Sunday, April 24, 2011

Capitalist Evolution?

M&A activity is showing signs of life, activity reaching its highest levels since 2007. What more appropriate symbol of the renewal of the economy, of the emerging spring-time of our business cycle, than the merger of two firms, their culture, management style and business as the genes, and the result of the union a manifestation of the process of economic evolution.

This metaphor might be passed off as nothing more than bad writing except that it is the way many people actually view things; capitalist evolution likened to natural evolution, perhaps with the implication that capitalism, like biology, is a fundamental life force.

It really is taken seriously in some quarters, and I am not simply talking about alpha males evoking the survival of the fittest during moments of self-reflecting on their business conquests. For example, in the last chapter of The Ascent of Money, Ferguson cites this as the view among thought leaders now and voices from the past such as Thorstein Veblen. He goes on to compare the recent frenzy of financial products to the ushering in of a financial Cambrian age and writes that, “a long-run historical analysis of the development of financial services suggests that evolutionary forces are present in the financial world as much as they are in the natural world”.

If by evolution we mean that things improve over time, and that in the course of this improvement some of the old ways fall by the wayside, then the economy and markets do indeed evolve. As does nearly everything to which we put our hands. We can just as easily say that horsemanship, metallurgy or warfare evolve. This is nothing more than saying that we are imbued with intelligence and creativity, which may indeed be the consequence of evolution of our species. But that does not mean that everything we create is innately part of an evolutionary process. We make things better over time and create new things. It isn't just laundry detergent that is constantly “new and improved”. There is nothing particularly remarkable about tagging economic progress as evolution when all that is happening is an upward trajectory because of our application of intelligence, creativity and a desire to improve things.
If we follow this line of thought and try to apply the theory of biological evolution to the markets, we will not end up where we would hope. A species would not survive in the natural world if it pulled its evolutionary strategies from the capitalist playbook. And the converse is also true. The capitalist paradigm most resembles an evolutionary strategy that has failed in nature. That is, taken as a biological evolutionary process, capitalism leaves something to be desired.

Capitalist Evolution
I have three words: Destroy, Destruction and Destroy”Marvin Hagler

In Capitalism, Socialism and Democracy, Joseph Schumpeter repeatedly speaks of “capitalist evolution” resulting from “the opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism”.

The phrase "creative destruction" romanticizes the common; creative destruction basically means out with the old and in with the new. Creativity without Schumpeterian “destruction” is difficult to fathom given fixed resources and a preference for better over worse.

But by whatever name, creative destruction is not the norm. Capitalist evolution has more to do with consolidation, with successful firms growing to dominate the market on the one hand, and breeding more of their kind on the other. This is the the dynamic of competition, firms following the scent of what is making money, leading economic rents to collapse.

The sort of evolution that we see in the markets, that is embodied in M&A as it is elsewhere, must take the world as it is. And do so even if it thinks it knows better. Otherwise it will become an also-ran against other firms willing to ignore the possibility for surprises. This is the way to read Citigroup CEO Chuck Prince’s famous statement, “as long as the music is playing, you’ve got to get up and dance”. That statement could say something about obliviousness or imprudence, but unfortunately it is also stating the way things work in the free market system.

To see the pressures to consolidate and stamp out diversity, consider the following:
  • Everyone is integrated into the most efficient production process. This requires specialization based on comparative advantage.
  • Efficiency leads everyone to 'go with the winners'. That is the way economic rents are reduced. So even if an economy starts with many different enterprises and approaches, there is a tendency to swarm toward the few, based on the existing economic world, preferences, resources, and technology.
  • Everyone becomes tied to the same networks, be they power, transport, communication.
  • Everyone buys the same sort of products. The convergence even greater now than in the past because of the economies that come from people “locking in” to use common platforms and software.
Go back to M&A as an example. It reduces diversity and creates a larger entity that by design is structured or selected to do better in the current environment. Maybe it looks like natural selection, but it is not all that similar, at least not that similar to the route of natural selection that has come to dominate the biological world.

It turns out that an entity optimized to compete and survive in the present is not one that is resilient in the face of unexpected shocks. Resilience requires taking resources away from profit maximization in the present, and if the current world lasts too long, then pursuing that strategy means being eaten up by more single-minded competitors. So we all have to go with what works best now, go with the winners.
The greater the opportunities for capitalist adventures, the larger the crowd in the race to the fertile fields, and the lower the diversity in the economic landscape. If we were interested in having our species, however defined, last, we would pursue a different strategy than what is possible in the competitive world. As I will discuss below, one such strategy is to do what biology does, which in any state appears non-optimal.

