A Guest Review of Tim Harford’s [amazon_link id=”1408701529″ target=”_blank” ]Adapt:Why Success Always Starts With Failure[/amazon_link]

By Keith Wade, Chief Economist, Schroders

Tim Harford’s latest book is an appeal for more experimentation in government policy, business and life. The complexity of the modern economy and society means that efforts to solve our problems are often thwarted by the interactions and unforeseen consequences which unfold on any chosen path. We should accept the limits to our wisdom and be a little more humble in our approach to problem solving. Viewed from the wreckage of the post financial crisis economy such an argument has great appeal.

To highlight the complexity of the modern economy Harford begins with the case of someone trying to build a toaster from scratch. An extraordinary project which demonstrates the effort involved in bringing together the resources needed to construct a simple household appliance – the modern toaster contains more than four hundred components and sub components – and illustrates the extraordinary level of specialisation present in today’s world economy.

In the light of such intricacy, Adapt goes on to argue for an experimental approach to decision making where policymakers and businesses are open to the idea that a single line of attack is unlikely to succeed. Instead, a more experimental and adaptive method is needed where decisions are reached through a process of trial and error.  One consequence of this is that we should be more tolerant of failure as it is part of the evolutionary process through which we reach solutions.

Harford marshals an impressive array of evidence to support his case from the Iraq conflict, where an adaptive approach to the insurgency which responded to local conditions ultimately triumphed over the top down strategy of the Pentagon, to the development of the Spitfire fighter plane where a civil servant was prepared to go against conventional wisdom and take a flyer on a different approach to stopping Hitler’s bombers. More recently he cites the so called “randomistas” in development economics who have pursued a series of trials to capture the best approach to tackling poverty. In short it is a call for more decentralised and less top-down decision making.

Such an argument is hard to disagree with and, of course, underpins the market economy where thousands of experiments are carried out every day by individuals and businesses, whether they know it or not. “The market fumbles its way to success as successful ideas take off and less successful ones die out”.

Of course, the argument is not new and has been expounded by others, most recently by John Kay in “The truth about markets”. Where Adapt succeeds is in its ability to draw together the conclusions of different fields to tell a coherent story. Harford acknowledges his debt to Kay and others, but goes on to develop his case by examining the shortcomings of markets and the experimental approach. Here he draws on the experience of engineers in learning from industrial accidents to identify situations where a market driven experimental approach may prove very costly.

Experiments are fine in a world where failure does not cause much damage. Many situations are like this where the creative destruction of the market can be contained i.e. most businesses can fail safely without bringing down the entire economy. However, there are others where this is not the case and failure can have catastrophic consequences. The financial crisis of 2008 was one searing reminder of the danger of allowing markets free reign as the failure of Lehman Brothers threatened to bring down the entire banking system and world economy.

From Harford’s perspective the banking crisis was not caused by any particular action by an individual or institution, but by the nature of the financial system itself which had become “tightly coupled”. This is an engineering term used to describe systems which are closely linked so that rather than absorbing shocks they magnify them until they ultimately spiral out of control. Here Adapt goes into the world of industrial accidents and the experience of the nuclear industry where engineers have grappled for years with tightly coupled systems.

In the lead up to the financial crisis, products such as credit default swaps made the system more tightly coupled as they enabled banks to move risks off their balance sheets and take on more and more risks. The problem was compounded by the fact that the authorities did not know where the risk had ended up (mostly in the insurance industry) and so did not know how to short circuit the problem as the banking system blew up. Harford’s message to those trying to build a better banking system today is that human error cannot be avoided so the challenge is to build structures which can withstand shocks rather than exacerbate them.

It is hard to find fault in such a wide ranging and cogent analysis which deserves to be widely read. However, there is an elephant in the room. In accepting the case for more experimentation and more decentralisation how do we account for the rise of China? The world’s second largest economy arguably represents the triumph of top down planning over the free market. As the West struggles in the aftermath of the financial crisis the contrast with fast-growing China has become even starker. Perhaps because it might warrant another volume, Adapt does not address the rise of China. An omission certainly, although not one which detracts from a brilliant book in which ideas sweep superbly across the economic landscape.

