[This article was originally published at Judgment Calls on May 19.]
Edmund Phelps died last Friday. Obituaries focus on the expectations-augmented Phillips curve, the natural rate of unemployment, and his 2006 Nobel prize. That work, which reshaped how central banks think, deserves all the attention it will get. But there was another strand of Phelps’s thinking—less celebrated in mainstream circles but more interesting to me—that I want to highlight.
In the years after his Nobel prize, Phelps turned his attention to what he called “dynamic capitalism”: not just an economy that grows, but one that generates a continuous stream of novel commercial ideas. His book Mass Flourishing argued that what distinguishes the Anglo-American economies from continental European corporatism is not their high savings rates or even their institutions in a static sense, but their openness to entrepreneurial experimentation and the varieties of entrepreneurial judgment that makes such experimentation viable. This is not the macroeconomics of the graduate textbook but something closer to what Austrian economists have been saying for decades.
What struck me when I read Phelps’s Kauffman Foundation piece in 2005—I blogged about it at the time—was his account of the capital market as a matching process. In his telling, entrepreneurs cannot fully articulate their vision; they operate under what Knight would call genuine uncertainty. Financiers, similarly, cannot objectively rank projects. What they can do is identify entrepreneurs whose “model of the world” seems compatible with their own. The result is not a textbook auction of capital to highest-expected-value projects but a decentralized sorting of worldviews. Phelps explicitly credited this insight to Hayek and Michael Polanyi—the idea that everyone in a market economy carries around some piece of personal knowledge that no central authority can aggregate or replicate.
This is a significant concession from a mainstream macroeconomist, and I don’t think it was fully appreciated at the time. The standard approach to entrepreneurship in economics—when it appears at all—treats the entrepreneur as a residual claimant who responds to price signals. Phelps was saying something different: that the heterogeneity of beliefs among both entrepreneurs and financiers is not a friction to be minimized but the very engine of dynamism. A world in which all financiers agreed on which projects were worth funding would be a world of fast convergence and slow discovery. The disagreement is the point.
This framing connects directly to work Nicolai Foss, Samuele Murtinu, and I have been developing on entrepreneur-investor matching under Knightian uncertainty. The basic problem is this: what makes entrepreneurial projects difficult to finance is not primarily incentive misalignment—the moral hazard and adverse selection that dominate the academic finance literature—but something more fundamental. Entrepreneurs and potential funders often cannot agree on how to classify the relevant future events. They hold different subjective beliefs about what the venture is, what it could become, and whether the underlying resources are the right ones. We call this intersubjective uncertainty, and it is a direct consequence of the Knightian conditions Phelps was describing: when entrepreneurial imagination is genuinely novel, there is no shared category into which it fits, and therefore no easy basis for agreement.
The matching that results is not arbitrary, but discriminating in ways the standard model misses. Projects that are highly novel in their value proposition but relatively transparent in their resource structure call for different financing arrangements—and different persuasion strategies—than projects where the product is familiar but the underlying resource combination is opaque and hard to evaluate. What looks like capital market inefficiency is often the system working as it should: financiers applying their own theories of value, entrepreneurs finding the funders whose worldview is close enough to make a deal, and both parties gradually developing shared cognitive ground through experimentation and communication. Phelps’s insight was that this pluralism of financier judgment is not a bug. Our work tries to show, in some detail, why this is and how the matching actually unfolds.
I’m also working on a paper that pushes deeper into the epistemology of that process. Mises observed that the entrepreneur and the historian are doing essentially the same thing in opposite temporal directions: both are trying to make sense of human action—the motives, valuations, and choices of situated persons—through what Mises called thymology, the interpretive understanding of human conduct. The historian asks what an actor was doing and why; the entrepreneur asks what consumers, competitors, and partners will do and why. The methods are similar. This matters for the matching problem because successful enrollment of a financier requires the entrepreneur to exercise exactly this kind of prospective interpretation, to inhabit the financier’s model of the world well enough to communicate across the gap in beliefs. And it suggests that what separates better from worse entrepreneurial judgment is not superior data or a more rigorous hypothesis-testing protocol, but something closer to what a skilled historian possesses: source discipline, motivated reconstruction, and the imaginative capacity to think from within another’s worldview.
Phelps worried, in his later work, that this dynamism was eroding—that corporatist drift, risk aversion, and a cultural retreat from the spirit of enterprise were slowing the generativity of Western economies. Whether or not he is right on the cultural causes, the underlying point seems right: an economy that loses the pluralism of its financiers, or that centralizes the selection of entrepreneurial experiments in the hands of government or consensus-seeking industry bodies, will run fewer and less diverse experiments. It will get less discovery, not more efficiency. The continental model he contrasted with Anglo-American capitalism, where experts convene to set product standards before any version reaches the market, is not just slower but weaker.
Economists who know Hayek’s work will find most of this familiar. What made Phelps worth reading was that he arrived at these conclusions from within the mainstream, using its tools and taking its constraints seriously, and that he was willing to say in the Wall Street Journal and at Nobel lectures that capitalism’s great virtue is not equilibrium but productive disequilibrium. That’s a harder sell than it sounds from inside a tradition that built its prestige on models of market clearing.
