Paul Romer's Errors

This is an overdue summary of the presentation Stanford's Paul Romer gave at the signature growth panel at the Atlanta AEAs ...

Romer started by observing the divergence of international incomes has been a powerful and vexing trend. Despite the ever-widening gap between developed and developing economies, he also noted research showing how life expectancy across countries has converged. This bodes well for the future, and suggests to me a stepping stone to convergence in other things.

Second, Romer made a fantastic point that the workhorse model of gains from trade (globalization) is comparative advantage, but it is a story that should be updated with new goods. Instead of the two trade goods being fish and apples, for example, we should talk about trade in cholesterol pills and blood pressure pills. The first implication seems to be the consumption benefits of trade are too often neglected. The implication Romer was making is that trading in recipe-driven goods represents an inefficiency. We should imagine a globalized economy where production is localized and IP is licensed, rather than one where final goods (physical objects) are traded.  In his words, "globalization should be a flow of ideas, not goods."

But the real insight offered in Romer's talk was when he called out the "two errors" of development thinking. He got to them by sketching out a few growth equations, starting with the familiar 

Y = A * F(K,H,L)

and then expanding the A term as a function of technology and rules:

Y = A(Technology,Rules) * F(K,H,L).

Understanding the importance of rules is the key insight. Private property is a kind of formal rule governing social interaction. We have other rules for marriage, educational advancement, and so on. Technology is the conventional way economists thought about the growth equation and includes hardware like computers, phones, and printing presses.

When thinking about how to accelerate economic development, the first error people tend to make “Technology cannot change.”  The given tech level of a country is given. The second, and more important, error is that "Rules can change with stroke of a pen.” While there is a growing consensus that rules are the most important factor in permanent changes in a developing country, Romer forces us to accept that rules are very difficult to change.  Nations in particular, even when its leaders recognize the need for rules to change, have difficulty making them happen.

Here in America, there is tremendous acrimony about new legislation of almost any kind. Witness the current fight in the U.S. Congress over health care reform. So why do we imagine it would be trivial for another country to change its laws, let alone norms, customs, cultures?  So the real challenge for development practitioners is how to make rule-changing easier.  Any thoughts?

Comments

[Michael]

Great post Tim. I think the challenge of rule-changing that you mention is one of the most salient factors in determining how well countries and cultures are able to progress.

There are several models and frameworks explaining how institutions change, both in the form of laws and in the form of norms (one of my favorites comes from Acemoglu, Johnson and Robinson's article, "Institutions as the Fundamental Cause of Long-Run Growth"), but as far as how to make rule-changing easier, I don't believe there are any clear-cut answers. One immediate solution would be to foster a culture of change, progress and dynamism, but trying to grow this kind of culture constitutes a rule- or norm-change in and of itself, and is thus not super helpful.

[Tim Kane]

Thanks Michael. That was a great paper. However, I think the word "institutions" is a bit ambiguous. I've been saying it for years now, and at the AEA realized other people were using it with a completely different definition. Kind of like "technology" ...

[Norris Krueger]

Interesting- wrestling with "how to grow a more entrepreneurial Idaho?" makes this particularly timely. A couple of questions arise --

1) "Rules" also include the deep assumptions that drive policy making. Judging by what I'm hearing at various conferences, those rules have changed in DC... policy is VERY top-down, institutionalist. (Entrepreneurs don't really create jobs, rather institutions create conditions and entrepreneurs almost randomly surface, but it's the institutions that are critical.) So, do we have a case where one important Rule changed overnight?

2) If you can forgive 2 Q's in one post, can we think about the well-entrenched "Rules' versus the more malleable "rules" that we can more readily affect? Brad Feld suggests that it takes decades and probably outside impact to create a truly entrepreneurial culture in a community. There are just too many Big Rules that change slowly no matter what we do. My response is: Anthropology suggests that there are seemingly important norms that can change overnight (ans seemingly trivial 'rules' that seem implacable.) My question to you: Aren't there rules (small r) that we *can* change? And is this something worth studying? For example, are there rules that changing facilitate changing Rules? (Key leverage points for accelerating a shift to more entrepreneurial community?)

Anyway, love the blog -- always thought-provoking (and often useful!)
Norris

[Nathan Smith]

I didn't read Romer's paper (is there a link?) but from a modeling point of view, are we doing anything more than reinterpreting the Solow residual and throwing in a bit of narrative? We need to do better than that to solve the problem Tim points out about "institutions" being ambiguous (or at worst, hand-waving).

[John B. Chilton]

I don't accept your example of passing legislation in U.S. as a good example of the difficulty of changing rules. That's an example of a desired stability of rules built into the constitution, and reinforced by the American public that seems to favor gridlock as a way, however imperfect, of limiting the size of government.

Compare that to unstable countries where the constitution and laws are subject to wide swings, disrupt property rights, result in takings, etc.

[Mr. Econotarian]

Law can rarely escape the culture it is embedded in. The US has been lucky in attracting so many different immigrants who were alienated over a single generation from their home cultures which were less accepting of the inviolability of private property. The US has also made "independence" and "freedom" into a state religion of sorts, whereas other cultures respect filial piety, or redistribution of wealth to the extended family, clan, or entire village.

The US has also been lucky that our English land-owner culture that enabled our high level of economic freedom has turned out to also be highly economically rewarding.

However, it is time we tell the world that economic freedom is not just a culture, or a kind of religion, but it has shown itself scientifically to be a useful societal ordering for creating mass wealth.

We certainly can't force people to give up their culture. We can only lead by example, and try to inform people of the facts.

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Tim: As I wrote on my blog, Truth on the Market, I think Tyler is pretty far off base with this one. See http://www.truthonthemarket.com/2009/04/28/what-does-tyler-know-about-law-and-economics-anyway/

[mts]

I didn't read Romer's paper (is there a link?) but from a modeling point of view, are we doing anything more than reinterpreting the Solow residual and throwing in a bit of narrative? We need to do better than that to solve the problem Tim points out about "institutions" being ambiguous (or at worst, hand-waving).

[George Detellis]

I have worked in Haiti for the past 27 years and in the Dominican Republic for the past 10. These two countries share the same island, but are worlds apart economically. A simple comparison of their "rules" - property rights, labor laws, tax structure explains why Haiti is poor and the Dominican Republic is relatively wealthy.

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