[amazon_image id=”1408701529″ link=”true” target=”_blank” size=”medium” ]Adapt: Why Success Always Starts with Failure[/amazon_image]

I’m a latecomer to Tyler Cowen’s immensely successful book, [amazon_link id=”0525952713″ target=”_blank” ]The Great Stagnation[/amazon_link], but as the months of 2011 have rolled by, the title seems more perceptive than ever. Stagnation is a kind description of what’s happening to the western economies now. Certainly, the success of the book shows that it struck a chord.

For those who’ve not read it, let me sum up the argument. The advanced industrial economies – this is mainly about the US – have reached a technological plateau and growth is not going to regain its earlier rates for a long time. Cowen’s description is that all the ‘low-hanging fruit’ in terms of benefits from technological innovation have gone. (He focuses very much on the internet as the locus of innovation.) As evidence, he cites the failure of real median incomes to grow. Much of the online innovation we see brings only private benefits, he argues, so the super-wealthy in finance have prospered but no-one else; whereas past innovation had public benefits too. Further evidence comes from the increase in spending on government consumption, health and education without any corresponding improvement in outcomes.There is still some innovation, of course, but Cowen concludes: “The revenue-intensive sectors of our economy have been slowing down, and the big technological gains are coming in revenue-deficient sectors.” Whereas GM and Ford created hundreds of thousands of jobs, Google’s and Facebook’s employment-creation has been in the low thousands. So not only has the innovation not led to revenues and profit, neither has it led to jobs. With neither labour nor capital making any gains, the productivity effect of the internet must be illusory.

There’s much in the book to agree with. However, I’d make the following comments.

1. The observed outcomes for median incomes, or for the health of the average American, will reflect more than just technological changes. There has been an interplay between innovation and rent-seeking behaviour by powerful groups (mainly financiers but also the health care big business), played out in the US political process. Although the UK has been similar, other countries which do have the internet but not the same politics and power structures have not experienced the same stagnation of median incomes.

2. Innovation is much more than the internet. Not only do some internet/computer companies make a lot of revenue, there are also innovations in biotechnology, materials, nanotech, robotics, green tech – almost all enabled by very cheap computer processing power and communications. I don’t think there’s any doubt that some of these will be enormously profitable and create jobs (although if I knew which, I’d be running my own investment fund.)

3. The book only touches on globalisation – another internet/ICT-enabled phenomenon, but distinct from technological change. One can debate what part it has played in the absence of job creation in the US but it seems in important element in the mix.

4. Job creation comparisons are not straightforward. The mass production businesses of the previous generations of technology were centralised hierarchies, albeit with large supply chains too. Internet era businesses are decentralised and networked, so it’s possible that a reasonable comparison of business ecologies would give similar numbers – or not; I just don’t know. But there’s also a whiff of lump of labour fallacy here, of the kind that shows up in every consultancy study that claims X industry has created Y thousand jobs; we know that economies adjust to the resources and technologies available, meaning aggregate employment rates depend on labour market structures (taxes, participation rates) and the level of demand. I’d suggest low US job creation at present has more to do with weak demand than with Google.

Having said all this, I think it’s an important book and valuable contribution to the policy debate. It must be right to highlight the importance of technology, something all too often overlooked in economic policy. Cowen calls for a culture more welcoming to science, and a much greater degree of civility in politics. Who can disagree with that, looking at the extraordinary spectacle of American politicians squabbling their way over the edge of the precipice of default? I wish the book had included more about rent-seeking and power structures in the analysis as these seem to me at least as important as technological change in trying to understand the important shifts in the leading economies. The historical examples suggest that in the end it’s ordinary consumers who benefit from innovation, but the process is tempestuous and characterised by power struggles. The power struggles are being played out right now, and the median wallet is currently losing.

