Wednesday, August 29, 2012

Gordon on Growth

Bob Gordon is making a big splash with a new paper, Is US Growth Over?

Gordon's paper is about the biggest and most important economic question of all: Long-run growth. It's easy to forget that per-capita income, the overall standard of living, only started to increase steadily in about 1750. The Roman empire lasted centuries, but the average person at the end of it did not live better than at the beginning.

Gordon's Figure 1, reproduced here shows how growth picked up in the mid 1700s, reached 2.5% per year -- which made us dramatically better off than our great-grandparents -- and now seems to be tailing off.

As Bob reminds us with colorful vignettes of 18th and 19th century living, nothing, but nothing, is more important to economic well being than long-run growth.

And modern growth economics is pretty clear on where the goose is that lays this golden egg: Innovation. New ideas, embodied in new products, processes and businesses. For example, see Bob Lucas' "Ideas and Growth" which starts

What is it about modern capitalist economies that allows them, in contrast to all earlier societies, to generate sustained growth in productivity and living standards? It is widely agreed that the productivity growth of the industrialized economies is mainly an ongoing intellectual achievement, a sustained flow of new ideas

Growth theory neatly divides economics into "growth effects," which is really how fast new ideas are born and implemented, versus "level effects." Many economic distortions screw up the level, making an area or a country less well off than its neighbors. But so long as the frontier keeps growing, even level effects only retard a country a few decades.

Here's a picture. The red line represents 2% growth (real, per capita), starting at $100,000 income. By 2100 your great grandchildren are earning $738,000. The blue line shows a "level effect." Suppose some set of harebraned policies is so awful that it reduces the level of GDP by 20% -- but does not interfere with the growth mechanism. It's pretty bad. But the blue line is really just shifted to the right, lagging a decade or so behind but still participating in the eventual miracle.

By contrast, the black line says, what if there is a policy or change in the environment that has no effect on the level of GDP, but lowers the long-run growth rate to 1%. 2%, 1%, what's the difference? Cumulate that over a century, and your great grandchildren make $300,000, not $738,000.

OK, so, to Bob's first thesis: Long-run growth is slowing down. The big ideas of the first two industrial revolutions, roughly the harnessing of energy, urbanization, clean water, have been used as far as they can. The computer revolution, to Bob, seems to running out of its ability to raise productivity. 20-somethings updating their facebook profiles instead of paying attention class are not the jet-packs and rocket ships we thought we were going to have by 2001.

I think Bob has the right question here. And his warning is well-taken. Just because growth has been steady does not mean it's assured. The "trend" does not come for free. Each improvement in productivity takes hard work, and disruptive new companies putting established incumbents out to pasture.

But I think  -- or at least I hope -- he has the wrong answer (and he freely admits this is speculative).

My pet theory is that the real defining innovation of growth was Gutenberg. Science gives us real knowledge, at last, by controlled experimentation. But controlled experimentation is extraordinarily expensive.  A farmer can't afford to test which crops grow best, a country doctor can't do clinical trials. For society to gain knowledge by scientific method, we need communication. One doctor's clinical trials inform another doctor's practice a thousand miles away. Gutenberg made that possible.

More generally, the process of growth, of incorporating new ideas into the economy, almost always represents standing on the shoulders of giants, appropriating, slightly improving, and implementing someone else's ideas. That, for example, is why we see clusters of innovation such as Silicon Valley.

Well, if Gutenberg (and subsequent innovations that used his ideas, the newspaper, the scientific journal, and the public library) lowered the costs of communicating ideas and widened the community of people that a given idea could reach, the internet just did that tenfold. As I look at the cool stuff -- nanotechnology, genetic engineering etc. -- underway and the instant worldwide communication of ideas, I have hope we'll see that 2.5 percent again. If we let the process run.

For example, think how Bob's idea got to your desk. When I was a young economist, before the internet, he would have mailed a paper to the NBER, a month or two later the working paper would have been distributed. The internet buzz I saw that got me to go look at it would have taken a few more months to percolate to me by older information networks, then I'd have to go read it in the library. Finally, who knows how I would have gotten to you. That all happened in a week. The diffusion of ideas is on steroids.

Well, maybe my pet theory is wrong. Still, long-run growth is the issue,  it is not guaranteed but hard-won,  we didn't always have it and we could lose it, and that would be a catastrophe.  

Bob prognosticates not only that we seem to have run out of productivity-increasing ideas, but that "six headwinds" stand in the way. His headwinds are 1) Demographics: aging and reduced labor-force participation 2) Plateau in US educational attainment 3) "The most important quantitatively in holding down the growth of our future income is rising inequality." 4) Globalization and outsourcing 5) Energy and enviroment 6)  Household and government debt.

Here I think Bob is mostly confusing "level" effects with "growth" effects.  He is also mixing constraints -- run out of ideas -- with self-inflicted wounds -- dysfunctional public education, refusing to let in immigrants, refusing to use nuclear power or GM foods.  And, I don't see how he can focus on the US. Suppose we cede the frontier to, say, China, as the UK ceded the frontier to us in Bob's graph. But as long as we still use China's ideas and technology, and they grow at 2.5 percent, so do we.

The optimistic lesson of growth theory is that, no matter how badly you screw up level effects, growth will bail you out eventually. So, any "headwinds" need to be clearly linked to the possibility that economic distortions lower the rate of finding new ideas and incorporating them. The whole point of growth theory is that, in the long run, that's all that matters.

Do they? My impression of modern growth theory is that the economics of innovation production and adoption are not well understood. Do the distortions of a high-tax,  regulated, crony-capitalist, welfare state,  just screw up levels? Or do they  reduce the spread of ideas behind long-run growth? My fear is "yes."

In any case, just posing the question this way argues that the dangerous "headwinds" are entirely different from the ones that Bob highlights. The returns from innovation, starting new companies, introducing new products and processes -- and in that process making established incumbents very unhappy -- are the most likely targets.

But it's also clear that ideas are public goods, or high fixed cost zero marginal cost goods. Their production and diffusion depends a lot on non-market structures, like, say, universities. (Don't jump from that observation to "they need to be subsidized," as it it's all to easy to subsidize bad ideas too.) That's another lesson of Bob Lucas' paper, which is remarkably free of economic incentives.

Finally, a warning about statistics. Here is my last picture, blown up.

As you can see, if you're just looking at GDP trends, it's hard to tell a "level" effect from a "growth" effect for several decades.

Much discussion of our current slump presumes it's a temporary "level" shock; the blue line will go back up quickly to the red line. The "stagnation" hypothesis is that we're on the blue line -- we lost about 5% of GDP in the recession, and now we're on the growth path with a lower level. That's disastrous enough. Bob warns us that we might be on the worst of the blue and black lines. That would be a huge disaster.

All said before.  The graph reminds us is that it takes a long time to figure out which it is based on just eyeballing the GDP or productivity data. We have to think. Which Bob is prodding us to do.