Standing on the Sun. Christopher Meyer
that in different environments capitalists will adapt, generating new rules; that the new rules will be taken up wherever they work well; and that some of the existing rules will not be favored in new (and increasingly influential) environments. In the jargon, capitalism is an adaptive system.
Not to get too Discovery Channel, if you were watching the evolution of homo sapiens and got to the part where the monkeys came down from the trees, you might notice that they were using their limbs differently on the ground and imagine that someday they might look like tailless, upright apes. That would happen because the monkeys with capabilities best fitting their no-longer-arboreal environments got to pass their genes on to successors more frequently than those that didn't. In the same way, capitalism will end up optimized for a new world not because of policy or revolution but because of adaptation.
To state it all but redundantly, adaptive systems come to reflect the features of their environments. In chapter 1, we explored how capitalism's environment has changed broadly, deeply, and rapidly. Knowing that, one could adopt one of two points of view: either this shift has no feedback on capitalism itself, or it does. If the economy is like a machine, a change of environment will mean nothing to it. It will go through all the same motions it did in the old environment, even if they prove less productive. But if it's more like a natural, organic system, made up of individuals who can figure out new ways to make a living, the system will discard things that are not working out well in this new world, and adapt.
Capitalism Is a Set of Rules
What is it exactly that changes when a system like capitalism evolves? Economist Paul Romer addresses this question in the theory of history he is developing. A new theory of history sounds awfully ambitious, and it is, but Romer brings it down to two forces. Change in human society, he says, is the result of fresh ideas, and those come in two flavors: technologies and rules. “Technologies are just ways to rearrange physical objects to make them more valuable to us,” he explains, and “rules are just ways to structure the interactions that people have with each other, to get the most value out of those interactions.”4 Ideas of both kinds are easily spread, and they often go hand in hand. The constant quest to gain value on both fronts propels civilization forward.
At the level of an economy, a rule might be a matter of law or it might be less formally stored in culture, values, and norms. Romer cites, for example, the social repercussions that followed as people in communities got past their sense—their internalized rule—that if they were harmed by someone the right response was to exact vengeance. When a new rule took hold—that instead of meting out retribution they should seek compensation—civilization advanced. “If a man is wronged and retaliates by burning his antagonist's house down, there is a net loss to the economy,” Romer explains. “If he instead sues for the value of the house and prevails, there is a transfer with no overall cost.” (Legal costs were presumably de minimis at the time.)
We're in full agreement with the emphasis Romer places on rules in his theory of history. The march of technology is stunning and constantly commented upon, but it is only half of the force that advances civilization. The new possibilities created by technological progress must be navigated with new rules. This, we think, is appreciated on a very deep level, even if it is rarely articulated as well as it has been by Romer. It's why many people relish what John Maynard Keynes said about the power of new mental models:
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.5
So let us point out that capitalism is nothing but a set of rules, some explicit but most implicit. The rules dictate the conduct of exchanges, economic and otherwise, among owners, managers, citizens, and the state. Some of these rules turn out to serve society better than others. For example, in the introduction we mention the question of how a capitalist society should deal with an entrepreneur whose venture fails. If a business goes bankrupt, it might be considered fair to hold its founder completely accountable for the loss. Those who can't repay their investors or vendors might justifiably be sent to debtors' prison. On the other hand, throwing a borrower in jail, in addition to the costs of incarceration, removes the possibility of repayment—and meanwhile deprives society of whatever business venture that bold risk taker, now wiser, might have pursued next.
Developing bankruptcy protections as an alternative to debtors' prison is one of the steps in the more general shift Romer noted from vengeance to compensation. It was logical to realize that treating debt as a sin meant taking potentially productive assets out of the labor force and paying to imprison them. In a society that prized innovation, it made more sense to acknowledge that debt happens and devise a system for dealing with it productively. The rules changed, and capitalism adapted.
Coevolution
Did a less punitive stance toward capital squanderers mean they got off scot-free? Ideally, no. Easing up on bankrupts threatens to create what economists call moral hazard—a situation in which someone has an incentive to make bad choices because others will pay for them. For the rules to serve society well, they must achieve a careful balance that encourages reasonable risk taking while discouraging recklessness and free riding. And note that some of that balance can be achieved by rules other than laws. For most of the twentieth century in the West, moral hazard was contained by the social stigma of bankruptcy; debtors' prison or not, “going bust,” becoming a “deadbeat,” and declaring financial failure were sufficiently painful that no non-sociopath would choose them.
But after leniency regarding bankruptcy became the norm, some borrowers responded to that change with new behaviors. A century without debtors' prison eroded society's aversion to bankruptcy, and it became a tool of management. Frank Lorenzo, former CEO of Continental Airlines in the United States, embraced bankruptcy in the 1980s to restructure its labor agreements, even though Continental was not in such dire balance sheet straits that Chapter 11 was necessary. Lorenzo shocked business commentators but also earned their admiration for the creative use of the law. In that case, moral hazard was not an issue: there's no suggestion that Lorenzo's predecessors considered the bankruptcy strategy when negotiating raises with pilots in earlier years. But when Lorenzo didn't burn in business opinion hell, it inspired a truly bankrupt use of bankruptcy law: land speculators in the 1990s observed that in Florida and Texas, the law allowed them to walk away from deals gone bad, and thus they began buying high-risk properties. The deals looked bad to anyone who feared bankruptcy, but to those immune to its stigma, it was an attractive “heads I win, tails my creditors lose” opportunity. Since then, Florida has evolved its bankruptcy statutes to close this loophole, as community shunning was no longer a sufficient deterrent. Indeed, according to the Web site of a Florida bankruptcy lawyer, “There are no good or bad reasons to file for bankruptcy … There is no shame, stigma or embarrassment in filing bankruptcy anymore.”
Yes, this should put you in mind of bailouts, whether in the context of AIG or Greece, and yes, it's been a similar story: Anglo-American capitalism has so strongly rewarded financial innovation, and has been so averse to letting financial institutions take their lumps, that moral hazard has moved from a curiosity of economists to the editorial page. And yes, we have lawyers, in many cases holding public office, who defend those institutions as doing their jobs as society needs them to. But that's not our point here.
Our point is to introduce you to the key concept of coevolution. This is the phenomenon by which changes in one species spur reciprocal changes in another, in a sort of arms race of adaptation. As computational biologist Stuart Kauffman says, “When the frog gets a sticky tongue, flies get Teflon feet.” The growth of digital networks and the changes in the music distribution industry are an economic example. The rules and technologies beget innovations in behavior; the new behaviors induce changes in the rules (in this case, both social and legal).