[amazon_image id=”0525952713″ link=”true” target=”_blank” size=”medium” ]The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better[/amazon_image]

Here’s a quotation from Mill’s [amazon_link id=”0199553912″ target=”_blank” ]Principles of Political Economy[/amazon_link] that modern economists should take to heart:

For practical purposes, Political Economy is inseparably intertwined with many other branches of social philosophy. Except on matters of mere detail, there are perhaps no practical questions, even among those which approach nearest to the character of purely economical questions, which admit of being decided on economical premises alone.

Perhaps one of the many consequences of the Great Financial Crisis will be the welcome revival of Political Economy.

[amazon_image id=”0199553912″ link=”true” target=”_blank” size=”medium” ]Principles of Political Economy and Chapters on Socialism (Oxford World’s Classics)[/amazon_image]

You can never read too many books about the Industrial Revolution, in my view. This is partly because I grew up in a Lancashire mill town, with family members working in the cotton industry – until the mills closed in the late 1970s, their machines taken straight to the museums. But of course, it’s everybody’s heritage. The decisive shift to the modern world started in those decades of industrial invention from the late 18th century. The answer to the question, What did the Victorians ever do for us? is almost everything.

Luckily, there have been lots of excellent new books about the Industrial Revolution and the Enlightenment, the intellectual context for practical innovation. These include the academic – such as Joel Mokyr’s [amazon_link id=”0691120137″ target=”_blank” ]Gifts of Athena[/amazon_link] and [amazon_link id=”0140278176″ target=”_blank” ]The Enlightened Economy[/amazon_link] – and the more accessible – such as Jenny Uglow’s [amazon_link id=”0571216102″ target=”_blank” ]The Lunar Men[/amazon_link] and Richard Holmes’s [amazon_link id=”0007149530″ target=”_blank” ]The Age of Wonder[/amazon_link].

I’ve just finished reading William Rosen’s [amazon_link id=”1845951352″ target=”_blank” ]The Most Powerful idea in the World: A story of steam, industry and innovation[/amazon_link]. It doesn’t make this first rank, although its ambition is commendable. The idea is to set the conventional history of inventions of this and that – Watt’s condenser, Stevenson’s Rocket – in the context of social and legislative innovations, such as the enabling patent laws and the emergence of a class of self-improving practical artisans in Britain. This is obviously a fruitful approach, and one that has become much more widespread in recent years. The Lunar Men is a brilliant example of bringing the social and political context to life. In the academic literature, Paul David is an economic historian who, along with Mokyr, did much to reattach innovation to the specifics of its time.

Unfortunately, Rosen doesn’t manage to make his account sparkle, and I think it’s because he can’t resist including technical detail, at the expense of the story. For example, there are too many paragraphs like this one: “And so the challenge of converting the reciprocating motion of the early atmospheric engines into rotary power occupied a fair chunk of the 18th century. The fundamental problem of direct conversion was not ignorance; the crank and the cam were well known to Newcomen and his successors. In fact they were known to his predecessors…” and on for another half page before we get a diversion into biomechanics and kinetic energy for the next couple of pages. If the kinetic energy is actually important to the story, I need the beginner’s guide; if not, these pages should have been edited out. I also got the sense, whenever Rosen heads into economic territory, that headstrong concepts such as ‘supply’ and ‘demand’ are in danger of bolting, with the author hanging terrified onto the reins.

Having said this, this is a mostly very readable book which is obviously based on a vast amount of research. It will introduce people to some of the key technologies of the Industrial Revolution, and above all to the important idea that their impact would have been far less if the innovators had lived in a different time and place. Its emphasis on the importance of patent protection is timely, too. Innovation, in other words, is a social system as well as a technological one – as today’s debates over intellectual property in the digital world demonstrate all too clearly. Rosen does not make the link explicit – he is certainly not making a foolishly simplistic argument that because patents were essential for Boulton and Watt to build and sell their improved steam engines, strong enforcement of DRM is essential for innovation now. However, the book does do us the service of underlining the need for careful thought about the legal framework for an innovative economy – and in fact, for thinking there’s every reason to believe a patent framework established about a quarter of a millennium ago is unlikely to be suitable in the modern, intangible economy.

