Broken Symmetry

Gawande on Systems Theory

From a commencement address:

Medical performance tends to follow a bell curve, with a wide gap between the best and the worst results for a given condition, depending on where people go for care. The costs follow a bell curve, as well, varying for similar patients by thirty to fifty per cent. But the interesting thing is: the curves do not match. The places that get the best results are not the most expensive places. Indeed, many are among the least expensive. This means there is hope—for if the best results required the highest costs, then rationing care would be the only choice. Instead, however, we can look to the top performers—the positive deviants—to understand how to provide what society most needs: better care at lower cost. And the pattern seems to be that the places that function most like a system are most successful.

The observations apply to lawyers and law.

Balance-Sheet Networks

From Robert M. May, Simon A. Levin and George Sugihara:

although the study of payment flows is of immediate interest to central bankers, it may miss an essential aspect of systemic risk, namely the ‘contagion dynamics’ of public perceptions and asset valuation associated with the interaction of balance-sheets (the mutual financial obligations and exposures that link companies). For example, how contagious are inflated valuations of Internet stocks? Are there hidden, mutually dependent risks associated with such high valuations? It could be useful to examine the dynamic network of balance-sheets, and if possible to quantify the inter active effects of valuations, credit policies, hedging and so on among financial institutions, especially investment banks. Such balance-sheet networks could be helpful in studying the effects of asset- pricing bubbles, credit crises and the poorly understood but potentially worrying effects of the current widespread use of derivatives (futures and options) and dynamic hedging by investment banks to manage risk on the fly.

Just discovered Sugihara through a link in an interesting post on O'Reilly Radar.

Bookstaber Smooths Out Complexity

Interesting as usual:

Finance is often regarded as a game, but by the conventional von Neumann definition it is not. Granted it is ostensibly circumscribed by the rules of law, but so is war circumscribed by the rules of the Geneva Convention (at least conventional war). Adversaries at war do not have to play by the same rules or even play the same game. Indeed, what more is the strategy of war than playing the game that works to your advantage, and doing so while keeping your adversary unaware of that game? What more is the charge of “asymmetric warfare” than having an adversary that is not playing by your rules or your game – and is winning the war in the process?

Symmetry and Entropy in Market Bubbles and Crashes

From Dion Harmon, Marcus A. M. de Aguiar, David D. Chinellato, Dan Braha, Irving R. Epstein, Yaneer Bar-Yam:

Predicting panic is of critical importance in many areas of human and animal behavior, notably in the context of economics. The recent financial crisis is a case in point. Panic may be due to a specific external threat, or self-generated nervousness. Here we show that the recent economic crisis and earlier large single-day panics were preceded by extended periods of high levels of market mimicry --- direct evidence of uncertainty and nervousness, and of the comparatively weak influence of external news. High levels of mimicry can be a quite general indicator of the potential for self-organized crises.

Via Physics arXiv blog.

What I like about this work is how at the conceptual level it fits with other theories of markets making phase transitions between high and low entropy states, with symmetries breaking as the transition begins and picks up steam.

There is a lot of talk about whether Quantitative Easing has done much. Folks like Scott Sumner seem to be arguing that it has not because market expectations were adjusted at the moment QE was announced (or quickly thereafer). I'm more skeptical about that claim because I imagine that it takes more than days or even weeks for organizations to propagate new information about prospective rates through their entire ranks, such that there remains an impedance mismatch between Fed signals and market reactions. But at an even more fundamental level, the market response to Fed signals does not appear to be linear within some regimes, including the one we live in now, which looks to me like a liquidity trap, albeit not homogeneously sticky for all industries and firms. (Consumer internet, in particular, seems to be attracting capital investment at an accelerated pace compared even with hardware and software solutions providers.)

Tyler Cowen on Methodological Individualism

Over at MR, Tyler offers some thoughts and a wealth of interesting links on the subject.

Foucault understood how actual historical explanation relies on the use of broad categories, classes, and exemplars, and in a manner which is not logically reducible to statements about individual beliefs and desires. The writer (theorist) has nothing close to a complete mental model of how the interacting categories reduce to component individual parts, and so some or most of the moving parts of the explanation retain their autonomy at a partially macro level. The Austrians will kick and scream on this one, but if you combine imperfect information and the sense/reference distinction, methodological individualism ends up as more of a slogan than anything else. There is a reflective equilibrium to the explanatory process, and micro relies on some macro foundations, not just vice versa, and individuals rely on the social for some of their cues. Atomistic reduction to the level of the individual in general will not succeed.