Evolutionary diversity goes hand in hand with not being optimal in the present environment. Nature is rife with what would pass as bad management practices. It is not likely that there will be a lot of diversity while at the same time requiring that each of the diverse agents will give one another a run for the money in the present. There may be a few types of firms that can compete, but look around in any sphere of business or markets, and you will see that the norm is for all to converge on what works now. Diversity cannot last, only optimality to the present can.

The Asexual Capitalist
When we speak of evolution we also are speaking about reproduction, which leads to the question of why we have sex. Asexual species can reproduce more quickly and efficiently than ones that require the mating of a male with a female. So why don't the asexual species overrun the sexual ones? Why doesn't natural selection get rid of the males?

Sexual reproduction is not only less efficient than asexual reproduction rate, it also tends to preserve “suboptimal” characteristics – biological traits that are irrelevant in particular ecological settings. Sexual organisms carry an unnecessary second copy of almost every gene, and the interaction of the duplicated genes creates unnecessary diversity, and in fact is the source of many diseases that reduce an individual’s odds of evolutionary success. Species are not as streamlined and efficiently built, as honed to meet the world as they might be. Darwin remarked that:

Organs or parts in this strange condition, bearing the stamp of inutility, are extremely common throughout nature. Some of the cases of rudimentary organs are extremely curious; for instance, the presence of teeth in foetal whales, which when grown up have not a tooth in their heads; and the presence of teeth, which never cut through the gums, in the upper jaws of our unborn calves. Nothing can be plainer than that wings are formed for flight, yet in how many insects do we see wings so reduced in size as to be utterly incapable of flight, and not rarely lying under wing-cases, firmly soldered together!

What appear in the obvious physical traits also appear, and are of more importance, on a less visible level: the “pseudo genes” that seem to have no particular purpose, that are turned off and therefore certainly aren't doing anybody any good – at least not in the current environment.

DNA for many species is riddled with these pseudo-genes, unused sequences that are potentially transformable into new, functional gene. The classical formulation of evolution – or at least one thread of it that was prevalent in the eighteen hundreds – believed in the same sort of trend toward efficiency that forms the bedrock of economics, namely that the forces of nature would eliminate such inefficiencies, and thus over time the species would lose diversity, becoming increasingly streamlined. But as Darwin remarked, we see nonfunctional parts remain at the macroscopic level, and we see the same at the microbiological level as well The reason is simple: the resulting diversity, though less than optimal in any one environment, enhances the odds of survival when the environment changes in unanticipated ways, in ways for which the species has no genotypical prior. The dominance of sexual reproduction over the asexual alternative rests on the apparent inefficiency of carrying around this excess baggage of pseudo-genes.

So although at first it seems to be almost self-evident that if a species can reproduce asexually with more efficiency and reproductive fidelity, then it would be the dominant approach to evolution, there is a reason that nature has not worked that way. Despite this inefficiency, the number of sexual species far outweighs the asexual ones. Although there is general agreement that in the short term asexual reproduction (a.k.a. cloning) is better, that it can maintain a given ecological niche, asexual reproduction tends to be a dead end in the long run because no ecological niche is stable.
Second, and more important from the perspective of pushing an analogy to economics, is that no ecology is stable. Surprises and shocks occur that are not in the organism's genotypical prior – that is, shocks where the organism has no way of being pre-adapted. Its genome may no longer be up to the job, and if it is reproducing asexually there is not much it can do about it. Absent a few random mutations, it is stuck with what it has. So in the long run asexual lineages usually degenerate and go extinct.

In contrast, if organisms reproduce sexually, the shuffling and recombination of genes increases the odds that some offspring may be lucky and get dealt a set of genes that produce offspring that happen to be well-adapted for the shock. By bringing together the variations arising in different individuals that can turn out to be beneficial ex post, sex increases the odds of survival.

Asexual species are like weeds, optimized for quick growth. But over time they give up their territory to species that may be poorer colonizers but are more effective long term survivors. Thus asexual reproduction is not the way to go if a species plans to stick around for more than a few ticks of the evolutionary clock.

