Paul Romer’s & Paul Krugman’s dangerous idea
from Lars Syll
If you have an apple and I have an apple and we exchange these apples then you and I will each have one apple.
But if you have an idea and I have an idea and we exchange these ideas, then each of us will have two ideas.
George Bernard Shaw
Adam Smith once wrote that a really good explanation is “practically seamless.” Is there any such theory within one of the most important fields of social sciences – economic growth?
In Paul Romer’s Endogenous Technological Change (1990) knowledge is made the most important driving force of growth. Knowledge (ideas) are presented as the locomotive of growth — but as Allyn Young, Piero Sraffa and others had shown already in the 1920s, knowledge is also something that has to do with increasing returns to scale and therefore not really compatible with neoclassical economics with its emphasis on decreasing returns to scale.
Increasing returns generated by non-rivalry between ideas is simply not compatible with pure competition and the simplistic invisible hand dogma. That is probably also the reason why neoclassical economists have been so reluctant to embrace the theory wholeheartedly.
Neoclassical economics has tried to save itself by more or less substituting human capital for knowledge/ideas. But knowledge or ideas should not be confused with human capital. Although some have problems with the distinction between ideas and human capital in modern endogenous growth theory, this passage gives a succinct and accessible account of the difference:
Of the three statevariables that we endogenize, ideas have been the hardest to bring into the applied general equilibrium structure. The difficulty arises because of the defining characteristic of an idea, that it is a pure nonrival good. A given idea is not scarce in the same way that land or capital or other objects are scarce; instead, an idea can be used by any number of people simultaneously without congestion or depletion.
Because they are nonrival goods, ideas force two distinct changes in our thinking about growth, changes that are sometimes conflated but are logically distinct. Ideas introduce scale effects. They also change the feasible and optimal economic institutions. The institutional implications have attracted more attention but the scale effects are more important for understanding the big sweep of human history.
The distinction between rival and nonrival goods is easy to blur at the aggregate level but inescapable in any microeconomic setting. Picture, for example, a house that is under construction. The land on which it sits, capital in the form of a measuring tape, and the human capital of the carpenter are all rival goods. They can be used to build this house but not simultaneously any other. Contrast this with the Pythagorean Theorem, which the carpenter uses implicitly by constructing a triangle with sides in the proportions of 3, 4 and 5. This idea is nonrival. Every carpenter in the world can use it at the same time to create a right angle.
Of course, human capital and ideas are tightly linked in production and use. Just as capital produces output and forgone output can be used to produce capital, human capital produces ideas and ideas are used in the educational process to produce human capital. Yet ideas and human capital are fundamentally distinct. At the micro level, human capital in our triangle example literally consists of new connections between neurons in a carpenter’s head, a rival good. The 3-4-5 triangle is the nonrival idea. At the macro level, one cannot state the assertion that skill-biased technical change is increasing the demand for education without distinguishing between ideas and human capital.
Paul Krugman also has some interesting thoughts on the history of that dangerous idea — increasing returns:
I have worked and written on a lot of topics. It is, however, the idea of increasing returns that has been the most important theme in my work. And it is my work in helping to clarify the role that increasing returns plays in economics that is the main excuse I have for my existence. The idea of increasing returns is, of course, a very old one, going back at least to Adam Smith. Nonetheless, until the 1980s economics was heavily dominated by what we may call the Ricardian Simplification: the assumption of constant returns and perfect competition …
The world isn’t really characterized by constant returns, and it was essential to go beyond the Ricardian Simplification, if only to be able to say to the policymakers that we had explored that terrain and found little of use.
If one admits increasing returns into one’s economic model, two other consequences follow. First, increasing returns are intimately bound up with the possibility of multiple equilibria. There can be multiple equilibria in constant-returns models, too, but they are rarely either plausible or interesting. By contrast, it is very easy to be persuaded of both the relevance and importance of multiple equilibria due to increasing returns … Second, once there are interesting multiple equilibria, you need a story about how the economy picks one. The natural stories involve dynamics — the cumulation of initial advantages that may be accidents of history …
All of this is fairly obvious, and indeed the history of thought in economics is littered with manifestos on the need to take into account increasing returns, multiple equilibria, dynamics, and the role of history … Nonetheless, it wasn’t until the 1980s that increasing returns really got into the mainstream of economics. I wasn’t the only one in the movement: Paul Romer, in particular, wrote several papers I wish I had written … applying increasing returns to economic growth …
Paul Krugman Incidents from my career
In one way one might say that increasing returns is the darkness of the neoclassical heart. And this is something most mainstream neoclassical economists don’t really want to talk about. They prefer to look the other way and pretend that increasing returns are possible to seamlessly incorporate into the received paradigm.
A couple of years ago yours truly wrote a review of David Warsh’ s great book on growth theory – Knowledge and the wealth of nations – for an economics journal. The editor accepted it for publication – but only if I was willing to lift out the parts where I highlighted Warsh’s discussion of increasing returns to scale and the efforts neoclassical economics over the decades had put into trying to willfully “forget” this disturbing anomaly. Moral: some dogmas are not to be questioned – at least not if you want to be published!