For earlier posts on the horribles that result from methodological individualist theory in antitrust law, see here. Also note that Kenneth Arrow has expressed at least strong skepticism about methodological individualism. The picture that develops is of a feedback loop between individuals, groups, and the set of formal rules and procedures for encoding and transmitting them. We can't understand the behavior of the system with a myopic focus on any single part.

Networks of Economic Market Interdependence and Systemic Risk

by Dion Harmon, Blake Stacey, Yavni Bar-Yam, and Yaneer Bar-Yam:

The dynamic network of relationships among corporations underlies cascading economic failures including the current economic crisis, and can be inferred from correlations in market value fluctuations. We analyze the time dependence of the network of correlations to reveal the changing relationships among the financial, technology, and basic materials sectors with rising and falling markets and resource constraints. The financial sector links otherwise weakly coupled economic sectors, particularly during economic declines. Such links increase economic risk and the extent of cascading failures. Our results suggest that firewalls between financial services for different sectors would reduce systemic risk without hampering economic growth.

Via Brandon Keim at Wired.

Former Apple CEO John Sculley on Steve Jobs, Systems Thinker

From a fantastic interview of Sculley at Cult of Mac:

The iPod is a perfect example of Steve’s methodology of starting with the user and looking at the entire end-to-end system. It was always an end-to-end system with Steve. He was not a designer but a great systems thinker. That is something you don’t see with other companies. They tend to focus on their piece and outsource everything else.

Van den Steen on Knightian Uncertainty and the Firm

From AER: (via MR)

According to Knight, then, people differ (with respect to uncertainty) in the confidence in their judgment and “the most fundamental change of all in the form of organization” is the “system under which the confident … ‘insure’ the doubtful … by guaranteeing to the latter a specified income in return for an assignment of the actual results” ( p. 269). While this is often interpreted as risk aversion, Knight’s “confidence” actually refers to the belief that your judgement is correct, i.e., ν. This description does fit the mechanism in this paper: the principal tells the agent what to do and gives the agent a fixed wage in exchange, i.e., he insures the agent against the principal’s mistakes; and it is the more confident player who becomes the boss.

From this interpretation of Knight, the essence of a firm is that it allows the confident entrepreneur to make all decisions under uncertainty and then bear all the financial consequences of these decisions, i.e., absorb the uncertainty. The driving force in the existence of a firm is, according to Knight, the difference in confidence, which was also one of the driving forces in this model. This is quite different from the Coasian view, where it is the cost of transactions, i.e., the cost of contracting on decisions, that drives firm boundaries...

Although I'm not convinced of the generality of Van den Steen's theory (which strikes me, because of his emphasis on differences in priors, as a better description of insolvent organizational dynamics than it does of technology startups, for example), I do find this interpretation of Knight pretty interesting.

Coming at this with my priors from having studied probability theory in the context of quantum mechanics, I tend to imagine Knightian subjective uncertainty as the Hilbert space for a particle, with objective uncertainty then being the expectation value for a particular observable. Then Van den Steen's theory suggests that the Knightian entrepreneur effects the collapse of a wave function into a particular state. But the actions of the Knightian entrepreneur may or may not be consistent with how a rational actor would behave in view of the expecation values! Rather, as Van den Steen suggests, it is the confidence of the entrepreneur (or at least the confidence projected), which results in a measurement and collapse into a particular state. That's very interesting because decisionmaking by an organization does seem to be driven at least partially by signals of confidence.

Incompatible observables permit another thought experiment. There are plenty of classical equivalents, and I see no reason why these should not constrain organizational economics as much as they do anything else. The most relevant pair of observables for financial statements are time and frequency. So one can imagine an entrepreneur who forces the system into a non-Gaussian state that maximizes or minimizes time-averaged measures of productivity, making it difficult, if not impossible for anybody who takes over to move the system back into a healtier state -- there simply isn't enough of what Van den Steen calls "confidence" available to make the measurement! But this too suggests that Van den Steen's might be a better theory of the insolvent firm than of a growing firm.

Broken Symmetries and the Culture of the Ants

From Deborah M. Gordon:

Ants can show us how the rhythm of local interactions creates patterns in the behavior and development of large groups.

