1978))); Bulls II, 95 F.3d at 599 (“[T]he NBA has no existence independent of sports. It makes professional basketball; only it can make ‘NBA Basketball’ games . . . .”). It thus follows that only one source of economic power controls the promotion of NFL football; it makes little sense to assert that each individual team has the authority, if not the responsibility, to promote the jointly produced NFL football. Indeed, the NFL defendants introduced uncontradicted evidence that the NFL teams share a vital economic interest in collectively promoting NFL football. After all, the league competes with other forms of entertainment for an audience of finite (if extremely large) size, and the loss of audience members to alternative forms of entertainment necessarily impacts the individual teams’ success. See Bulls II, 95 F.3d at 597; see also Brown, 518 U.S. at 248 (“[T]he [teams] that make up a professional sports league are not completely independent economic competitors, as they depend upon a degree of cooperation for economic survival.”); Nat’l Football League v. N. Am. Soccer League, 459 U.S. 1074, 1077 (1982) (Rehnquist, J., dissenting) (“The NFL . . . competes with other sports and other forms of entertainment in the entertainment market. Although individual NFL teams compete with one another on the playing field, they rarely compete in the market place.”).

But most importantly, the record amply establishes that since 1963, the NFL teams have acted as one source of economic power—under the auspices of NFL Properties—to license their intellectual property collectively and to promote NFL football. Tellingly, American Needle does not dispute that the NFL teams collectively license their intellectual property to promote NFL football; in fact, when opposing the NFL defendants’ motion for summary judgment, American Needle relied on NFL Properties’s Articles of Incorporation, which state that the teams formed NFL Properties “[t]o conduct and engage in advertising campaigns and promotional ventures on behalf of the [NFL] and the member [teams].” And our review of the record reveals no evidence that requires us to question the purpose of the teams’ licensing agreement.

Simply put, nothing in § 1 prohibits the NFL teams from cooperating so the league can compete against other entertainment providers. Indeed, antitrust law encourages cooperation inside a business organization—such as, in this case, a professional sports league—to foster competition between that organization and its competitors. See Bulls II, 95 F.3d at 599. Viewed in this light, the NFL teams are best described as a single source of economic power when promoting NFL football through licensing the teams’ intellectual property, and we thus cannot say that the district court was wrong to so conclude.

Moving on, the failure of American Needle’s § 1 claim necessarily dooms its § 2 monopolization claim. As a single entity for the purpose of licensing, the NFL teams are free under § 2 to license their intellectual property on an exclusive basis, see Cook Inc. v. Boston Scientific Corp., 333 F.3d 737, 740 (7th Cir. 2003), even if the teams opt to reduce the number of companies to whom they grant licenses, see Bulls II, 95 F.3d at 598 (“To say that participants in an organization may cooperate is to say that they may control what they make and how they sell it: the producers of Star Trek may decide to release two episodes a week and grant exclusive licenses to show them, even though this reduces the number of times episodes appear on TV in a given market . . . .”); Gregory J. Werden, Antitrust Analysis.

of Joint Ventures: An Overview, 66 Antitrust L.J. 701, 730-31 (1998) (“An antitrust claim based solely on a single firm’s denial of a license to a trademark would readily be dismissed . . . .”). As such, American Needle has no colorable claim that the NFL teams and NFL Properties created a monopoly by awarding Reebok the exclusive headwear licensing contract. See Cook Inc., 333 F.3d at 740 (discussing competitive effects of exclusive-licensing agreements); Bulls II, 95 F.3d at 598. The district court was therefore correct to grant summary judgment to the NFL defendants on American Needle’s § 2 monopolization claim.

The New Economics by W. Edwards Deming

Recently, I stumbled upon the work of W. Edwards Deming while doing some reading on the applicaton of stastical control to quality improvement. I'm not sure for whom Deming would today be a recognized name, and after reading The New Economics I have a few guesses as to why his reputation may not have persisted for as long after his death as has the reputation of F.W. Taylor, for example.