[amazon_image id=”1845951352″ link=”true” target=”_blank” size=”medium” ]The Most Powerful Idea in the World: A Story of Steam, Industry and Invention[/amazon_image]

George Orwell’s essays are always worth revisiting. As he says in [amazon_link id=”0141036613″ target=”_blank” ]Books v Cigarettes[/amazon_link], there are “books that become part of the furniture of one’s mind and alter one’s whole attitude to life.” Certainly some of his, including [amazon_link id=”0141185295″ target=”_blank” ]The Road to Wigan Pier[/amazon_link] and [amazon_link id=”0141184388″ target=”_blank” ]Down and Out in Paris and London[/amazon_link], which I first devoured as an idealistic teenager and have returned to over the years, fall into that category. But this morning it was the essays collected in Books v Cigarettes that I turned to, prompted by a feature about the demise of Borders in the face of rivalry from Amazon. And not just Amazon as a retailer of physical books at cut prices, but Amazon as purveyor of e-books. This week the Association of American Publishers reported that e-book sales were up 160% in the first half of 2011, while sales of physical books had slumped.

The title essay of the Orwell, noting that factory workers regard book-reading as an expensive hobby not for the likes of them, compares the cost of reading favourably with the cost of other forms of entertainment. As Orwell puts it, they wouldn’t spend twelve and sixpence on a hardback that might take a whole day to read, but thought nothing of spending several pounds on a day out at Blackpool. But, he adds, “It is difficult to establish any relationship between the price of books and the value one gets out of them.” There are several complicating factors.

First, books are an experience good. You have to read them to know what they’re worth to you, and so evaluate the price with little information about quality. This is why reviews matter, why authors deliver series of books, and why Sherwin Rosen’s ‘superstar’ or winner-takes-all economics apply in publishing.

Secondly, books are a good example of consumption of goods as a signal. Millions of people bought Stephen Hawkings [amazon_link id=”0553175211″ target=”_blank” ]A Brief History of Time[/amazon_link], but only a tiny fraction of them read it. It was probably, like making coffee in a cafetiere, a signal of being middle class and cultured. Coffee table books are all signals, as are fashionable recipe books, and – in their own way – old paperbacks of George Orwell’s work scattered around the house.

Thirdly, books have a new social value. They bring people together in book groups. They are gifts in the gift economy of book swaps – we have one at the local station. They are useful small presents when wine or chocolates won’t do.

None of which is relevant to the brutal competitive struggle in book retailing, where Amazon is coming to have a dominant position. Publishers share some of the blame, as they all let Amazon have discounts which enable it to undercut bricks and mortar booksellers, especially independents. The short term lucre blinded the publishing industry to the longer-term strategic issues. There are two areas for competition authorities to look, I think. One is whether the barriers to entry to online bookselling have become insurmountable, with any book needing to be on Amazon to sell – or whether, on the other hand, the technologies which enable on-demand printing and online access to customers make it possible for a book to by-pass Amazon. The other is the retailing of e-books, where the pricing – just below hardback price – is clearly not reflective of either marginal or average cost and could only be justified as the recovery of capital investment. Even so, if e-book prices are cross-subsidising the prices of particular e-book devices, that would be a cause for concern too. These are empirical questions and I hope competition bodies are checking it out.

I’m sad about Borders. Their range had narrowed and dumbed down in recent years, but the stores have always been pleasant enough places to hang out. Still, as Orwell wrote in Bookshop Memories, “In a town like London there are always plenty of not quite certifiable lunatics walking the streets, and they tend to gravitate towards bookshops, because a bookshop is one of the few places where you can hang about for a long time without spending any money.” That was Borders’ problem – extracting the money. You can hang about in a cinema all afternoon, of course, but only after handing over the £15 for the 3D experience.

[amazon_image id=”0141036613″ link=”true” target=”_blank” size=”medium” ]Books v. Cigarettes (Penguin Great Ideas)[/amazon_image]