Via Teppo Felin at Orgtheory What Gordon suggests is that spatial and temporal periodicities could be used to coordinate (unconsciously) the behavior of groups of people. Isn't this what Thomas Schelling suggested decades ago? Why haven't economists (in particular) made more progress on these fronts? Here are my guesses:

1. The rational expectations model of group behavior is operationalized through revealed preferences, and tests of the model have been possible only through aggregate statistics like the CPI. (Maybe Google will have a hand in more fine-grained tests.)
2. Most economists never ask the why or how questions when it comes to preference formation. Take the Becker and Stigler classic as evidence.
3. (Most importantly) The data didn't exist at least until Csikszentmihalyi started handing out pagers for the ESM project in the 1980s.

One and two haven't changed.

Andy Grove on the Human Capital Needed for Scaling

This is easily the most insightful analysis of the most important issue the United States now faces that I have read this month:

Since the early days of Silicon Valley, the money invested in companies has increased dramatically, only to produce fewer jobs. Simply put, the U.S. has become wildly inefficient at creating American tech jobs. We may be less aware of this growing inefficiency, however, because our history of creating jobs over the past few decades has been spectacular -- masking our greater and greater spending to create each position.

My hope is that the loosening of the currency peg will help reverse some of these trends over the coming decades.

Law as Source Code

Sean McGrath, in a post that would make Jeremy Bentham proud:

The natural language, textual level of law is my focus. I'm not attempting to make computers "understand" law by turning it into propositional calculus or some such. I'm happy to leave that quest to the strong AI community. The textual focus is why I prefer to say that "law is source code" rather than to say that "law is an operating system" because when you "execute" the law, it does not behave like most software applications. Specifically, a given set of inputs will not necessarily produce the same outputs because of the human dimensions (e.g. juries) the ongoing feedback loop of Stare decisis, the scope for once "good law" to become "bad law" by being overturned in higher courts and so on.

I believe there is much that those who manage corpora of law can learn from how software developers have met the challenge of managing corpora of source code. There are many differences and complicating factors in law for sure (and I'll be addressing many of them in the KLISS posts ahead) but at a textual level - the level at which Bismarck's Sausage Machine largely works - there is a very significant degree of overlap in my opinion. And overlap that can be and should be leveraged.

Via Nat Torkington at O'Reilly Radar.

Deakin and Carvalho on Systems Theory and Economic Analysis of Law

From the Harvard Law School Corporate Governance blog:

In the paper, System and Evolution in Corporate Governance, which was recently made publicly available on SSRN, my co-author, Fabio Carvalho, and I explore the relevance of systems theory for an understanding of legal evolution, with specific reference to the law and practice of corporate governance. Evolutionary ideas play an important role in the contemporary corporate governance debate, being regularly deployed to support deregulatory initiatives and encourage belief in the likelihood of the global convergence of governance regimes. Close inspection suggests that many of these analyses are based on false analogies, drawn from misunderstandings of natural selection processes in the biological realm. They also suffer from a failure to address the issue of the social ontology of law. The key assumption in most law and economics analyses is that legal rules operate as surrogate prices. Given the importance of this step in law and economics reasoning, it is surprising that so little attention has been given to articulating and defending it. The effect, though, is severely to limit the value of the resulting analyses, by dissolving the distinction between the legal and economic systems.

I need time to digest, but find the thesis very interesting. Shadow pricing is a contribution to economic analysis of law most often associated with Gary Becker. I would love to see him and Posner respond on their blog.

For a not unrelated argument, see what Tjalling Koopmans had to say about Milton Friedman's argument for profit maximization.

For an extended comment on applications of systems theory to patent law, see the letter linked here.

American Needle and the End of Competition

Back in November, I offered a few thoughts on the significance of the Supreme Court decision in American Needle (available today here) for methodological individualist and functionalist theories of the economics of organizations:

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.

Sadly, albeit predictably, the Supreme Court today handed down a poorly theorized and thinly articulated restatement of methodological individualist theory. Consider this passage from the opinion at 13:

As Copperweld exemplifies, “substance, not form, should determine whether a[n] . . . entity is capable of conspiring under §1.” 467 U. S., at 773, n. 21. This inquiry is sometimes described as asking whether the alleged conspirators are a single entity. That is perhaps a misdescription,however, because the question is not whether the defendant is a legally single entity or has a single name; nor is the question whether the parties involved “seem” like one firm or multiple firms in any metaphysical sense. The key is whether the alleged “contract, combination . . . , or conspiracy” is concerted action—that is, whether it joins together separate decisionmakers. The relevant inquiry,therefore, is whether there is a “contract, combination . . . or conspiracy” amongst “separate economic actors pursuing separate economic interests,” id., at 769, such that the agreement “deprives the marketplace of independent centers of decisionmaking,” ibid., and therefore of “diversity of entrepreneurial interests,” . . . and thus of actual or potential competition.