Deming, unlike Taylor, was not offering easy solutions to his clients, his clients being managers at for-profit companies, teachers and administrators in schools and universities, and politicians or public servants in government -- really anybody who cared to listen. Rather, he was offering a theory about how organizations could improve their overall performance.

The Systems Theory according to Deming

Of special significance to your author is the fact that Deming chose to call his theory "systems theory." Deming defines a "system" as follows:

A system is a network of interdependent components that work together to try to accomplish the aim of the system. A system must have an aim. Without an aim, there is no system. The aim of the system must be clear to everyone in the system. The aim must include plans for the future. The aim is a value judgment. (We are of course talking here about a man-made system.)

Included in this chapter 3 of The New Economics is Figure 6, which Deming calls a "flow diagram" of "Production viewed as a system":

Figure 6 illustrates the interdependence of the components (most economists would call them agents today) within the system. Deming uses the figure to explain how the product is the result not only of how each agent does his or her job, but of how well the agents cooperate to achieve their mutual goal of a happy consumer.

As Deming sees it, "[a] system must be managed. It will not manage itself. Left to themselves in the Western world, components become selfish, competitive, independent profit centers, and thus destroy the system." By contrast, "[t]he secret is cooperation between components toward the aim of the organization. We cannot afford the destructive effect of competition."

More specifically, Deming places the responsibility with management for studying the market, identifying and selecting goals, and clarifying and facilitating the communication of those goals among agents. In practice, this involves listening to agents more than talking, since it is the agents (especially the agents in contact with people outside the firm) that have the freshest information to guide goal development.

Deming suggests that the ultimate goal should be for every stakeholder in the organization -- stockholders, employees, suppliers, customers, community, the environment -- to benefit over the long term. Contrast this with fiduciary duty to maximize profits for shareholders instituted by Dodge v. Ford..

On my view, Deming was prophetic. This book was published in 1993, when the first of two major financial bubbles were just getting started. But now that the global economy has exploded into a chaotic frenzy of new markets and firms, most of which only roughly fit within traditional geographical or jurisdictional boundaries, it is now obvious that there is no institution in the world powerful enough to guarantee to any stakeholder that it will be favored over all others that contribute to an organization. Until a few decades ago, capital was king. No wonder that the owners of capital, often being the scarcest resource available to a firm, got special protection from government. What is the scarcest resource over the very long haul? As Deming could see even in 1993, the answer is human capital -- people power. The systems theory that Deming espoused is about optimizing firms to make the best use of human capital, and it is completely consistent with the systems theory Broken Symmetry seeks to understand in gory detail. Get in the habit of thinking this way, and life will not be the same.

Let's take one example of Deming's application of systems theory to the problem of optimizing firms. Deming attributes this application to Shewhart, who Deming says:

invented a new way to think about uniformity and nonuniformity. He saw two kinds of variation -- variation from common causes and variation from special causes. Common causes of variation produce points on a control chart that over a long period all fall inside the control limits. Common causes of variation stay the same day to day, lot to lot. A special cause of variation is something special, not part of the system of common causes. It is detected as a point that falls outside of control limits.

According to Shewhart, a lack of knowledge about common and special causes of variation leads to two mistakes:

Mistake 1: To react to an outcome as if it came from a special cause when actually it came from a common cause of variation.

Mistake 2: To treat an outcome as if it came from common causes of variation, when actually it came from a special cause.

The "Common Cause of Variation" is a Martingale

At this point, I can explain to my readers why I believe Deming's representation did not last long beyond his death. These statements, devoid of any experience with statistical or physical theory, must seem completely obvious, even trivial. They are not if one can understand and interpret what Shewhart and Deming (both trained as physicists) are talking about here.

