Wednesday, July 29, 2009

Game theory and economic corruption

By George Dyson. Read the whole thing (via Robert Cottrell). Here is an excerpt:
We measure our economy in money, not in things. In the age of self-reproducing automata, we can suffer a declining economy, and pandemic unemployment, while still producing as much stuff as people are able to consume. We are facing the first economic downturn to include free cell phones, more automobiles than we have room for (in many locations you can now rent a car for less than it costs to park one) and computers that cost less than a month's health insurance yet run at billions of cycles per second for years.

Why the growing imbalance between the cost of people and the cost of machines? What prices are going up the fastest? Health care — the cost of maintaining human beings. What prices are going down the fastest? The cost of information and machines. What, really, is health-care reform? Human beings are being cared for by a dysfunctional, antiquated system, and we hope that this can be reformed by adopting efficiencies from the domain of machines. Where will this lead? Are we using computers to sequence, store, and more faithfully replicate our own genetic code, or are computers optimizing our genetic code (and health) so that we can do a better job of replicating them?

Replication of information is generally a public good (however strongly pockets of resistance may disagree). When financial instruments become self-replicating, trouble often ensues. The derivatives now haunting us were produced, not from natural factors of production or other goods, but from other financial instruments. There are numerous precedents for this.

As early as the twelfth century it was realized that money, like information but unlike material objects, can be made to exist in more than one place at a single time. An early embodiment of this principle, preceding the Bank of England by more than five hundred years, were Exchequer tallies — notched wooden sticks issued as receipts for money deposited with the Exchequer for the use of the king. "As a financial instrument and evidence it was at once adaptable, light in weight and small in size, easy to understand and practically incapable of fraud," wrote Hilary Jenkinson in 1911. "By the middle of the twelfth century, there was a well-organized and well-understood system of tally cutting at the Exchequer... and the conventions remained unaltered and in continuous use from that time down to the nineteenth century."
Until the Restoration tallies did not bear interest, but in 1660, on the accession of Charles II, interest-bearing tallies were introduced. They were accompanied by written orders of loan which, being made assignable by endorsement, became the first negotiable interest-bearing securities in the English-speaking world. Under pressure of spiraling government expenditures the order of loan was soon joined by an instrument called an order of the Exchequer, drawn not against actual holdings but against future revenue and sold at a discount to the private goldsmith bankers whose hard currency was needed to prop things up. In January 1672, unable to meet its obligations, Charles II declared a stop on the Exchequer. At the expense of the private bankers, this first experiment with derivative financial instruments came to an end.
Financial systems exhibit the Gödelian incompleteness characteristic of all sufficiently powerful formal systems: within the given system it is possible to construct statements (or financial instruments) whose value appears to be sound, but cannot be proved within the system itself. No financial system can ever be completely secure and closed. There is no limit to the level of concepts (including fraudulent ones) that an economy is able to comprehend. The system depends on trust.
"A Banker," explained Sir William Petty, co-founder of the Royal Society and author of Political Arithmetick, in 1682, "is honest only upon the Penalty of losing a beneficial Trade, founded upon a good Opinion of the World, which is called Credit." Credit, by definition, cannot easily be restored; its nature is to shift somewhere else. We should be less concerned with loss of money and more concerned with loss of trust. If we have to start over with more trust and less money, is this really so bad? "Is not a Country the Poorer for having less Money?" asked William Petty. "Not always," he answered, "For as the most thriving Men keep little or no Money by them, but turn and wind it into various Commodities to their great Profit, so may the whole Nation also." 15

Charles II had the right idea. He trusted (and endowed) the small group of oddballs who were forming the Royal Society, and put a stop on the Exchequer. If he had rescued the bankers, and ignored William Petty's band of Natural Philosophers, where would we be now?

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