In other words, unless you see your self-interest as opposed -- or at best completely orthogonal -- to another's, you can't agree (even informally!) to work together toward a common goal because that would deprive the sacred market of its quota of wasteful speculators, betting against the outcomes that reasonable and well-informed minds agree would be the best for all stakeholders.

That the Supreme Court believes that a diversity of entrepreneurial interests are best promoted by such rules demonstrates their complete lack of on-the-ground experience with how successful entrepreneurial ventures are formed and operated. Successful entrepreneurs succeed because and when able to convince a plurality of actors whose interests are not otherwise aligned to cooperate.

There is silver lining. First, the reasoning in the opinion is so thin and weak, that it cannot hold up long against the rising tide of evidence and theory that demonstrate the benefits of cooperation in fostering growth and differentiation of products and services. Fortunately, the officials now in charge of the DOJ/FTC are better aware of new economic theory.

Second, and far more importantly in the short-run, the actual basis for the holding appears to be very narrow:

The question whether NFLP decisions can constitute concerted activity covered by §1 is closer than whether decisions made directly by the 32 teams are covered by §1. This is so both because NFLP is a separate corporation with its own management and because the record indicates that most of the revenues generated by NFLP are shared by the teams on an equal basis. Nevertheless we think it clear that for the same reasons the 32 teams’ conduct is covered by §1, NFLP’s actions also are subject to §1, at least with regards to its marketing of property owned by the separate teams. NFLP’s licensing decisions are made by the 32 potential competitors, and each of them actually owns its share of the jointly managed assets. Cf. Sealy, 388 U. S., at 352–354. Apart from their agreement to cooperate in exploiting those assets, including their decisions as the NFLP, there would be nothing to prevent each of the teams from making its own market decisions relating to purchases of apparel and headwear,to the sale of such items, and to the granting of licenses to use its trademarks.

This passage provides a rudimentary prescription for subject-matter-specific patent pools to avoid antitrust liability. First, the Supreme Court acknowledged that this was a close question -- helpful to any party that distinguishes itself along the lines that follow. Second, the Supreme Court cited favorably the existence of an independent corporation with independent management, which showed no favor to particular owners (because revenue was shared "on an equal basis"). Third, it is the joint management and marketing of individually-owned assets rather than the management and marketing of assets owned in common that rubbed the Supreme Court the wrong way. Fourth, the Supreme Court pointed to the lack of encumbrances on the individually owned assets ("there would be nothing to prevent each of the teams from making its own market decisions" [apart from their agreement to cooperate]). Fifth, in a later passage, the Supreme Court suggests that limiting shareholder assent to management decisions to a mere majority vote would deflect some scrutiny. (This is particularly poor reasoning, however, since a shareholder majority might be controlled by an even more concentrated group!)

Suppose that a group of universities formed a subject-matter-specific patent pool for the purpose of managing and marketing exclusive rights to HIV/AIDS therapeutics. What this passage suggests is that if the patent pool were formed as a corporation with its own managers, and that if each university owner assigned its patent rights to the patent pool, then the pool might be able to market and license the IP without running into antitrust liability.

Not addressed are the more difficult and complex questions of how the board of directors should be constituted, or whether the universities could grant an unrestricted exclusive license to the patent pool and retain ownership so long as the exclusive license was otherwise unencumbered.

Some day, one can only hope, there will be an explicit recognition of the fact that competition is simply one way among many to get people to cooperate, and that it is cooperation rather than competition that is the source of wealth.

Parting thought: This decision is going to give heartburn to lawyers defending joint ventures that develop and license industry standards, but a boost to aggregators operating in the secondary market.

Reprise: An Economy Made of Glass

Want a handwavy physics-based explanation for what happened at 2:45 p.m. on Thursday, May 6, 2010? Here's a post from the B.S. archives:

[I]f an economy is modeled as cross-linked clusters of synchronized oscillations, then we might expect to see viscoelasticity and time-dependent transitions in its equilibriums also. Should bubbles and crashes be modeled as viscoelastic creep?