What Deming and Shewhart call a "common cause of variation" is what most engineers, scientists, and even economists and other social scientists would recognize as a normal or Gaussian distribution in outcomes. As wikipedia explains:

By the central limit theorem, the sum of a large number of independent random variables is distributed approximately normally. For this reason, the normal distribution is used throughout statistics, natural science, and social science as a simple model for complex phenomena. For example, the observational error in an experiment is usually assumed to follow a normal distribution, and the propagation of uncertainty is computed using this assumption.

By contrast, when Deming and Shewhart talk about "special causes of variation," they're talking about distributions of outcomes with fat tails -- pareto distributions (a/k/a power laws), Levy distributions, and so on. Deming and Shewhart were studying Martingales and non-convergent stochastic dynamics decades before these became popular in academic fields! Even better, they were teaching managers inside large corporations how to recognize non-Markovian dynamics and correct system design without making the problem worse.

An Application to Financial Regulatory Reform

How might this be applied to the financial system? Fat tails developed, which almost destroyed the system. Lots of folks are jumping in now with reform proposals that promise to make the system more efficient, more stable. What would Deming and Shewhart have to say?

Chapter 9 provides some tantalizing clues. Chapter 9 is called "The Funnel," and describes a process whereby marbles are dropped through a funnel (which is wide enough for each marble to have some clearance) onto a table cloth, with the position at which the marbles come to rest being marked. Without doing the experiment yourself, you can imagine that the actual pattern of marks formed after such an experiment will be a cluster of marks on the table under a target under the funnel -- not one spot right on the target. As Deming explains by successively considering various alternatives, most active efforts to reduce the radius of the cluster of marks will not be successful.

1. If at each drop, the funnel is moved from its last position to a new position to compensate for the last error (for example, by moving northeast to compensate for a mark southwest of the target), then the results are worse -- the pattern of marks has an even wider radius.
2. If at each drop, the funnel is moved from its starting position to a position equal in distance and opposite the direction of the last error, then the results are even worse -- a plot of the radius of marks now shows distinct oscillations.
3. If at each drop, the funnel is moved over the mark where the last marble fell, then the marks will merely drift off "to the Milky Way."

What's going on here and how is this relevant to the financial system? Banks are funnels for cash and other assets -- the marbles flowing through our system. The marks on the table are the marks on the books of each bank -- marks of how each asset is valued at a given moment. The various alternative rules for moving the funnel around represent the effects of mark-to-market rules on the financial system -- rules intended to correct for the default gaussian spread of marks!

1. When corrections are made to book value in each period to account for newest market prices, volatility in asset value is increased. This is equivalent to moving the filter in a direction equal and opposite to the last mark after each drop.
2. Making corrections to book values of cost only makes things worse, increasing volatility in the system even further!
3. Marking assets to exactly the last market price (i.e., without taking into account historical value at all) sets the whole system adrift.

How and why was FAS 157, which implemented these rules, ever put into place? The answer is that the accountants who work on these regulations work for the banks and institutions that wanted to mark up their book value during the Great Moderation that preceded the present financial crisis. And they're not entirely to blame because most of these people do not have a systems-wide view of the consequences of these rules. But it should be clear how important they can be.

I hope this example demonstrates the instrumental value of systems theory to policymakers. Until now, law and economics (the economics being mostly neoclassical) was the only quantitative tool in the toolbox. What this example shows is that systems theory can provide insight. As Deming points out, none of the active efforts to correct the error would have been as helpful as simply moving the funnel closer to the table cloth or using a sticky table cloth (by analogy to the financial system, this could mean better matching the frequency of marks to market to the frequency of transactions or increasing the transactions costs relative to the size of the transaction).

The Problem with American Anti-intellectualism

From W. Edwards Deming's The New Economics at 173:

On arrival [at] Western Electric, following directions, I found my way to Mr. Chester Coulter on the fifth floor. I was to join a group of about two hundred people working in so-called research and development. The head of the organization was a Dr. H. Rossbacher. My esteem for him increased year by year. He had a respect for theory. In a conversation that I overheard one time, somebody complained to him that the way we were starting off was too theoretical. HIs reply was that if we have ever accomplished anything here, it started off with studies that some people complained were too theoretical. He had no use for the word practical.

