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The Actuary The magazine of the Institute & Faculty of Actuaries

The origin of wealth

This is the time of year when yourboss’s boss, trapped for hours atHeathrow airport, decides to givecopies of the management bookshe’s just browsed to all her subordinates, withstrict instructions to obey it.

These books are shamelessly marketed atexecutives with such titles as 10 Practical StepsYou Can Take Today to Spend More Time at theOffice and Less With Your Family. So count yourselffortunate if, instead, you receive The Originof Wealth by Eric Beinhocker.

The first of four sections is a solid introductionto traditional economics. It is one of theclearest, most concise yet thorough accounts Ihave read, and a promising start to this book.The account is refreshingly candid about theshortcomings of traditional approaches, especiallyin relation to equilibrium and rationalbehaviour. If you never understood economics,this is a good place to start.

The second section introduces complexityeconomics. Complexity economics is based oncomputer models of vast numbers of agents,each of which makes decisions on a simplebasis. When put together these models canproduce sudden price moves, business cycles,periods of stability punctuated by bursts ofvolatility – all generated from within the economyitself rather than being responses to externalshocks. There are parallels in biologicalevolution, which also exhibits long periods ofstability punctuated by rapid change. Theauthor is a great storyteller; this section is anengaging and informative read.

At times the author overplays his hand. Heenlists the support of a motley band of sceptics,including market traders, complexity theorists,behavioural economists, and evolutionary theorists,united only by their view that mainstreameconomics has everything wrong. Unfortunatelythe sceptics contradict not only classical economicsbut also each other, leaving the reader indespair of ever putting the pieces together./p>

Like traditional economics, complexity economicsmakes a number of unrealistic assumptions.Where traditional economics requires usto perform the difficult task of optimising utilityfunctions under uncertainty, a model citedfrom complexity economics requires us each tooccupy one square on a chessboard and trade only in sugar. It is difficult to see how this couldbe calibrated to the real world. Analogy withcomputer models gives no quantitative explanationof why business cycles are measured inyears rather than minutes or millennia. So, tomy mind, complexity theory is at best a promisingavenue for further investigation, and notyet a body of theory proven to have any predictivevalue.

Several slips suggest a less then secure groundingin probability. For example, convincing evidenceis presented that extreme share pricemoves follow a Pareto distribution. The bookcites this as evidence that prices are not random.

The third section moves on from a literaturesurvey to some of Beinhocker’s own ideas. Hisingredients are physical technologies and socialtechnologies. These are brought together in anevolutionary market where only the fittest survive.Physical technologies are familiar mechanicalinventions. Social technologies are ways oforganising people to greater economic productivity:for example, partnerships, corporationsand management hierarchies. The authorargues that social technologies are every bit asimportant as physical technologies in creatingwealth. Anyone working for a large organisationwill appreciate the section on complexitycatastrophes. It shows how growing organisationscan grind to a halt, because every time anorganisation doubles in size the effort of coordinatingits different parts grows fourfold.

Finally, at the end of the third section we geta response to the author’s opening question:what is the origin of wealth? Physics tells us thatthe disorder in the world can only increase; heatcannot flow from colder to hotter. This is whatmakes time go forwards and not backwards. Theauthor characterises wealth as a reduction inentropy, ie the creation of order out of disorder.

The business consequences of this analogy arenot intuitive. In physics we cannot reduceentropy in one place without increasing it somewhereelse. In economics this implies that ifsomeone becomes richer then someone else hasbecome poorer. The author even suggests thatstrategies become more effective when we deliberatelycut off our options to ensure irreversibility,thus forcing time’s arrow in the direction ofprogress. Cortés is commended for ordering hismen to burn their ships after landing in Mexico.

The section on entropy starts with Samuelson’sobservation that ‘the sign of a crank or halfbakedspeculator in the social sciences is hissearch for something in the social system thatcorresponds to the physicist’s notion of entropy’. The remainder of the section unintentionallyillustrates the wisdom of Samuelson’s words.The claimed relation between wealth andentropy remains unconvincing to this reviewer.

The final section of the book explains whatthe theories mean for business and society.Rather than focusing on producing a perfectstrategy, firms must learn to become adaptablein the evolutionary fight for survival. The boatburningcommendations are dropped in favourof the conventional wisdom of keeping alloptions open. The key to this is deep analysisof the alternatives, in which, we are frequentlyreminded, the author’s consulting firm is availableto help. Whatever your favoured economicstarting point, the conclusions of managementbooks everywhere are reassuringly consistent.

Outlining the implications for society, theauthor adopts a messianic tone. The corporationis a uniquely successful institution and a vitalcontribution to wealth creation. At a time whencorporations face vocal criticism from the antiglobalisationmovement, arguments proclaiminga positive role are likely to play well with thebook’s intended corporate audience. A politicallyincorrect chart supposedly shows howProtestantism leads to greater trust and economicgrowth, while Islamic societies exhibitmistrust and economic stagnation. No space isgiven to less flattering explanations: for example,Chomsky’s suggestions that the Islamicworld is kept in servitude under corrupt despotspropped up by Protestant western governments,or that single-minded corporate pursuitof profit exerts a malign influence on governmentpolicy and undermines democracy.

What then happened to the book your boss’sboss so kindly brought back from her holiday?The first couple of chapters are read thoroughly,the rest forgotten. Such is an appropriateapproach to The Origin of Wealth, whose firsttwo chapters are well worth reading.

Andrew D Smith works for Deloitte; views expressedare his alone and not those of Deloitte.