Such an analogy might offer practical value to financial regulators. Generally speaking, the fragility of a glass will depend on the size and shape of the molecular clusters and the number of cross-links among them. The bigger the clusters and the more the cross-links, the more fragile the glass to external shocks. Smaller clusters and fewer cross-links mean less viscosity and elasticity.

We're so heavily cross-linked through digital exchanges and statistical arbitrage, when that big market sell order came through for P&G, the whole market splintered into a thousand desynchronized clusters.

Something I'd like to read more about is what happened in the bond markets at 2:45 p.m. Anybody have a link? Is it the case that credit still gets traded almost entirely by humans? I generally wonder why we don't trade credit the way we trade equity. What are the historical and practical reasons for the fact that we have public indices for equity, but not debt?

Eric Smith and Duncan Foley on the Parallels between Economics and Thermodynamics

Available here:

The most important point of this paper (more important than the establishment of formal parallels between thermodynamics and utility economics) is that economics, because it does not recognize an equation of state or define prices intrinsically in terms of equilibrium, lacks the close relation between measurement and theory physical thermodynamics enjoys.

There's plenty more where that came from at Eric Smith's page.

Is there a European Union? The United States used to be compared with European States.

Tyler Cowen today observes:

Say that Portugal, Italy, and Greece were more like Germany, economically speaking that is. Toss in Albania to make the contrast starker. They would have higher productivity and higher output. They would export more. But with their higher wealth, they would import more too. That includes more imports from Germany, most likely. German *net exports* might well decline, as Germans buy more olive oil and high-powered computer software from Albania. But German exports need not decline *on net* (over a longer run of continuing global growth they certainly will not decline) and that should prove good enough for the German model to sustain itself.

This raises the interesting question of whether Greece ever really became part of the European Union. Or indeed whether there is a European Union at all. I don't mean in the technical sense of course.

Here's another quote from Chernow's biography of Alexander Hamilton:

Governor Clinton argued that the United States covered so vast a territory and possessed such a variety of peoples "that no general free government can suit" all the states. In rebuttal, Hamilton outlined his vision of American nationalism, showing that a true nation, with a unified culture, had been fused from the diverse groups and regions of the original colonies. In all essential matters, "from New Hampshire to Georgia, the people of America are as uniform in their interests and manners as those of any established in Europe." A national interest and a national culture now existed beyond state concerns. This was an assertion pregnant with significance, for if Americans had already constituted a new political culture, they needed a new order to certify that reality. And the Constitution bodied forth that order.

After all, that is why we call it our "constitution." There's lots going on here so let me break it down a little:

• Hamilton in the New York Convention and through the Federalist lays the foundation for "the national interest and national culture" by communicating his vision of it to the individuals who make of the citizens of the confederated states;
• The act of ratification was just what Chernow calls it -- a certification of a constitution that had already been constituted through the aggregation of individual commitments necessary to state ratification;
• The United States is compared by Hamilton with individual European states whereas at present an analogy to the European Union seems more apt;
• The European Union seems never to have had any conflicts that might foster a sense of identify as part of the European Community... until the present financial crisis?
• Even the "the national interest and national culture" were insufficient to head off the conflict among the United States caused by what Gouverneur Morris called "the curse of heaven."

Lots of interesting things happening in the world today.

Where to find the mind: Identifying the scale of cognitive dynamics

from Luke Conlin, Ayush Gupta, and David Hammer:

There are ongoing divisions in the learning sciences between perspectives that treat cognition as occurring within individual minds and those that treat it as irreducibly distributed or situated in material and social contexts. We contend that accounts of individual minds as complex systems are theoretically continuous with distributed and situated cognition. On this view, the difference is a matter of the scale of the dynamics of interest, and the choice of scale can be informed by data. In this paper, we propose heuristics for empirically determining the scale of the relevant cognitive dynamics. We illustrate these heuristics in two contrasting cases, one in which the evidence supports attributing cognition to a group of students and one in which the evidence supports attributing cognition to an individual.

What is a democracy?

From Gus diZerega:

To put this point in terms of systems theory, democracies are spontaneous orders that are in continual flux. That are variously enlarging and shrinking their boundaries by means of widespread consent rather than conquest, and are similarly acquiring and devolving decision making authority from other democratic bodies of which they are constituted. The image of stability and permanency that we associate with states is evidence of a breakdown in democratic processes. The organizations within a spontaneous order always have a tendency to seek to freeze adaptive processes at points where their dominance can be assured.

