For the last 40 years economists have shown little interest in the enterprise systems that form the backbone of the global economy. Why should they change their tack now? Bc they're again on the brink of missing out on understanding how technology shapes the way the economy works
If one is to believe some accounts, blockchain is a fairydust-based rocket propellant that will help us all travel to the Moon in no time, and make us younger, richer, more democratic, and more equal in the process.
If you ask others, the story sounds more prosaic: we are talking about an overengineered database for keeping accounting records: a massively redundant, energy-sucking transaction log. The whole thing is also more than a bit scammy.
Most economists tend to be on the latter side (cryptocurrencies don't help). Given their somewhat tenuous relationship with corporate accounting and general disinterest in databases: why should economists take more than a cursory look at this apparent hype topic?
Granted, specialization in the field makes sure that someone somewhere knows everything about the economics of dental prophylaxis, but hype aside: the invention of blockchain warrants a closer look than economists usually give healthy teeth. Or databases.
OK, there's the nascent field of “cryptoeconomics” which combines computer science (mostly distributed systems plus cryptography) with game theory and mechanism design to calibrate the consensus processes that decides which transactions go on record.
This is mostly driven by computer scientists and methodologically it leans more on engineering and operations research than economics. But it is not the current participants’ fault that economists have mostly remained on the sidelines at this juncture.
The problem is that much of what drove the relevant shifts in economic organization over the last forty-plus years has happened off the radar of economists, hidden inside enterprises, so to properly assess the sheer magnitude of this shift, we should have a look back first.
One of the dirty secrets of global capitalism is that the scientist who arguably had the biggest stake in kicking it off was also the only person to ever receive both the Economics Nobel and the Stalin Prize.
I am speaking of Leonid Kantorovich, whose invention of linear optimization was originally designed to help him minimize waste when cutting shapes out of plywood boards in the war-torn Soviet economy.
The western world took no notice of his solution, so it was later re-invented by Tjalling Koopmans from Holland and American George Dantzig. (Koopmans got to share the Nobel with Kantorovich; Dantzig was overlooked.)
Supported by early mainframe computing, Kantorovich’s invention fueled a short-lived attempt to solve the resource allocation problem in the entire Soviet Union using “cybernetics” — the simulation and optimization of the Soviet economy as a hermetic, circular system.
In the end it didn’t work of course. The task was too daunting, the methods too novel, the mainframes too slow and cumbersome, the bureaucratic corruption too deeply entrenched. But for a brief glimpse, the Soviet economy looked like it could be competitive.
Kantorovich’s “one little trick” was to take a system of linear equations and to leave one equation — the objective function — variable. All other equations then become resource constraints and we can find the value which optimizes the system: maximize yield or minimize waste.
Kantorovich’s linear optimization setup was soon expanded into more complex domains — dynamic, stochastic, combinatorial, what have you — and today it is ubiquitous.
Any time we ask ourselves whether we can improve a system, and try to come up with a formal, mathematical answer, we apply some sort of constrained optimization model.
It drives finance, engineering, machine learning, and in particular it drives the estranged fraternal twins of operations research and economics. When Facebook, Netflix, Spotify try to guess what might interest you most, they use Kantorovich’s one little trick.
Autonomous vehicles, dating websites, search engines, machine translations all optimize. Today, the idea that was supposed to modernize centralized planning in communist economies powers global commerce. Why tho?
Enterprises are simply smaller units to model, their process flows tend to be linear rather than circular, and enterprises — unlike countries — are allowed to fail. The social costs of getting it wrong are still steep, but nowhere near as as steep as failing national economies.
The supposed flaw of capitalism, its tendency to run redundant production lines that inevitably produce overstock, became its strongest point (partly because overstock hurts companies and shortages consumers).
With improved record keeping came improved prediction, reduced redundancy, and ultimately a better flow of goods, services and finances: an improvement in the allocation of economic resources we call “innovation”.
This did not go off without a hitch and management scholars like Henry Mintzberg repeatedly threw up their hands in disgust at the inability of strategic planners to shift things around properly. At times it seemed like capitalist planning was going the way of communist planning
But with the benefit of hindsight we can look back at multiple hype-and-disappointment cycles to realize — whatever we might think of it as political animals — consumers have embraced globalization wholesale.