On that note, I plan to post a review of Deming's New Economics sometime soon. Deming is fuzzy on the distinction between special and common causes of variation in production, and it's no accident why. Statistical models of special variation are very sophisticated.

What data sets should be used to test models of agent dynamics?

Geanakoplos and Farmer observe:

What is still largely lacking is an empirical foundation on which to build an evolutionary theory. This ultimately depends on developing a taxonomy of real nancial strategies together with a database of studies of nancial ecologies as they change through time.

It's out there. The right data sets for modeling agent dynamics are the time series of cash-flows into and out of firms. These data sets are obscured by accounting rules right now. Moreover, the time series of security prices are far too complex a phenomena to give any insight into individual or firm agent behavior.

It's always easier to build models for the data you have in front of you than it is to go out and get the best data. But it surprises me that no academic anywhere has ever tried to collect historical journal entries from several companies in a given market, and then modeled their behavior.

The authors also note that previous attempts at nonequilibrium models have failed because they made too many assumptions. How about making just one -- that particular activities of agents have a characteristic frequency. Start from their and work backwards in modeling the dynamics, and we may get further than if we start from the time-series of market prices.

Geanakoplos and Farmer on the Nonequilibrium Statistical Mechanics of Markets

The WSJ leads with Geanakoplos today and Marginal Revolution picks the story up. Skimming through SSRN publications by Geanakoplos, I find this chestnut:

An alternative point of view is that, due to a lack of a perfect rational ity, the market is not in perfect equilibrium and thus prices do not simply passively reflect new information. Under this view the market acts as a non-linear dynamical system: agents process information via decision-making rules that respond to prices and other inputs, and prices are formed as a result of agent decisions. Since this information processing is imperfect, the resulting feedback loop amplies noise. As a result a signicant component of volatility is generated by the market itself.

From a paper co-authored with J. Doyne Farmer.

Are markets flawed? Or is it competition?

Soros has this to say about the role of markets:

But markets are suitable only for individual choices, not for social decisions. They allow individual participants to engage in free exchange; but they are not designed to exercise social choices such as deciding the rules that should govern society, including how the market mechanism should function. That is the purview of politics. Extending the idea of a free-standing market, self-governing and self-correcting, to the political sphere is highly deceptive because it removes ethical considerations from politics which cannot properly function without them.

Soros didn't go far enough with reflexivity. But here he goes too far. It is not markets that are responsible for the emphasis we place on individual choice. It is the value placed on competition that devolves markets into individual free-for-alls. Competition, as currently understood by market actors and government regulators, has the underpinnings of the methodological individualism on which all of modern economics rests. Alternative methodologies and understandings of competition would not produce the same market dynamics, as comparison of various industries makes obvious (to borrow examples from Charlie Munger, consider cereal manufacturers on the one hand and airlines on the other).

Individuals spontaneously order into firms. What benefit is there to such integration if markets put less constraints on the same individuals? The function of markets is to synchronize buyers and sellers who cannot otherwise integrate their needs within a firm. Soros has it exactly backwards. It's not that markets are suitable only for individual choices; it's that individual choices are suitable only for markets.

In this context, Soros would do well to consider some of the New Institutional Economics and Organizational Theory literature, which provides theory on how and when institutional culture develops. I don't disagree with his point that institutional rules are needed. Just his point that government institutions are necessary or sufficient to meet those needs.

Reflexivity Goes Deeper than Soros Himself Seems to Realize

I was piqued by this bit at the end of Soros's recent lecture on his "general theory of reflexivity":

I am somewhat troubled, however, about drawing too sharp a distinction between natural and social science. Such dichotomies are usually not found in reality; they are introduced by us, in our efforts to make some sense out of an otherwise confusing reality. Indeed while a sharp distinction between physics and social sciences seems justified, there are other sciences, such as biology and the study of animal societies that occupy intermediate positions.

