Growthology

The Paul Collier School of Economic Development Goes Rambo?

[Today we happily welcome a guest post from one of our perspicacious interns, Charles Johnson.]

Dr. Kane's blog post about Easterly and the U.S. Army has gotten me thinking about how the military's Keynesian, supply side approach might fall short. 

Aside from Dr. Kane's paper, there's considerable evidence that security can help an economy recover. A paper out of Claremont McKenna and the U.S. Military Academy used the Law of One Price and examined a basket of 255 goods across Iraqi society to get a sense of whether or not the surge worked at reducing price disparities and hence promoting economic growth. Here's what they found, via (the sadly defunct) Odd Numbers blog.

1. The dispersion of prices in Iraq has been roughly twice the level of price disparities in the United States or Japan. 
2.  Regions with the largest U.S. military presence, which presumably brings greater security, saw the least amount of price dispersion. 
3.  And most importantly, price dispersion fell by about 11 percent after the surge started in February 2007, but picked up again after the surge ended in November, though at a slower pace.  

But where does one draw the line between security and costly occupations? 

Paul Collier, a development scholar out of Oxford, believes that U.N. peacekeeping forces can do best, but only if they are given ten years or more worth of money from the international donors. (Let's leave out, for the moment, the tremendous sexual abuse of children by peacekeeping troops overseas.)

Collier is a subscriber to the young male theory of violence and so he favors spending lots on infrastructure and getting the young men jobs so that they don't go killing each other, which sounds familiar when compared to what's been going on in Iraq. Collier says that it is foolish to expect conflict-emerging nations to compete on the international stage because they rarely have a comparative advantage. 

In this TED Talk at the State Department, Collier explains that post-conflict reconstruction is so very difficult and that donors should give money so to keep the state apparatus on life support. What's needed, he argues, is Accountants Without Borders, that tracks the money from donors and makes sure that it's all allocated properly. But Collier, just as in his book The Bottom Billion is foggy on when taxation should kick in and when aid money should exit, an essential component of becoming a responsible, modern state. To his credit, he mentions that it's foolhardy for local governments to finance the unfunded liabilities of a growing state, so, instead, he wants donor governments to finance it. 

Collier implores policymakers to be patient, something which policymakers are notoriously reluctant to be. Most Western governments don't last for 10 years and an open-ended commitment to post-conflict reconstruction "budget support" might be seen as a blank check. Worse yet, as Dambisa Moyo, herself a student of Colier's at both Harvard and Oxford, notes in her book, Dead Aid, there becomes little case for government when your government doesn't provide any public services. (See her interview with Peter Robinson at Uncommon Knowledge.) What Africa needs, she argues, is a reverse of the Boston tea party: Taxation and Representation. Otherwise, it should just elect aid agencies if they are to provide the public goods. 

Despite the clearly better track record of U.S. occupations and economic growth, I'm hesistant about efforts such as the U.S.-development enterprise fund.

It seems to be dead from its inception for much the same reason that much of the aid money is destined for waste. Bill Easterly is right to pan it for being a kind of social engineering. Put simply, how would the U.S. government (and the Congress which designs the program) know what's best for Iraqi market needs? (Heaven help the Iraqi industries that seek to compete with congressionally-connected U.S. firms!)

Advocates point to the USAID involvement in Eastern Europe post-Berlin wall, but here granting that Eastern Europe made the transition to a market economy due to USAID enterprise funds grants too much. One of the few countries that triumphed in the most communist era, was tiny Estonia that ignored much of the wisdom of from USAID and the IMF. Its Prime Minister, Mart Laar, credits Milton Friedman's book, Free to Choose, with much of the genesis of the reforms success. He claimed that it was the one book on economics he had ever read. Laar instituted a flat tax, repealed protectionist policies, and his economy took off and ushered in the flat tax revolution that's sweeping the world.

One of those countries that now has a flat tax is Iraq. Iraq's economy, erstwhile run by the big government-Keynesian Baathists, is now doing quite well for itself. Its 45% tax rate that sought to soak the rich has been reduced to a 15% flat tax. Its currency continues to appreciate favorably. Its oil revenue and surplus grew in 2008, according to GAO. Why doesn't Iraq use this money to fund an enterprise or sovereign wealth fund? Why must the U.S. Congress pick winners and losers in Iraqi entrepreneurial ventures? 

 

Critics could take comfort that the $250 million proposed for an American-backed Iraqi investment is a drop in the bucket in the larger market for enterprise-capital inflows into emerging-market. But they might take heart in these figures, provided by Roy C. Smith's "Enterprise Capital in Emerging Markets" in The Independent Review: 

 

Total enterprise capital raised or deployed in emerging-market economies increased from $517 billion in 2001 to $1.57 trillion in 2006. These essentially private transactions greatly exceed sovereign-government financing totals for the years indicated. . . . 

Enterprise-capital inflow into emerging-market economies has tripled in the past six years, and wherever it has gone, it has had an important effect on economic growth. Indeed, as shown by the experience of Russia, India, and China, the ability to attract relatively large quantities of capital for private investment has made possible exceptional economic-growth rates, despite the many difficulties and imperfections in these countries’ investment climates.

Enterprise capital now appears to be far more effective in generating growth in developing countries than foreign aid and loans from multinational development agencies or from individual countries’ robust government- allocated national economic development efforts, which for nearly fifty years were regarded as the world’s best solutions for ending poverty and distress in theThird World. These “solutions,” however, did little to generate the rates of economic growth needed in the Third World o alleviate the poverty and distress.

Easterly and others have pointed out how aid money can tend to crowd out foreign investment. Perhaps the best thing the U.S. could do with respect to Iraq's economy is leave well enough alone and let the security and capital inflows do their magic. 

--Charles Johnson

That's Why We Need More Entrepreneurs

Scott Shane recently joined the New York Times as a blogger for the site's new You're the Boss blog and in his most recent post used a series of charts to show that the United States is actually becoming less entrepreneurial than we would like to pretend.