We expect exotic fruits year-round, and we simply don’t care that our “Made in Germany” cars or our California-branded iPhones are built from components from a couple dozen source countries.
Unless disrupted by unforeseen events, be it an Icelandic volcano or the sub-prime housing crisis that triggered the Great Recession, the rumblings of international goods transfers (and the financial transfers going in the other direction) can be perfectly ignored.
There are many ways to look at an enterprise. The “textbook” economic way is to think of it as a production function: inputs of all sorts are assembled and repurposed until they turn into a product which hopefully sells for more than the cost of all inputs and efforts combined.
The sociological enterprise is a hub of collective action held together by routines and rituals, by power and influence; the legal enterprise: a “nexus of contracts” where flows of materials, finances and human efforts are the result of agreements, promises and obligations.
The fundamental ingredient of such a contract is a transaction, typically taking on the form of “Florian to sell five firlots of flour to Fiorentina for fifty-four florins.”
Transactions capture that core building block of Adam Smith’s market economy: a (hopefully) voluntary exchange of things that will (hopefully) make both sides better off. The argument is then that transactions also happen not only across markets but also, similarly, inside firms.
Ronald Coase took this argument a step further and claimed that the complexity of a transaction decides whether it is conducted within an enterprise or across a market, since even market transactions come at a price.
There are many reasons why a transaction can become more complex than the Fiorentina’s florins example. Transactions can include multiple steps of delivery or payment, they can stretch out over time, or they can contain all kinds of surprises which might become known only later.
From fake pharmaceuticals to exploding batteries, at any time during or after, either side can feel the urge to withdraw from the transaction or alter the contract — to renege on it — if they feel that the cost of doing so is lower than the cost of sticking to the contract terms.
Companies internalize dispute resolution. Any transaction inside a company comes with a resolution process baked in. Right or wrong, hierarchy gets to make the final call, and oftentimes even a wrong call is preferable over neverending debate.
The other end of the spectrum is not quite as well established. If hierarchical firms are so much better at handling anything except simple on-the-spot transactions, what is the upper limit of firms? Arguably there could be one firm controlling a whole economy after all, right?
Coase published his argument in 1937, when enterprise record-keeping was still done with pencil, paper, and abacus. Eight years later, Friedrich Hayek pointed out why the economy should not be run as one single all-controlling enterprise.
Nevermind the advances in operations, the economy needs not only scientific inventiveness but also opportunity recognition. The best waypointers towards lucrative opportunities are prices, and only free markets can provide true prices: the marvel of the price system.
Today firms bundle their accounting, analytics, resource planning into large-scale enterprise systems. A modern enterprise might run any number of so-called “end-to-end processes”: cross-functional, formalized if-then relationships with predefined scope for human intervention.
Processes are usually named after their endpoints, like “order-to-cash” or “procure-to-pay”. The things being shifted around within these processes are the basic components of the global economy: materials, money, information and effort.
In some processes these components run separately, like logistics for materials, human resources for effort, and financial consolidation for money. Elsewhere they intersect, such as in procurement, sales, or notably, accounting.
Over the last decades, Coase and Hayek’s early mainframe-powered corporations have become faster and, surprisingly, leaner. As supply chains become more complex, they have not integrated vertically but rather disintegrated.
Even though hold-up problems haven’t gone away — quite to the contrary: the controlling entities, typically the companies that put their brand on the final product, have relied more and more on market interactions — outsourcing — for multi-tier assembly.
Four or five tiers in a supply chain are not uncommon, and in a just-in-time setting suppliers sometimes have to fly in their components with helicopters to keep production lines running, or risk steep penalties.
The other basic type of economic interaction, the market as agora for supply and demand, has shifted from a governance model to an IT operation mostly concerned with throughput. Markets themselves have become enterprise-d.
NYSE, which started as a gentlemen’s agreement under a buttonwood tree to curb the speculative tendencies of its founding members, is now the subsidiary of Intercontinental Exchange, a global IT company running stock and commodity exchanges.
Part 2 here.