But I had to abandon my reservations and recognize a dichotomy between the natural and social sciences because the social sciences encounter a second difficulty from which the natural sciences are exempt.

And that is that social theories are reflexive. Heisenberg’s discovery of the uncertainty principle did not alter the behavior of quantum particles one iota, but social theories, whether Marxism, market fundamentalism or the theory of reflexivity, can affect the subject matter to which it refers. Scientific method is supposed to be devoted to the pursuit of truth. Heisenberg’s uncertainty principle does not interfere with that postulate but the reflexivity of social theories does. Why should social science confine itself to passively studying social phenomena when it can be used to actively change the state of affairs? As I remarked in The Alchemy of Finance, the alchemists made a mistake in trying to change the nature of base metals by incantation. Instead, they should have focused their attention on the financial markets where they could have succeeded.

Why piqued? Because Soros seems oblivious to the fact that Heisenberg's uncertainty principle implies exactly what it is that makes social science distinguishable from natural science! Part of what Heisenberg's principle tells us (in mathematically precise terms) is that what we decide to measure will have an infuence on the system we choose to measure. We cannot treat our probe as independent from the system it measures except as an approximation. In many cases, the interaction of the system and probe through a measurement will irreversibly alter the system, making additional measurements impossible to reproduce without reproducing a copy of the system. That is all part of quantum mechanics.

To his credit, Soros acknowledges that there may not be a clean cut between the two -- he points to biology and animal sociology as intermediate cases. But his mistake is clear. His assumption that nature has not changed as a result of new theories and measurements is false. Sure enough, the changes are not as immediate or obvious. Yet there can be no doubt that the world is a different place because of quantum mechanics. What world would we live in had there been no Manhattan Project? Poverty of theory in Germany and Japan in WWII decided the fate of the world. The history of science is replete with similar examples of successful and failed experiments with nature, which have rippled out in their consequences for the rest of mankind.

But far from being fatal to Soros's "general theory of reflexivity," this observation of his mistake actually solidifies its claim to both validity and relevance. Instead of a dichotomy between natural and social science, What should Soros have called for? A better understanding of the system in which both natural and social scientists work. Our knowledge is a physical manifestation of the activities of scientists and non-scientists. What we measure is merely a function of the various activities of the system.

Many philosophers have made similar observations. In the legal context I think of Wittgenstein and H.L.A. Hart who wrote about how a rule does not include within it a rule for deciding how and when it should be enforced. But W. Edwards Deming had a simpler way of summarizing the point in a book of his that I've been reading with interest:

There is no true value of any characteristic, state, or condition that is defined in terms of measurement or observation. Change of procedure for measurement (change in operational definition) or observation produces a new number... There is no such thing as a fact concerning an empirical observation. Any two people may have different ideas about what is important to know about any event. Get the facts! Is there any meaning to this exhortation?

Communication and negotiation (as between customer and supplier, between management and union, between countries) require for optimization of operational definitions. An operational definition is a procedure agreed upon for translation of a concept into measurement of some kind.

Our perception of reality itself is more socially constituted than most of us appreciate! Consider how physicist Roger Penrose chose to depict reality as a cycle:

The cycle is manifest in the activities of people. The mathematical world is revealed, step by step, through consensus among living and dead mathematicians. The mental world represents the model everybody has, including mathematicians, of what exists. Both of these are embedded in a physical world along with a Noah's ark of other animals and a Garden of Eden of other living things.

We exercise control over our existence by formulating theories about what exists. There are plenty of things that exist that no person imagined to exist until a theory was developed that permitted for experiments, which in turn were consistent with other experiments, and so on. Nobody doubts anymore that we are made of atoms, quarks, and leptons. Yet none of us has seen any of these things. And if we were to stop looking for them, there is no doubt in my mind that we would eventually forget about them -- leaving their existence as ghostly as it was a hundred years ago.