Professor Shane, a professor of entrepreneurship, has been an outspoken skeptic of entrepreneurial capitalism, casting doubt on the extent and benefits of entrepreneurship. His latest line of research concerns genetics and entrepreneurship, identifying "the influence of genetic factors on the variation across people in opportunity recognition." This, Professor Shane purports to demonstrate, is heritable and independent of environment, as are occupational choices in general, such as teacher or manager or self-employment. (For a critique of opportunity recognition, see this recent paper: Download Creative Discovery Innovations June 2009.)

Notwithstanding potential sampling errors, the heritability of personality traits is a breeding ground for questionable claims. As the eminent Samuel Bowles has pointed out, "data from modern economies suggest that personality influences individual success, but the effects are quite modest." Moreover, "the correlations between parental and offspring measures of personality are strikingly low." The world periodically endures genetic determinism fads, and they rarely end well. 

Plus, if entrepreneurship is solely determined by genetic inheritance, why even have professors of entrepreneurship? 

In his latest post, however, Professor Shane is onto something: whether measured by the number of new employer firms started each year or the number of new establishments, the rate of entrepreneurship has fallen over the past two or three decades. Shane uses Census data that the Kauffman Foundation has helped fund, and I published charts on the falling establishment entry rate in a recent paper. And the share of Americans working in giant firms (those with more than 10,000 employees) has slowly but steadily risen in the past decade.

But there are a few points Shane fails to make. As one of his commenters notes, there has been a rebound in new firm and establishment creation since 2002. One of the datasets only runs through 2005 and when new Census data are released in August, we should know whether or not this rising establishment formation trend continued. With regard to new firm creation (nb, employer firms, not self-employed consultants or personal services), Shane's data run only up to 2007. But the Kauffman Index of Entrepreneurial Activity showed a slight uptick in new firm creation 2008. It will also be interesting to break all of this down by industry.

So what does this mean? We've actually seen a steady increase in the number of new firms started over the past few years. Shane's point is that while absolute numbers may increase, they fail to keep pace with population growth and so the rate, firm starts per capita, actually falls. That's right. But this only highlights the crucial need for more new firms, for more entrepreneurs. As we've noted before, using that same Census data, looking back over the past thirty years, if we had taken startups out of any given year, net job creation for the overall economy would have been negative in most years. No new firms, no new jobs. No one can escape, moreover, the great lesson of economic history that entrepreneurs are disproportionately responsible for radical innovations.

But the message is much broader than this: the real source of economic growth lurking in here is firm growth. This signals market success, generates jobs, and brings with it increasing returns to ideas. So even if the rate of entrepreneurship fluctuates on an annual or decennial basis, this doesn't mean that there aren't entrepreneurial firms growing to scale during that time. This, in fact, is precisely the pattern we would expect to see: a high rate of new firm creation followed by a period of falling entrepreneurship as firms fail, consolidate, and grow. This will (or should, provided barriers to entry are kept low) be followed by yet another period of high rates of entrepreneurial activity.

Children's Literature as Economics 101

Adam Smith should have published his magnum opus as a children's book. Or, more realistically, all macroeconomic and microeconomic professors, in a crisis-precipitated moment of soul-searching, should include some children's literature on their syllabi. 

Two of the most venerable names in children's book publishing are Little Golden Books and Richard Scarry. It recently occurred to me in the course of bedtime reading with our boys that two titles in particular do a remarkable job of explaining how the economy works.

The first, I'm a Truck, is the seemingly mundane tail of a long-distance freight truck on its journey from the big city to a port. Along the way the truck, Big Blue Bill, offers his readers a brief overview of how things like produce and milk and new cars and all manner of cargo reach consumers. We have fresh milk because we have trucks like Polar Bear Pierre to distribute it for us. Gustavus Swift would be proud.

But it is the second book I have in mind that truly matches Adam Smith insight for insight into things like the division of labor. This is Richard Scarry's What Do People Do All Day? (A side note: good question Mr. Scarry!) The book is four decades old by now, so some of the scenes are rather dated, yet if you want your child to know (or if you simply wonder yourself) how wealth is created, this books beats the facile fifth column lemonade stand story often used to illustrate the evils of big government. 

Farmer Alfalfa, for example, brings his corn crop into town and sells it to the local grocer. With this money, Farmer Alfalfa is able to buy a new tractor and a new suit from the local tailor, who, as a rabbit, has a large family to support. The grocer and tailor, in turn, use their goods and money to make their own profits. And so the cycle of specialization, buying, selling, and wealth creation propagates itself. 

Happy reading.

The Facts of Growth (Not a Mystery)

Stanford economists Charles Jones and Paul Romer have an ungated working paper with a title that will probably be confusing to lay readers, but may be one of the most important summary paper I've ever see (it probably is; I have yet to digest it). It is titled, The New Kaldor Facts: Ideas, Institutions, Population, and Human Capital

Here is a summary of our new list of stylized facts, to be discussed in more detail below:

1. Increases in the extent of the market. Increased flows of goods, ideas, finance, and people — via globalization as well as urbanization — have increased the extent of the market for all workers and consumers.

2. Accelerating growth. For thousands of years, growth in both population and per capita GDP has accelerated, rising from virtually zero to the relatively rapid rates observed in the last century.

3. Variation in modern growth rates. The variation in the rate of growth of per capita GDP increases with the distance from the technology frontier.

4. Large income and TFP differences. Differences in measured inputs explain less than half of the enormous cross country differences in per capita GDP.

5. Increases in human capital per worker. Human capital per worker is rising dramatically throughout the world.

6. Long-run stability of relative wages. The rising quantity of human capital relative to unskilled labor has not been matched by a sustained decline in its relative price.

Nicolas Kaldor's original article in 1961 also laid out six facts. They predominantly described the behavior and ratio of inputs and outputs: measured capital, labor, GDP, interest rate, and so forth. These new facts, as the authors discuss, define the agenda of study among growth scholars and show how much progress has been made in the field. I for one am impressed at how decisively we have moved beyond explaining growth in terms of ingredients, and have moved on to recipes.

So why is that so many popular discussion of growth emphasize how totally mysterious it is? William Easterly's book, "The Elusive Quest for Growth" is a case in point, but I think that kind of soundbite epitomizes the policy conversation. Growth is described ad nauseum as a "mystery" in reverent tones. And, not to make a pun, it really makes me sick. (This is no knock on Easterly -- his point is that experts tried to force correlations into causations, and failed. They were stuck on Kaldor 1.0)

How about this: growth isn't a mystery. By and large, we know what works and what doesn't. Corruption doesn't work well, property rights do. Globalization is working everywhere it is allowed. Protectionism is a disaster, in the long term and usually before. Democracy, unfortunately, seems insignificant in promoting growth, but free markets are essential. And, as every young American RTS playing teen knows, technology wins. And as almost every great innovator attests, entrepreneurship equals technology.

