July 17, 2013

Information, the Entrepreneur, and George Gilder’s New Economic Thinking

Arnold Kling

Senior Affiliated Scholar

There is fundamentally new economic thinking to be found in the latest book by George Gilder, called Knowledge and Power: The Information Theory of Capitalism and How it is Revolutionizing our World (Regnery Publishing, June 2013).

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George Gilder’s vision of data-driven capitalism has much to recommend it, but caution is warranted.
There is fundamentally new economic thinking to be found in the latest book by George Gilder, called Knowledge and Power: The Information Theory of Capitalism and How it is Revolutionizing our World (Regnery Publishing, June 2013). If conventional economics can be summed up as “follow the money” (i.e., incentives are what matter), Gilder's economics might be summed up as “follow the information” (i.e., economic success involves separating signal from noise in data).

Gilder draws on information theory, as developed by the famed mathematician Claude Shannon and others, as a central metaphor for the economy. In Gilder's rendition, information consists of striking surprises conveyed over a quiet, stable channel. Gilder then adapts this metaphor to economic phenomena, including entrepreneurship, finance, the role of government, and income redistribution.

At a philosophical level, Gilder makes an impassioned metaphysical case for human agency, and he claims that information theory supports such a metaphysical outlook. He argues that the theorems of Kurt Gödel and Alan Turing, two of the 20th century’s most brilliant mathematicians, are inconsistent with purely deterministic systems.

At a practical level, Gilder sees entrepreneurs as creative agents of change. This is a contrast with the standard view in economics, in which entrepreneurs are simply machines following a program given by market incentives. In the conventional view, and even among some Austrian economists, an entrepreneur is someone who, noticing that the price of ketchup is high and the price of tomatoes is low, thinks, “Aha! I should open up another ketchup factory.” This type of conventional thinking guides the economy toward a more efficient allocation of resources. But with this account of entrepreneurship, Gilder complains, the best an entrepreneur can do is help the economy reach a state of stagnation, otherwise known in economics as “equilibrium.”  

Instead, Gilder sees the entrepreneur as engaged in a continual effort to obtain information by testing out new products and services. While many of these efforts fail, in the aggregate they succeed fantastically by providing economic growth and a standard of living undreamt of centuries ago.

In the conventional view, the entrepreneur is embedded in a market that provides information in the form of prices. His role is to move the economy toward equilibrium. In Gilder's view, however, entrepreneurs create information where none existed before. Rather than sustain the equilibrium, their role is to disturb it.

Gilder suggests that the information theory metaphor is useful for describing finance. Investment projects are volatile and rich in information. The borrower (think of a real estate developer) knows much more than anyone else about the prospects and pitfalls of the enterprise. Savers, on the other hand, want financial instruments that are stable and unsurprising, offering little new information. For example, checking accounts are supposed to have limited upside but zero pitfalls. In between the borrower and the saver, the bank transforms an informationally rich project, such as lending to the real estate developer, into informationally boring deposits. This is a valuable economic function that promotes growth, although it also makes finance inherently crisis-prone.

Gilder applies the information theory metaphor to the role of government in the economy, with government ideally contributing to the quiet channel through which entrepreneurs can discern information. In an anarchic society without effective legal systems and property protection, the channel will be so noisy that information will not be readable. However, if government is too active, this also creates noise in the channel. Government has the ability to substitute power for information. That is, government directs the resources and energy of society not by the information-generating process of trial-and-error, but instead by the information-stifling process of fiat.

Knowledge and Power

This leads to the issue of the relationship between knowledge and power, which is central to Gilder's thinking. He argues that since entrepreneurs have the most knowledge about the circumstances surrounding their businesses, they should have power commensurate with that knowledge. He is horrified by redistribution schemes that take wealth and power away from those who have demonstrated that they have knowledge about how to deploy capital efficiently.

Thus, Gilder is not worried – or not worried solely – about taxes taking away the incentives for entrepreneurship. He is more worried that taxation will shift capital from people who know how best to use it to people who are removed from the knowledge of how to use it. 

Gilder would argue that redistribution is baked into the methodology of economic models that downplay agency and instead treat economic outcomes as random. For example, finance professors will describe the effort to “beat the market” when investing in stocks as a sort of coin-flipping tournament. Start with a very large number of players, have them each flip a coin five times, and see which flippers get the most heads. Some players will get heads five times in a row, making it appear that they are very skilled coin-flippers. By analogy, if we start with a large number of stock market investors, a few of them will outperform the market several years in a row. These sorts of models imply that wealth accumulation results from a combination of risk taking and luck. Instead, Gilder insists that it results from better knowledge, which has been used to create products and services that promote human flourishing. (He would make an exception, of course, for knowledge that only exploits government-created noise.)

On this issue, I have mixed views. On the one hand, when it comes to business success, I agree with Gilder. Even though luck plays some role, skill matters much more, because there are so many little choices that must be made wisely in order for an enterprise to succeed. The more skilled business team usually will win, just as in tennis the more skilled player usually will win. On the other hand, with financial speculation, skill and luck are more difficult to separate. To me, financial speculation is more like a multiple-choice question on a test. One can easily make a good choice for a bad reason, or vice-versa.

There is much to quarrel with in Gilder's book. For one, his political and social conservatism will put off many readers. Also, in his attempts to sharpen the contrast between his views and those of other thinkers, he often paints a caricature of the individual he is criticizing. For example, his depiction of Burton Malkiel, the American economist best known for his support of the efficient market hypothesis, as an adherent of technical analysis was completely unfair.

Is Gilder's recasting of information theory useful new thinking for economists? There are several reasons to think so.

1. The prevailing heuristic in macroeconomics is “aggregate supply and demand” for the entire economy, which is simulacrum for the well-established supply-and-demand analysis of individual markets. My opinion is that “aggregate supply and demand” confuses everyone who comes across it, from first-year students to high-level researchers and policymakers. (Just for starters, you can argue about whether the vertical axis should be measured as the price level or the inflation rate. Yet whether “aggregate demand” slopes up or down depends on that choice!)

2. Intangible factors are absolutely critical in the real world economy, but they are an awkwardly-treated “residual” in conventional economics. The information theory metaphor corrects that defect.

3. Gilder's claim that the wealthy should be judged by how they use their wealth to produce information adds a new twist to the old debate over “efficiency vs. equity.”

4. The focus on financial institutions as information-transformers helps to underline the futility of the project to stabilize the financial system through regulation. To be effective, the regulators would have to know more than the banks about the projects backing their loans, when in reality they cannot possibly know even as much.

In order to make a durable contribution to economics, the information metaphor will have to be elaborated and its implications will have to be tested. It would be a mistake, however, to dismiss it out of hand.