Paul Ormerod

Why Most Things Fail

The decentralized, market-oriented model may not give the very best result, the optimal outcome, for in most circumstances we have no way of knowing what this is, but it delivers a satisfactory outcome, which benefits most or all of its component agents. The visions of the world articulated by orthodox economics and by Hayek are fundamentally different. Conventional theory describes a highly structured mechanical system. Both the economy and society are in essence gigantic machines, whose behaviour can be controlled and predicted. Hayek's view is much more rooted in biology. Individual behaviour is not fixed, like a screw or cog in a machine is, but evolves in response to the behaviour of others. Control and prediction of the system as a whole is simply not possible.

Interestingly—and how unlike most modern-day economists!—Hayek understood and admired the achievements of other intellectual disciplines. Anthropology attracted his particular attention, and of all the social sciences he regarded this as the one which produced people who thought in a sensible way about the development of society. For Hayek, 'an economist who is only an economist cannot be a good economist'.

The complex interactions between individuals give rise to inherent limits to knowledge of how systems behave at the aggregate level. No matter how smart the planner, no matter how much information he or she gathers, there are inescapable limits to how much can be known about the system.

Vernon Smith gives a practical illustration of the limits to knowledge in his brilliant Nobel lecture, published in the June 2003 American Economic Review. Airline route deregulation in the US has led to the emergence of the so-called hub and spoke system. There are few direct flights between cities, and most journeys involve a change at one of the small number of 'hub' airports. Smith describes this as an 'ecologically rational' response. Significantly, as he points out, no one predicted in advance that this institutional structure would evolve. This is not because airlines were stupid; it is because customers did not know themselves in advance that this was the system they preferred. They were not cogs in a machine following fixed rules of behaviour. Their preferences evolved towards a system with which they were satisfied through a process of market experimentation. Following deregulation, different types of route structure were tried, but the hub and spoke evolved as a reasonably efficient outcome which worked.

This particular institutional structure was discovered through a process of evolution and competition. Another example is provided by the evolution of a single currency in the US, and the marked contrast of this experience with the attempt to foist a common currency on Europe by means of central planning. Successful institutions, or rules of the game, are not set by central planning diktat. Instead, they evolve. The US dollar bestrides the world. Acceptable in every country, fervently desired in most, it is a potent symbol of American economic strength and power. But it was not always so. Indeed, it was less than a hundred years ago that the US Congress established the Federal Reserve Bank, the American equivalent of the Bank of England or European Central Bank.

For most of America's history, from the English colonies established on the seaboard fringe of the continent over four hundred years ago to the early twentieth century, a wide and at times bizarre range of different types of money circulated within the United States itself. The monopoly of the dollar there is a comparatively recent event. The American republic was established in 1783, but as late as the mid-nineteenth century, a tremendous array of different types of money circulated in America, with states and banks being free to issue their own notes. As late as 1860, there were some 9,000 different kinds of privately issued dollar bills circulating, around a third of which were counterfeit. On no less than six occasions in the first half of the nineteenth century, Congress passed acts allowing foreign coins—French, Spanish, British—to circulate as legal tender.

Two attempts to establish a central bank in the US, of the kind with which we are now all familiar, failed. Prosaically called the First and Second Banks of the United States, both had short lives which had ended by 1840. America then waited until 1907 before the Federal Reserve Bank, with us today, was established.

The US emerged as the most important economic power in the world during the course of the nineteenth century. By the First World War, the American economy was over twice as large as that of imperial Britain, the second economic power, and living standards were distinctly higher. Yet these stupendous developments took place against a background of a baffling plurality of different currencies.

The American economy blossomed despite the lack of a single currency. Indeed, the success of the dollar owes a great deal to the process of gradual evolution over which it emerged. The dollar was not established by the diktats of the political elite but gained slow acceptance across the population as a whole.