There remain unanswered questions, sure. But because scientists have yet to control fusion hardly means they can't design an engine that harnesses energy for locomotion. Because philosophers have yet to agree on the meaning of life surely does not imply they have no sense of morality. Bottom line: we know everything we need to know about growth to end poverty on Earth in this century. Will humanity be successful in growing universal prosperity? My suggestion: stop with the mystery mumbo-jumbo, and start reading this paper.

The Future Happened Yesterday and Today

Not to self-aggrandize, but this report, authored by me, was released the other day. I started with a question posed by our Kauffman colleague Keith Mays: how many companies on the Fortune 500 list were founded during a recession? It turns out that well over half of the companies on the 2009 list started during a recession or bear market. 

This, in and of itself, is remarkable. But it also turns out that the Fortune figure, when broken down by decade and when looked at in the context of recent Census papers that Kauffman has helped fund, fits neatly into a narrative of the American economy moving from the bureaucratic capitalism of Galbraith's New Industrial State to the entrepreneurial capitalism of the past two or three decades (and the entrepreneurial capitalism of a prior era). The composition of the companies on the Fortune list is rather dynamic (surprisingly, I think), but even more importantly, startups have been enormously important in terms of job creation. Without startups, we would have had only a handful of years in which overall net job creation in the economy was positive.

In fact, startups are much less sensitive to recessions than the overall economy, which seems to run counter to conventional wisdom. In any case, the research paper tries to tell a story: we would appreciate any and all feedback.

I Paid How Much for a Computer?

Well, great. The entire economics profession is already under assault for not foreseeing the recession and disagreeing on how to end it. (Of course, this cuts two ways: maybe we should stop treating economics as a predictive science; and maybe we should realize that few other disciplines "saw" the recession coming. Should business school professors or sociologists be similarly excoriated?)

Now Michael Mandel raises the real possibility that no one really understands how the economy is performing at all.

Like a slow water leak that eventually erodes the foundation of a house, these apparently arcane import-price problems mean that the real growth of imports has been significantly underestimated for goods such as computers that have rapid model changes. That in turn distorts the productivity and growth stats, making them look a lot better than they really are. Adjusting for the finance bubble and the import-price problems means economywide productivity growth may have been about 1.3% per year rather than the reported 1.7%. Similarly, real growth of gross domestic product falls to roughly 2.3% annually from 2.7%. (The exact size of the downgrade depends on what is assumed about the correct change in import prices.)

Michael raised similar issues at the blogger's conference a couple of months ago, but now he wades into the thankless swamp of import price data to buttress his arguments.

So let me see if I get this: we don't really understand anything?

Lincoln's Industrial Policy

Paul Kedrosky has a good essay in the most recent Washington Monthly, the provocative thesis of which is: "So while it's true that our best hope for future growth is riding on America's entrepreneurs, the best hope for our entrepreneurs may be riding on government."

In describing how economic crises can often produce rather enlightened public policy, Paul highlights an oft-overlooked characteristic of President Abraham Lincoln--his economic policies. Understandably, Lincoln is usually remembered in the context of war and slavery and political philosophy, but his Second Annual Message to Congress was basically a far-sighted industrial policy that helped lay the foundation for an era of inspired entrepreneurial capitalism. (Lincoln's economic insight has not gone completely unremarked upon, of course; Michael Novak provided a brilliant meditation on it in The Fire of Invention.)

Atlantic and Pacific telegraphs; the Pacific Railway Act for the construction of a transcontinental railroad; uniform currency; development of the West's mineral resources; canals--all were at the heart of Lincoln and the Republicans' economic policy. Granted, the South's secession played no small part in opening up the legislative road--before the Civil War, the future Confederate states had basically acted like a gigantic reactionary obstacle to everything from economic development to women's rights. With Confederate legislators gone, the new Republican party helped boost the American industrial revolution. 

Paul also mentions the Morrill Act, which Lincoln signed in 1862 and is one of the most frequently cited Congressional achievements of the nineteenth century. To a certain extent this is true, but it is also overblown. The Morrill Act helped put many of the existing small-time state schools on the road to national importance, but its effect was limited by a shortage of resources. It was really the Hatch Act of 1887, establishing the agriculture extension system, and the Second Morrill Act of 1890, providing money for the first Act and adding discrimination clauses, that pulled higher education and industry into a tight and enduring embrace. As higher education historian Frederick Rudolph wrote several decades ago:

"[T]he growth of a body of applied agricultural science, the experiment stations, farmer approval, and federal and state financial assistance all fed upon one another."

One of professors summed all this up with what I still think is one of the best phrases used to describe what government economic policy should (ideally) do: releasing the energy of people to create. Things like the Hatch Act and the Bayh-Dole Act cannot anticipate the nature and scope of the far-reaching effect they will eventually have since they're usually passed in response to a discrete issue. (In the latter case, university-industry linkages had increased markedly in the 1970s and companies like IBM were constantly pushing against the cumbersome commercialization process. In a historical analogy to general incorporation in the 1800s, Congress finally created a general platform for university commercialization. Incidentally, "platform" is another wonderful term for describing what economic policy should be about.) Likewise, the gradual separation of military and civil government in Europe helped, as John Keegan has written, free up the energies of people to create and innovate, resulting in the Industrial Revolution.

So the question for policymakers, always and particularly in times of crisis, should be: where are the points at which a specific policy or repeal of policy can release individual energy? This need not presume any particular knowledge on the part of policymakers, but it should prompt a more nuanced understanding of economic complexity. 

Entrepreneurial Experiments -- Research and Questions

This post is to share some original research I have in process with readers of this blog. For the last few months, I've been preparing to conduct some new economic experiments, and would love to engage in a discussion with you & get your advice. Dan Houser, a professor at George Mason University, and a graduate student, Xiaofei Pan, are helping me prepare to conduct the experiments at the GMU ICES labs, hopefully this summer.

