cite an obvious example, “structured finance”—the conglomerations of thousands of dubious mortgages diced and sliced and recombined and all trebly insured against failure—was supposed to eliminate the surprise of mortgage defaults. The mortgage defaults that came anyway and triggered the collapse came not from the aggregate inability of debtors to pay as calculated by the economists, but from the free acts of home buyers. Having bet on constantly rising home prices, they simply folded their hands and walked away when the value of their houses collapsed. The bankers had accounted for everything but free will.
The real error, however, was a divorce between the people on the ground who understood the situation and the people who made the decisions. John Allison is the former CEO of a North Carolina bank, BB&T, which profitably surmounted the crisis after growing from $4.5 billion of assets in 1989 when he took over to $152 billion in 2008. Allison ascribed his success to decentralization of power in the branches of his bank.
But decentralized power, he warned, has to be guarded from the well-meaning elites “who like to run their system and hate deviations.” So as CEO, Allison had to insist to his managers that with localized decision-making, “We get better information, we get faster decisions, we understand the market better.”
Allison was espousing a central insight of the new economics of information. At the heart of capitalism is the unification of knowledge and power. As Friedrich Hayek, leader of the Austrian school of economics, put it, “To assume all the knowledge to be given to a single mind … is to disregard everything that is important and significant in the real world.” Because knowledge is dispersed, so must be power. Leading classical thinkers such as Thomas Sowell and supply-siders such as Robert Mundell refined the theory. All saw that the crucial knowledge in economies originated in individual human minds and thus was intrinsically centrifugal, dispersed and distributed.
Enforced by genetics, sexual reproduction, perspective and experience, the most manifest characteristic of human beings is their diversity. The freer an economy is, the more this human diversity of knowledge will be manifested. By contrast, political power originates in top-down processes—governments, monopolies, regulators, elite institutions, all attempting to quell human diversity and impose order. Thus power always seeks centralization.
The war between the centrifuge of knowledge and the centripetal pull of power remains the prime conflict in all economies. Reconciling the two impulses is a new economics, an economics that puts free will and the innovating entrepreneur not on the periphery but at the center of the system. It is an economics of surprise that distributes power as it extends knowledge. It is an economics of disequilibrium and disruption that tests its inventions in the crucible of a competitive marketplace. It is an economics that accords with the constantly surprising fluctuations of our lives.
In a sense, I introduced such an economics more than 30 years ago in my bookWealth&Poverty and reintroduced it in 2012 in a new edition. It spoke of economics as “a largely spontaneous and mostly unpredictable flow of increasing diversity and differentiation and new products and modes of production…full of the mystery of all living and growing things (like ideas and businesses).” Heralding what was called “supply side economics” (for its disparagement of mere monetary demand), it celebrated the surprises of entrepreneurial creativity. The original work was widely popular around the globe, published in 15 languages and for six months reigning as the number one book in France. President Ronald Reagan made me his most quoted living author.
In the decades between the publication of the two editions of Wealth&Poverty, I became a venture capitalist and deeply engaged myself in studying the dynamics of computer and networking technologies and the theories of information behind them. In the process, I began to see a new way of addressing the issues of economics and surprise.
Explicitly focusing on knowledge and power allows us to transcend rancorous charges of socialism and fascism, greed and graft, “voodoo economics” and “trickle down” theory, callous austerity and wanton prodigality, conservative dogmatism and libertarian license.
We begin with the proposition that capitalism is not chiefly an incentive system but an information system. We continue with the recognition, explained by the most powerful science of the epoch, that information itself is best defined as surprise: by what we cannot predict rather than by what we can. The key to economic growth is not acquisition of things by the pursuit of monetary rewards but the expansion of wealth through learning and discovery. The economy grows not by manipulating greed and fear through bribes and punishments but by accumulating surprising knowledge through the conduct of the falsifiable experiments of free enterprises. Crucial to this learning process is the possibility of failure and bankruptcy. In this model, wealth is defined as knowledge, and growth is defined as learning.
Because the system is based more on ideas than on incentives, it is not a process changeable only over generations of Sisysphean effort. An economy is a noosphere (a mind-based system) and it can revive as fast as minds and policies can change.
That new economics—the information theory of capitalism—is already at work in disguise. Concealed behind an elaborate mathematical apparatus, sequestered by its creators in what is called information technology, the new theory drives the most powerful machines and networks of the era. Information theory treats human creations or communications as transmissions through a channel, whether a wire or the world, in the face of the power of noise, and gauges the outcomes by their news or surprise, defined as “entropy” and consummated as knowledge. Now it is ready to come out into the open and to transform economics as it has already transformed the world economy itself.
[Now, skipping some interesting work in chapter two, let’s jump to chapter 3.]
Chapter Three: The Science of Information
The current crisis of economic policy cannot be understood as simply the failure of either conservative or socialist economics to triumph over its rival. It cannot be understood as New York Times Nobelist Paul Krugman or Ron Paul and the libertarians might wish, as a revival of the debate between Keynesian and Austrian schools—John Maynard Keynes and Paul Samuelson against Friedrich Hayek and Ludwig Von Mises. The hard science that is the key to the current crisis had not been invented when Keynes or Hayek were doing their seminal work.
This new science is the science of information. In its full flower, information theory is densely complex and mathematical. But its implications for economics can be expressed in a number of simple and intelligible propositions.
All information is surprise; only surprise qualifies as information. This is the fundamental axiom of information theory. Information is the change between what we knew before the transmission and what we know after it.
From Adam Smith’s day to ours, economics has focused on the nature of economic order. Much of the classical and neo-classical work was devoted to observing the mechanisms by which markets, confronted with change—especially change in prices—restored a new order, a new equilibrium. Smith and his successors followed in the metaphorical paths of Newton and Leibniz, mounting a science of systems.
What they lacked was a science of disorder and randomness, a mathematics of innovation, a rigorous measure and mandate for freedom of choice. In economics, the relevant science has arrived just in time. The great economic crisis of our day, a crisis of theory as well as practice, is a crisis of information. It can be grasped and resolved only by an economics of information. Pioneered by such titans as Kurt Gödel, John von Neumann, and Alan Turing, the mathematical structure for this new economics was consummated by one of the paramount minds of the 20th century, Claude Elwood Shannon.
In a long career at MIT and AT&T’s Bell Laboratories, Shannon was a man of toys, games, and surprises. They all tended to be underestimated at first and then become resonant themes of his time and technology—from computer science and Artificial Intelligence to investment strategy and Internet architecture. As a boy during the roaring twenties in snowy northern Michigan, young Claude—grandson of a tinkering farmer who held a patent for a washing machine—made a telegraph line using the barbed-wire fence between his house and a friend’s half a mile away. “Later,” he said, “we scrounged telephone equipment from the local exchange and connected up a telephone.” Thus he recapitulated the pivotal moment in the history of his later employer: from telegraph to telephone.
There is no record of what Shannon and the world would come to call the “channel capacity” of the fence. But later in the era Shannon’s followers at industry conferences would ascribe a “Shannon capacity” of gigabits per second to barbed wire, and joke about the “Shannon limit” of a long strand of linguini.
Shannon’s contributions in telephony would follow his contributions in computing, all of which in turn were subsumed by higher abstractions in a theory of information. His award-winning Master’s thesis from MIT kick-started the computer age by demonstrating that the existing “relay” switching circuits from telephone exchanges could express the nineteenth-century algebra of logic invented by George Boole, which became the prevailing logic of computing.