"Macroeconomic Resilience"

That's the title of a new anonymous blog.

Check out the categories, which include "complex adaptive systems," and "system dynamics".

I like what I'm reading so far. If the quality continues, then the blogger will not stay anonymous for long.

Sherrington on Complexity in Economics

From the Royal Society:

The real world of finance and economics is significantly more complicated than the simplistic MG. However, (i) already one sees several conceptually important aspects that are likely to extend to reality; one is the inadequacy of the doctrine of ‘rational expectations’ in which it is assumed that, given the same information, every agent will make the same deduction and achieve equilibrium —- it has already been pointed out that, even for the MG, there is no representative agent, but only a representative stochastic ensemble —- and another is clear from the recognition that, even if agents could change their strategies, there is no optimal solution in which all have the same strategy, as, by definition, not everyone can be in the minority, (ii) the model could be extended in increments of ‘reality’ or complication, for example, including the accumulation and expenditure/gambling of varying degrees of capital, the effects of market impact, allowing for producers, who must both buy and sell in order to carry out their business, and for consumers,16 or involving limitorder-book bidding, settling and price movement, (iii) the inclusion of some of these effects will result in there never being any ‘equilibrium’, although there might be periods of relative stochastic quasi-steady state, albeit probably also punctuated by catastrophic crises, (iv) many of the drivers of cooperation involve information with no spatial-range restriction, thereby justifying meanfield theory treatment as a good approximation, and (v) one could investigate the introduction of global ‘friction’ and ‘bias’ mechanisms, as, for example, through the imposition of trading taxes and/or other political and legal constraints and incentives.

Indeed, one can imagine many other social-science problems involving many individuals, often grouped into intermediate local, political or national groups, where the interest is in collective behaviour under the influence of both heterogeneous inherent/cultural inclinations and national and international laws. Clearly, anticipated reactions to variation of the laws are of crucial importance in trying to anticipate the resultant ‘health’ of the whole. Minimal models and their incremental complication play an important role in separating the essential from the peripheral, in anticipating the likelihood of catrastrophes and trying to devise ‘dampers’ to avoid or minimize them. Disorder, in the guise of different inherited and culturally nurtured inclinations, such as risk aversion, honesty and emotionality, as well as mental and physical abilities, is part of the natural make-up of individuals, while frustration is a feature of their collective coexistence requiring a degree of compromise to better the whole.

Read the whole thing. See earlier post on applications of the Ising Model to Keynes.

Via Stefan at the Backreaction blog.

Alexander Hamilton on Our Interconnectedness

Although Phil Weiser spoke eloquently, I thought it worth pointing out that the conception of society as a system of interconnected networks has venerable historical antecedents. Consider what Ron Chernow has to say of Alexander Hamilton's address to the the Annapolis Convention of 1786, which led directly to the Constitutional Convention:

The Annapolis address, with its conception of the political system as a finely crafted mechanism, composed of subtly interrelated parts, had a distinctly Hamiltonian ring. It reflected the penchant of systemic solutions, his sense fo the fine interconnectedness of things.

Here's an excerpt of the address to which Chernow seems to refer:

If in expressing this wish, or intimating any further sentiment, your commissioners should seem to exceed the strict bounds of their appointment, they entertain a full confidence that a conduct dictated by an anxiety for the welfare of the United States will not fail to receive a favorable construction. In this persuasion, your commissioners submit an opinion that the idea of extending the powers of their deputies to other subjects than those of commerce, which had been adopted by the State of New Jersey, was an improvement on the original plan, and will deserve to be incorporated into that of a future convention. They are the more naturally led to this conclusion, as, in the course of their reflections on the subject, they have been induced to think that the power of regulating trade is of such comprehensive extent, and will enter so far into the general system of the Federal Government, that to give it efficacy, and to obviate questions and doubts concerning its precise nature and limits, may require a correspondent adjustment of other parts of the Federal system. That there are important defects in the system of the Federal Government is acknowledged by the acts of all those States which have concurred in the present meeting; that the defects upon a closer examination may be found greater and more numerous than even these acts imply, is at least so far probable, from the embarrassments which characterize the present state of our national affairs, foreign and domestic, as may reasonably be supposed to merit a deliberate and candid discussion in some mode which will unite the sentiments and councils of all the States.

You're in good company, Mr. Weiser.

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.

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.

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.