The experiments are for the study of work and entrepreneurial behavior under different policy regimes, including taxation, welfare, and social insurance. I'll share a link to the preliminary literature review / experimental design working paper in a future post. Questions on my mind are:

1. Will higher federal taxes reduce entrepreneurship and growth, or are those fears overblown?

2. What's the best way to design an experiment for work under different policy regimes? Once we nail that down, what is the best way to design the choice of riskless versus risky (entrepreneurial) work?

3. Is there research already in existence informing this topic?

I was inspired by Vernon Smith (wikipedia entry here) after I spoke with him at Chapman University during last November's Global Entrepreneurship Week (hat tip to the Leatherby Center there). I was surprised to learn that experimental economics hasn't pushed very deeply into growth policy questions. According to a 2003 paper by Sutter and Weck-Hanemann (2003), “Experimental studies on issues of taxation abound.” However, these generally explore tax evasion, whereas “studies on the effects of tax laws on labor supply are very rare." Tax evasion is really just a subset of income shifting in response to taxes, related to the subset that naturally interests the Kauffman Foundation, which is the degree to which higher taxes are a barrier to entrepreneurial risk-taking.

The study of labor supply's elasticity has evolved in recent years. A consensus exists, holding that the number hours worked (i.e. labor supply) is inelastic with respect to tax rates, especially for males (primary earners). However, Larry Lindsey suggested in a 1987 paper that the key elasticity is not labor per se, but income. Martin Feldstein explored the idea of "elasticity of taxable income" (ETI) thoroughly in the late 1990s. Clearly, this is where my interest in entrepreneurship comes in. If higher taxes act as a job-lock by keeping more workers tied to their riskless salaried job (with untaxed fringe benefits) instead of a risky startup, then there is a short-term loss, measurable in terms of deadweight loss, and also a long-term loss, the immeasurable reduction in potentially innovative activity.

So what does the ETI literature tell us about entrepreneurship? Glenn Hubbard, Austan Goolsbee, and Doug Holtz-Eakin have written on this, including chapters in the 2000 tome, Does Atlas Shrug?, edited by Joel Slemrod. Goolsbee describes the "new tax responsiveness" (NTR) literature in terms of a methodology using econometric analysis of empirical data from natural experiments. The term confused me when I first heard it, because these are not really experiments in the proper usage of the term. But economists are able to assess activity before and after an unanticipated (exogenous) event such as a major tax reform, they call it a natural experiment. In any case, the early estimates of ETI were above 1, meaning that income was highly sensitive to taxation to the extent that an X percent increase in the marginal tax rate led to an equal or greater than X percent reduction in taxable income.

There may be more detailed papers about ETI and entrepreneurship, but the most useful survey of ETI I have found is a recent chapter (ungated here) by Seth Giertz in the 2009 AEI book Tax Policy: Lessons from the 2000s. Giertz reports that "recent studies report [ETI] estimates closer to 0.4." Estimates are narrowing, while at the same time we are learning that the ETI is not constant over time nor across earners. It seems the ETI rises with income itself -- the rich are so sensitive. Some studies that are able to focus on higher-income earners find estimated ETI slightly over 1.

Nonetheless, the NTR literature is limited to empirical econometrics, with all the pros and cons it entails. Giertz identifies a handful of issues that complicate ETI estimation: exogenous shifts in income distribution, mean reversion, endogeneity of the tax rate, institution factors in the tax system (shifting base, enforcement), transitory responses and income shifting, and transfers between economic agents. I know enough econometrics to worry that the empirical ETI debate is unlikely to be resolved since the results will be so sensitive to the inclusion or exclusion of other variables. It is worth noting that Giertz' paper makes no mention of insights made by experimental econ. But it seems to me that experiments can isolate ETI behavior and control for all the noise that muddies the signal in empirical work. It sure can't hurt.

Experiments and Taxes. A pioneering study was published by C.W. Swenson in 1988, updated and improved by M.A. Sillamaa in 1999, which confirmed Lindbeck’s theorem that higher marginal labor taxes will depress work effort even when all income is redistributed. Sillamaa reports that a marginal labor tax rate rising from 12 to 87 percent (across five discrete rates) - with revenue fully redistributed as a demogrant - is associated with a decline in total work intensity of 21 participants, from 7734 tasks to 6824. But by focusing narrowly on the Lindbeck theorem, this research sheds little light on richer, and more realistic, aspects of fiscal policy. Full revenue redistribution, in particular, is a very strong assumption.

And yet, the Sillamaa study establishes a firm foundation for future research using an experimental framework that includes (1) tedious work, (2) real money payments based directly on work effort, and (3) leisure opportunities as a valid participant activity. This framework could be extended to richer policy environments which would yield valuable insights into work behavior.

More recent experimental studies have explored the Laffer curve (Sutter and Weck-Hanemann 2003; Levy-Garboua, Mascalet, and Montmarquette 2008). But these studies use a 2-player game design where one player is the worker and the other is the tax authority. The results inform psychological motivations and rules of fairness, showing for example that a “veil of ignorance” about which player will fill role A or B leads to a greater sense of work obligation and a subsequently lower work elasticity. These papers treat tax revenue as a total loss to the worker, an assumption of zero redistribution. This is also a very strong assumption, but in the extreme opposite direction of the earlier papers.

The experimental framework I am planning on uses elements from both of these branches. The innovation I have in mind is structuring games so that all players are worker-taxpayers facing an identical environment, a faceless governing authority that can set taxes and welfare policies exogenously. A big question on my mind is whether work effort will change when the redistribution rate changes. If we redistribute a portion of tax revenues equally (so that all players get the same split), then I assume the free rider problem will loom larger as the rate of redistribution rises from 0 to 100 percent of tax revenues. But maybe social pressure in small groups will cause work to intensify with high redistribution rates.

Well, that's a pretty long preview. I'm excited about the research, and really happy to use the blog to share it with you. My hope is that experiments will offer a clean room approach to identifying ETI, which the empirical approach will have difficulty resolving alone. I can only imagine one topic of greater importance for economics, which is the precarious state of the global financial system (though I'm confident Bob Litan has that covered). The decades ahead will see developed countries struggling with the limits of taxation (here, here), and the more light we can shed on that topic, the better.