Capitalists are also like weeds. In a capitalist system, speed of development and colonization – grabbing market share – is of the essence to capture and generate market share. The hope is to then turn from the asexual mode to garner the flexibility to maintain that market in the face of changing preferences and market conditions.

If something like pseudo-genes appeared in the Schumpeter's capitalist evolution, where individuals are optimizing for a given environment, such baggage would be stripped away in the quest for economic efficiency. The competitive economy casts off excess baggage, as it does useless appendages. The competitive system is less forgiving of the inefficiencies of carrying around excess baggage than is nature. Modes of production and the workforce are not left free to roam away from what generates the most profit. If they do, it is chalked up to poor management, and the business will be on the acquiree end of an M&A transaction.

When the going gets tough, the hidden genes get going
To understand the origins of diversity in species, we need to go beyond the genetics into what is termed the epigenetic system. Epigenetics is easy to see in our own bodies. Our liver cells and kidney cells both have the same DNA the same genes, but something tells kidney cells to beget kidney cells and liver cells to beget liver cells. That something is the epigenetic inheritance system. It tells genes when to turn on and turn off.

The reason we humans can share so many genes with other species is that, although the genes might be the same, the sequences making up switches, and thus the nature of of the genes' interaction, have evolved to be different. Small changes in switches can produce very different patterns of genes turning on and off during development. The diversity of organisms is largely due to evolutionary modifications of switches, rather than genes. This is also the reason that large changes can happen so quickly (at least relative to evolutionary time): the genes stay the same, but switches change. These changes can occur in the parts of DNA long thought of as “junk”, and are the major force in evolution, rather than the rapid appearance of entirely new genes.

The combination of a high rate of generation and a good chance of being appropriate means that adaptation through the epigenetic system will both be much faster and more likely to have a positive result than adaptation through genetic change. When faced with an environmental challenge, these hidden genes come to the fore to be captured by natural selection and generate evolutionary change.
There are a number of characteristics between sexual versus asexual reproduction that relate to the tendency for economies to be unstable in the face of shocks. The diversity emerging from the genetic and epigenetic mixing, especially under stress, creates less-than-optimal variations in species that kick in to allow the species to survive these shocks. The capitalist system at its most efficient does not have a similar mechanism. Indeed, the tendency is decidedly in the opposite direction. We go with the winners, and those who decide to take a non-optimal path will disappear from the scene well before a shock comes about which derives a benefit from that diversity.

Destruction not by murder, but by suicide.
In my book, A Demon of Our Own Design, I draw two examples from biology to illustrate the ways to cope with the risk arising from unanticipated events. On one side I have the cockroach, an insect that has survived for eons with the simple escape mechanism of moving away from gusts of air. In any one environment, the cockroach will be less than optimal, because it does not even consider visual or olfactory cues. On the other side, I have the furu, a fish that once inhabited Lake Victoria, a large lake in the center of Africa. The furu developed into many species to take advantage of every nook and cranny of the lake’s ecology. Finely tuned but not robust, the furu disappeared once the unanticipated happened, the Nile Perch was introduced into the lake.

The point of this comparison is to illustrate that being optimal in any given environment might not be optimal in the long run. The robust but coarse response might always be an also-ran, but be more survivable as shocks occur. The non-optimal but robust species survive because over eons species are beset by one surprise after another, surprises for which they do not have a genotypical prior.
Sexual and asexual reproduction operate much like the cockroach and the furu, respectively. Sexual reproduction is less efficient in any given setting but is more survivable and robust across varying environments. Asexual reproduction is best if you are a fit organism in the current ecology, and if that ecology doesn't change. (Or if it doesn’t, but long-term survival is not the objective).
Given the constraining effect of competition on diversity, given the rapid push for all hands to move in the direction of the current best thing, if someone were to put a gun to my head and ask me to fit economics into the biological world of evolution, then I would answer that capitalism evolves asexually. It wants weeds, the short-term winners.
And it is because of this that stability begets instability in the capitalist system. If we want to speak of capitalist evolution, the process of stability breeding instability is ingrained into the genes, the process of evolution, because the more dominant the opportunities are for success, the less diversity there will be, and the more the capitalists will follow the asexual path. We go with the winners, and those who decide to take a non-optimal path will be taken from the scene well before a shock comes about which derives a benefit from that diversity.