There is no dichotomy between social and natural science. Rather, social science should embrace these constraints that have been on all science for as long as we've been doing experiments.

George Soros Explains His Worldview

And it is surprisingly fascinating:

While I was reading Popper I was also studying economic theory and I was struck by the contradiction between Popper’s emphasis on imperfect understanding and the theory of perfect competition in economics which postulated perfect knowledge. This led me to start questioning the assumptions of economic theory. These were the two major theoretical inspirations of my philosophy. It is also deeply rooted in my personal history.

The FT has a whole website up with transcripts from each of his lectures, which are ongoing this week. It's little things like this that make my day.

Transcripts of first three lectures are here, here, and here.

For an earlier post on epistemlogical and ontological questions that offers one version of reflexivity, see here.

In reponse to Soros's proposal that we dichotomize the natural and social sciences, I have this to say: His misinterpretation of Heisenberg's uncertainty principle kills his proposal. In fact it is true of both natural and social scientific theories that our theories influence how reality evolves. It is true too that bad natural science may not have as catastrophic or immediate consequences for us as bad social science. But what we perceive depends in part on our theory of what exists, and those theories are not social. Soros's dichotomy is in fact a continuum.

To wit, from whence did Soros derive his understanding of positive and negative feedback loops? By analogy to the natural sciences. Our exploration of nature is the ultimate origin of all of our theories, bot natural and social.

Mandelbrot and the Glassy State of the Economy

From Fractals and Scaling in Finance, page 367:

Everyone agrees that the distribution of firm sizes is far from Gaussian, hence the proper metaphor is not a "soft," but a "hard" object. This leaves open the question of whether it is a real solid or a glass. Physics describes glasses as being extremely viscous liquids that mimic solids and happen to be particularly difficult to study. In the same way, the lognormal distribution averages mildly in the very long run, but in the short run it mimics the wild randomness of the scaling in a very treacherous fashion. One can call it a sheep in wolf's clothing.

Why is Mandelbrot skeptical of lognnormal distributions of firm size? Because market concentration appears to be a scale invariant quantity -- i.e., the amount of concentration appears not to vary as much with the number of firms in the market as one would expect from distributions with finite variance.

Truth on the Market Merger Guidelines Symposium

Check it out. The symposium offers a preview of the arguments and evidence to be presented at FTC/DOJ hearings on the guidelines scheduled through the winter.

The big shift that could occur as a result of these hearings is a move away from market definition to more direct measurement of the effect of mergers on consumers. The legal formalists of antitrust law tend to go into fits at the suggestion, but is there an area of law more appropriate for legal realism than antitrust? Even legal formalists have to admit that there are rule of law virtues in issuing opinions on decisions that cite the actual grounds on which the decision turned, rather than a reframing of those grounds in terms of market definition rules that turn judges into home plate umpires.

W. Brian Arthur on How Science and Technology Evolve

From the NYT:

“What I began to realize as I got into the project is that everything emerges out of technology,” Dr. Arthur said in a recent interview. “It’s technology that gives rise to both modern science and the economy, and we tend to think of it in reverse — that science gives rise to technology and the economy gives rise to technology. But technology is more fundamental than either one.”

Think about what this means for how we view the relationship between industry and universities.

Distinguishing Exogenous from Endogenous Market Crashes

Simoleon Sense links to what could be a useful bit of anlaysis from Sornette et al.:

[W]e have provided an objective test of the hypothesis that the largest negative markets moves are special and form two distinct populations. The exogenous crashes can be attributed to extraordinary important external perturbations and/or news impacting the market. The endogenous crashes can be seen as the natural deaths of self-organized self-reinforcing speculative bubbles giving rise to specific precursory signatures in the form of log-periodic power laws accelerating super-exponentially.

Sornette applied a similar approach to analyzing YouTube video traffic here.

I'm slowly warming up to Sornette's idea of log-periodic scaling. The mathematical part of this model, at bottom, arises from a treatment of fractional dimensions as complex rather than real-valued quantities.