Dust . . . Wind . . . Dude*

Blogging can often be a low-return activity: you invest time and energy in a post yet have only a rough idea of how many people actually read it, let alone enjoy it. And, quite frequently, the only readers who bother to comment are those with negative reactions.

My long-agonized-over post from last Friday was a rare exception to this last characteristic. Regular readers Michael Martin and Derek Ozkal posted extremely thoughtful comments and Robin Hanson, whose musings started the whole thing, offered a quick riposte to my long-windedness. I must confess that I have little to add to their comments; Robin has established an entirely new research project with regard to how feedback cycles close themselves.

So here's my next question: what is the relationship between the long run and short run in economic growth? Robin's growth mode concept brings the former to the fore, but surely short-term policies and innovation matter in the maintenance of long-run economic growth. I cited this recent NBER paper in support of this proposition.

Or do they? If we look at aggregate statistics, the short-term doesn't really seem to matter much at all: the massive R&D investments after World War Two, for example, did little to bump up the long-term U.S. growth rate. We assume they maintained it, of course, and can cite plenty of innovations that came out of such investments. And it doesn't seem clear to me that extremely short-term things like tax rates matter as much as they're said to matter.

One of the thing that endlessly confuses me about the urban economics literature is that "smart" cities (higher levels of college degrees) are time and again proven to grow faster than their counterparts. But this cannot have always been the case--either such human capital didn't matter to the previously dominant industrial cities or it was a different type of human capital. Yet, at least according to Robin's concept, we have remained in the same growth mode for two centuries.

The longue duree perspective can be quite humbling. Unnecessarily so, perhaps?

*A classic.

Will Economics Imitate Life?

I had the privilege of attending last week a seminar organized around Matt Ridley's forthcoming book on human progress across time. Clive Crook briefly summarized it, and Robin Hanson did an interesting post based on his comments at the seminar. Robin implores that if we are going to theorize about humanity's history of technological progress and economic growth (to the extent we can measure it), we need to be precise about things. We cannot ascribe a central causative role to, say, the invention of writing if it doesn't fit the timeline of facts. 

The facts Robin has assembled--mentioned in his post and developed in this paper--tell a story of three primary "growth modes" in human history. These correspond with the advent of hunter-gathering, agriculture, and the industrial revolution, with each new mode being characterizied by a much faster rate of the doubling of world product than before. This is an enormous topic (and one, Robin pointed out to me, that should naturally be considered by a blog devoted to economic growth) and won't be resolved in one post, one essay, or one book (as the voluminous literature devoted to economic growth demonstrates).

But, Robin's provocative puzzle and the discussion around Ridley's new book made me wonder about the relationship between economic thought and human nature. Much commentary of late has attacked the conventional economic assumption of rationality, with a corresponding celebration of behavioral economics and its emphasis on irrationality. Yet each of these basically assumes that human thought defaults to deductive and inductive reasoning. People have a generalized principle (self-interest, rational expectations) that they naturally apply to every situation. Or, people encounter facts A and B and our hunter-gatherer brains irreversibly induce C.

Do our brains really work that way? Actually, no. As Ridley remarked in an earlier book in reference to the human brain: "No general-purpose induction here." We are rational, to be sure, but abductively so. What does "abductive" mean? I don't claim to be an expert, but the term itself originated with American philosopher Charles Sanders Peirce in his analysis of Aristotle and has variously been described as "inference to the best explanation" or the formation of explanatory hypotheses. It was also adumbrated by William Whewell and his "philosophy of induction" and has been explained as the method of reasoning used by Sherlock Holmes.

To greatly simplify, abductive reasoning is the constant creation of hypotheses to explain a set of facts or observation, usually precipitated by a new or surprising fact that does not fit the conclusion that deduction or induction would draw. This isn't confined to scientific investigation--it's how our brains function. Neuroscience keeps confirming that perception is inference, that our brains are theory-generating machines and, not surprisingly, some of the best work in this area has been done in the field of artificial intelligence, where researchers must figure out how the human brain works. In terms of vision, for example, there is a hole in the middle of every person's sight line, but our brains fill it by inferring from the surrounding images. In terms of daily life, we constantly draw inferences that seem to explain new or surprising situations and freely revise those inferences in the face of new information. (I suppose from this you could proceed to some sort of neuro-ontological hierarchy but I have neither the capacity nor inclination to pursue that.) Even economics has been touched by the revival of interest in abductive reasoning.

So what does this have to do with economics, economic growth, and human progress? Economics is the study of human behavior, which naturally implicates human thought processes--the closer one can get to how we think, the closer you get to more relevant theory. But Robin's questions about growth prompt larger issues: the question of the causes of growth and progress is really one of the most important that economists and social scientists can consider.

When people talk about economic growth, innovation usually appears on everyone's list as a causal factor. So what is innovation and what causes it? In exploring the causes of human progress, the brilliant economist Nathan Rosenbergn advanced the idea that the freedom to experiment lay at the core: "freedom to conduct experiments is essential to any society that has a serious commitment to technological innovation or to improved productive efficiency." Experimentation with ideas, tools, and modes of organization matters because "there are many things that cannot be known in advance or deduced from some set of first principles."

If abductive reasoning means anything, it does not mean knowing something in advance (the eventual logic of induction) or from first principles (the essence of deduction). In fact, Rosenberg's observations are reminiscent of both abductive reasoning and Donald Campbell's evolutionary model of how new knowledge develops: blind variation and selective retention (BVSR). Every idea or innovation begins as a variation, and they are blind in the sense that a true innovation is one whose consequences cannot be known or foreseen (or induced) in advance. The way it propagates is that it is selected from among other variations and is somehow retained. Perhaps abductive reasoning was missing or implicit in Campbell's thinking.

So if we're thinking about reasons for why human progress became so rapid in the last two hundred years, or relatively rapid around 10,000 years ago, is there any weight to be given to abductive reasoning? On its face, it sounds silly. As a matter of explanation, if the human brain works abductively, we cannot ascribe to it a unique role in growth. Is there a manner by which abductive reasoning could be externally institutionalized? I suppose the market might be such a mechanism because its development over several millennia worked to channel experimentation and provided selective retention.

I'm left at a seemingly dead end, it appears. The explanations for human progress and its increases must be endogenous to humans and human society (unless we're prepared to admit truly exogenous causes like alien visits into our analysis). The timing must be right, so an innate feature of the human brain likely cannot serve as an exclusive cause in 1800. Experimentation is attractive, but surely the human capacity for wonder is timeless? Institutions seem to be coming to serve as a default explanation for growth differentials, but an intriguing recent paper raises some questions on this front.

Part of me is tempted to find solace in circular explanations like feedback cycles. Robin's growth grooves post struck me as leaving options open only for discrete, one-way explanations. I could be misreading it, but it was only later (reading Ridley's Red Queen, by chance) that circular explanation occurred to me as an answer to Robin. That is, can we seek answers in the interaction among many different factors and the associated positive feedback effects they would generate, causes becoming effects becoming causes in turn? I realize that's far from a new idea in economics, but I seem to have been led there inexorably by my own semi-logical reasoning.

Keynes, Once Again More Prophetic Than Present Day Economists

A recent Business Week cover story asked, "What Good Are Economists, Anyway?" The online material included snapshots of the views of three macroeconomists, including Thomas Sargent:

In the 1970s, Sargent was one of the thinkers behind "rational expectations," which says that ordinary people can correctly anticipate the range and likelihood of possible future outcomes. Sargent now says that theory was an oversimplification. In real life, he explains, households and businesses are highly uncertain. Developments such as an unexpected government action or a major company going bust can cause people to drastically revise their beliefs about what might happen next. The good news: Beliefs may shift back again through unexpected positive events.

This rings a bell. Oh, that's right:

"Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface."

--John Maynard Keynes, "The General Theory of Employment," QJE, 1937.

Keynes wasn't a perfect economist, of course. In particular, and of interest to certain readers, Keynes had one foot firmly in the arts community, as a member of Bloomsbury and patron of the arts. It's a wonder, then, that he didn't give more weight to human creativity and entrepreneurship (aside from his brief discussion of animal spirits, not totally apposite) in his writings.

Alex Tabarrok's "Future of Growth"

Video of Alex Tabarrok's talk at TED. My favorite points:

• "How do you get more ideas?  More idea creators. ... Today less than 1/10th of 1 percent of the world's population are scientists and engineers."

• "We will see an Einstein in Africa in this century."

• "$200,000 ... this is a rather modest prediction."

The Tabarrok thesis is that global growth in per capita income is accelerating. This is a big, big deal ... the 0.1 percentage point increase in the growth rate every decade for the last 2 centuries has already destroyed most of human poverty, and Alex is showing how growth will finish the job in this century. By the way, the 0.1 per decade acceleration is my rule of thumb projection, so don't slam Alex if you think it is stupid, although I suspect he would agree with me. The data tell this story; it is not make-believe.

Analysis: Naturally, I loved Alex's talk and highly recommend it.  But I am always stunned at the kind of reaction that optimistic economists get, and I felt it again when I read many of the comments at the TED page.  For example, Jake Koethler writes, "The third world will never be developed to the extent that the rest of the world is. There aren't enough natural resources to sustain that level of development." I have been trained to impressed by lines on paper representing big abstract things like GDP per capita. But this is not natural. So Jake may be right, but I suspect he is falling for the instinctive zero sum fallacy. Division of labor disproves the limits to growth on one level, but Jake would probably say that labor is not the limiting factor here. Resources -- oil, gold, steel, agricultural capacity, water -- are the limiting factors.

I'm not sure I can disprove in this post the notion that limited stocks of any one thing limiting to overall prosperity, but it is clearly a powerful article of faith among many super smart people. Hopefully, we optimistic economists can make a convincing case that there is ultimately only one resource constraint: GDP per capita. A simple explanation: it is not the country with the most gold that dominates the world, rather it is the country that is the most productive. Every other thing's economic value derives from its balance of scarcity that ultimately rests on human demand. Because something is finite does not mean it can limit what is theoretically limitless, especially because all finite resource can arguably be reused. The execption is oil, but that's just one form of potential energy, and the sun is a lot bigger.

Those who believe in the resource constraint problem are logically arguing that too much growth causes slower growth. That reasoning is difficult to reconcile.

This may all seem trivial, but many beliefs about modern conflict hold fast to the principle of finite resource constraints. They see competing groups fighting for water, and deduce that water is a source of conflict. But poor people don't want water; it is just a proxy for what they really desire, which is prosperity.

When Education Becomes an Economic Burden

In their new book and in their prior work, Claudia Goldin and Lawrence Katz have convincingly demonstrated the enormous boost the U.S. economy received in the last sixty years from increasing investments in education. For the last two decades, anxiety has risen that the United States has reached some sort of education plateau or decline and that economic growth will accordingly suffer.

A new McKinsey report, highlighted by Thomas Friedman the other day, appears to prove that this is indeed the case. Had the United States kept pace with our own prior achievements and more recent stars like Finland and South Korea, our GDP today would be $1 to $2 trillion larger. That might seem like a drop in the bucket in a $14 trillion economy, but how much has the Federal Reserve spent thus far on its various firefighting moves? Oh, right, $1.2 trillion. And bailouts? Um, $1 to $2 trillion. 

OK, so what: surely we can make all this up through faster growth? Well, right, about that, see economic growth has become increasingly dependent on education over the past three decades. That knowledge-based economy everyone's always talking about? It's for real, and it requires concomitant investments in not just knowledge creation, but the ability of people to codify and, most importantly, use that knowledge. I just happened to be reading Dominique Foray's fabulous Economics of Knowledge when I ran across this McKinsey report. The juxtaposition is like finding out when McDonald's breakfast ends: "total mind blow." 

I'm not usually disposed to let one report or one apparent trend scare me, but considering the nature of knowledge in the abstract, the history of American education and growth, and the sorry state we find many of our schools in today--well, it's a tad daunting.

I make no claims to be an education expert, and I know I keep coming back to this, but I simply can't help thinking about the "high school movement" with regard to these issues. Goldin and Katz are again the authorities here. The nature of knowledge, in general terms, hasn't really changed in the last century, but it's economic importance, the way we use it, and the way we propagate it, have changed radically. This should have clear implications for our educational system.

What those are, I'm not in a position to say, but it becomes more obvious every day that we need some serious institutional innovation in the realm of education, akin to the rise of secondary schools that arose with the industrial economy. Technology has a role to play here; alternative models like KIPP, too.

Any brilliant ideas out there?

To What End, Growth?

A great essay by Phil Auerswald and Zoltan Acs:

"Continued institutional innovations will be required to ensure that democratic societies with market-based economies are as resilient in the future as they are prosperous. . . . Unfortunately, political action to support entrepreneurship is stymied by a political system still living in the past. On the one side is a party committed to economic liberty, a party which has an historic affinity to entrepreneurs, but which today is analytically handicapped by its 19th-century interpretation of the nature of markets and market failure. On the other side is a party committed to economic rights, a party which has an historical appreciation for the benefits that can derive from enlightened government action, but which today is functionally handicapped by its 20th-century (Galbraithian) interpretation of American capitalism. The result is a debate in which both parties are well intentioned and both are programmatically wrong. This has produced a depressing stalemate in which neither side of the aisle produces the policy initiatives required for a renewal of sustainable prosperity."

Arnold Kling on Bloggingheads.tv Discusses Our "Lost Decade"

The reverberations from Kauffman's Economic Bloggers' conference continue. 

A few days ago, Arnold Kling wrote a blog post about what he considered the two most interesting things from the conference, one of which was the presentation of Michael Mandel on the 1990's as a lost decade. Here is what Kling wrote,

Michael Mandel's view is that our current macroeconomic and stock market troubles reflect the readjustment of estimates about economic growth since 1997. He sees a need for both investors and statisticians to revise those estimates. The statistical argument is that when a firm outsources production overseas, it fails to report to the government statisticians the payments that it makes to overseas producers. Thus, what should be counted as imports instead gets counted as domestic production. One implication of this is that productivity growth has been over-estimated. We had a long argument starting at about 5 AM Saturday morning (we had early flights out of Kansas City) over whether overall economic statistics are or are not consistent with his suggested revisions.
Apart from that, I have an even harder time with Mandel's story relative to investors. The way I look at it, an investor who looks at a firm's accounting statements would know whether it is producing or importing its intermediate products. If investors knew the reality all along, then this should have been reflected in stock prices all along--it does not explain the sudden drop in the last six months.
Mandel's view is that investors, particularly foreign investors, had a rosy view of American firms' ability to grow and hence to repay debt. Thus, they treated American private debt as risk-free. This changed when the housing bubble burst. High stock prices depended on the "credit bubble" continuing to inflate, and when it popped the market crashed.

At Bloggingheads.tv, Kling talks with Russell Roberts about Mandel's idea. The whole discussion is worth watching.

(Russell Roberts did not attend our conference, but his co-blogger, Don J. Boudreaux did.)

The Agony and Irony* of Taxes

Since the release of President Obama's budget preview there's been a lot of noise made over the question of taxes, specifically relating to two issues. First, the federal government's long-term fiscal problems, which Tim wrote about yesterday. The second issue is the question of what impact higher taxes will have on entrepreneurship.

There's no doubt that Uncle Sam is flirting with budgetary fire--the numbers being thrown around about the long-term deficit are almost beyond belief. And quite frightening. It seems likely that some combination of higher tax rates and trimmed entitlements will be unavoidable. But it is also doubtful that higher taxes can make much headway against the enormous mountain of government debt, particularly given the towers of debt that households will continue to struggle with. California, moreover, is Exhibits A through Z as to the effects of relying solely on higher taxes to prop up the governmental edifice. 

Thus, it would seem that some sort of entitlement restructuring will end up being the only conceivable way to boost fiscal health. (I must admit, however, to being a tad mystified at the proposal to make Pell grants an entitlement--the rationale of making college more affordable for more people doesn't hold water against the evidence that rising tuition costs have been, in part, a product of expanded federal aid.)

The second tax issue--the effect on entrepreneurship--is much more ambiguous and thus emotionally-freighted. Will higher taxes on those with incomes over $250,000 dampen the entrepreneurial spirit? There is certainly reason to think it will: lots of small businesses, for example, file individual income tax returns and thus would face higher taxes. (Secretary Geithner maintains that this would be an incidentally small number.) The always-perspicacious Jim Manzi makes a persuasive case that higher taxes will in fact affect the probability calculations made by prospective entrepreneurs and dissuade many from taking the plunge.

Yet that can't be the whole story. For one thing, William Nordhaus has calculated that entrepreneurs capture only about two percent of the surplus they generate--consumers (society) capture the rest. Entrepreneurs take risks, to be sure, but it just doesn't seem quite right that they go through the analytical  probability calculations that Manzi outlines. In many cases, they are explicitly pursuing "psychic rewards," knowing that the pecuniary payoff might be less than that.

In a larger sense, let's put the whole tax issue in perspective: taxes might actually be one type of undergirding for entrepreneurship, so the dampening effect of a slight uptick in tax rates may be overstated. Last month there was a fantastic essay in The New Yorker on the struggles of free-market economists in Iran against the statist Islamic regime, which doesn't seem to understand anything close to basic economics. By depending almost exclusively on oil revenues, the Iranian government does not have any incentive to cultivate productive entrepreneurship--the citizenry depends on the government. In countries like the United States, the government depends on the people and entrepreneurs, and taxes are the mechanism of that dependency. This, needless to say, is much more salutary for economic growth and democracy.

*with apologies to Alkaline Trio

Does the Long Run Still Matter?

Were we to flatter ourselves, we might say that today's Financial Times Insight column by the legendary Peter Bernstein was a gauntlet thrown down at Growthology's doorstep.

It wasn't, of course, but Bernstein's short essay raises serious questions related to the entire premise of this and many other economics blogs. Has "the possibility of the long run" run away? That's Bernstein's question, and while his specific point pertains to investments, we cannot escape the larger economic growth implications of passages such as these:

"What kind of long run is this mess going to produce? . . . Can capitalism remain a 'going concern' [quoting Bill Gross] after an extended period characterised by massive government intervention into the economy--and bail-outs of firms that would otherwise have failed? . . . Will our society and economy emerge so risk-averse after these experiences that years will have to pass before we return to a system naturally generating vibrant economic growth and a renewed willingness to both borrow and lend? Or will we head in the opposite direction, where faith in ultimate bail-outs will justify the wildest kind of risk-taking? Or will the entire structure collapse from government debts and deficits that turn out to be so unmanageable that chaos is the ultimate result?"

Heartening stuff.

Bernstein's starting point is a comparison between equity and bond yields and the famous observations made by Keynes that only the short-term storms, not the long-run fate of the ocean surface, matter for economists. But the question for us, as Bernstein frames it, is very serious: what should a long-run perspective on economic growth look like in the face of this incredible tempest? It's clear that no one can simply say, well we're concerned with the long term so we should do X, Y, Z, irrespective of how emergency policymaking will or will not impinge on the long term. 

No one can see the future, of course, as Bernstein reminds us: "the unknown today seems more than usually unknown. . . . The long run is an impenetrable mystery. It always has been." So it's somewhere close to impossible for anyone to know or precisely foresee the short and long term balance of crisis response and long run growth prospects. 

Yet we cannot pretend that the immediate future won't affect the long term. I know I'm sounding circular here, but it's an important consideration--to what extent are we foreclosing the possibilities of long-term growth, or to what extent are we expanding those possibilities? Should, that is, the short and long term questions go together? Or should we somehow imagine them to be separate, throwing our hands up in the face of complete and utter uncertainty?

Our Debt to Darwin

Last Thursday marked the 200th anniversay of Charles Darwin's birth, and this year marks the 150th anniversary of the publication of his most famous work, On the Origin of Species. There have been plenty of books and articles commemorating the occasions, and there will undoubtedly be more throughout the year. But even on a blog dedicated to economic growth, we shouldn't let this pass unremarked. 

Darwin's primary intellectual contribution, after all--the evolutionary mechanisms of variation and natural selection--is one of the greatest and most influential ideas of all time. It is difficult to imagine a more fundamental and revolutionary change in human thought and perception than the teasing out of natural selection's implications over the last century and a half. (The shift, helping to spark the Renaissance and Enlightenment, from a closed to an open worldview in the late Middle Ages may be comparable.)

And economics has not been immune to this: "Ideas about 'rational' economic man are being overturned by new ones from a discipline called behavioural economics. . . . What is surprinsg is the degree to which human beings ar enot rational, and how the reasons for this are likely to involve Darwinian explanations."

More than that, an entire sub-field, evolutionary economics, has grown up in the Darwinian shadow. (The institutionalist school in the late 19th and early 20th centuries was also heavily influenced by Darwin.) I don't presume to be an expert on this, and much of the work in evolutionary economics strikes me as interesting but often of marginal relevance. (There are, of course, exceptions.) 

But the core of the idea, variation and selection, is unbelievably powerful and seems like an almost-perfect description of the intricate patterns of economic change. As applied to economics, that is (or should be) rather non-controversial. It is the larger implication of natural selection--the necessary lack of foreknowledge and the absence of a teleological end--that is apt to cause a stir. 

So any innovation, for example, can be called a variation. The fact of variation, however, does not presuppose merit or, importantly, success. As to the first, we need look no farther than the innovation of, say, collateralized debt obligations or subprime mortgages to understand that "innovation" is not necessarily synonymous with progress. Regarding the second, the inability to foresee success, we can all think of innovations--eight tracks, the Pinto, laser discs--that are now either ridiculed for their inanity or failed to really catch on. It is only in the messy process of selection--an economic as well as social phenomenon--that innovations are retained and propagated. Both--the generation of the new knowledge and their interaction with the environment--are crucially important.

I'm not smart enough to be able to say how the variation and selection model should reshape economic thought. (And many have already sought to apply it to various fields.) But, when we all seem to flailing about in the face of a severe recession (Gregory Clark says there has been no advance in economic knowledge in seven or eight decades), we could do worse than seek insight and understanding from one of history's most brilliant ideas.

The Bizarro Bailout

The ongoing sagas of the stimulus bill and financial bailout are, understandably, dominating headlines and online chatter. In no way do I intend to belittle the severity of the current recession and the overall gravity of the situation but, if history is any guide, these policy debates run in parallel to a bizarro world in which a separate economic future is developing.

In this bizarro world, the high-growth companies of tomorrow are just coming into existence, and innovations we cannot even imagine are in their infancy. A few years ago in the American Economic Review, economist Alexander Field declared the 1930s to be "the most technologically progressive of any comparable period in U.S. economic history."

In the bizarro spirit, then, I spent part of the morning canvassing what I like to think of as the frontiers of economic growth--the spaces where our future is being made right now. The stimulus and bailout matter to these frontiers, of course, but it's important to note that the as-yet-imagined future is materializing without word from Washington or Wall Street or anywhere else.

This is just awesome.

Stem cells are key.

The stimulus is apparently directed toward "shovel-ready" projects, but instead of shovels, what about nano-particles?

And this just sounds crazy, but still awesome.

Leadership and Growth

In Why Globalization Works, his fabulous book on political economy, Martin Wolf quotes Nobel-laureate Kenneth Arrow: "truly among man's innovations, the use of organization to accomplish his ends is among both his greatest and his earliest."

Numerous elements, and the innumerable interactions among them, go into generating economic growth. Some, like population growth and demographic change, contribute to what Joseph Schumpeter called the "circular flow." Others, such as technological innovations, war, and institutional change, are more discontinuous in their impact and, at least according to some schools of thought, are what really drive progress.

Per Arrow above, it seems logical that the quality of a society's organizations--their effectiveness, their structure, their growth--should also be an important growth factor. To the extent this is true, it would mean that the way these organizations are managed or lead is a key ingredient in growth. 

This is what an astute colleague pointed out to me yesterday, and that, therefore, a site about economic growth should also cover leadership. According to her, our economic future depends on our ability to produce effective leaders and that the extant leadership literature is of, um, marginal relevance. 

Let this post thus initiate a continuing dialogue on the subject of leadership and growth. I don't quite know what that means yet, but it seems fruitful, so I invite Tim and Bob and readers to weigh in. Conjecturing, this dialogue might end up covering Max Weber, philosophy, Warren Bennis, behavioral economics, and much, much else.