More on the Effect of Social Policy on Innovation and Growth

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

My last post was on the false trade-off between social policies and growth. In particular, I took a shot at an essay by Michael Strain, but his essay is simply a good example of an argument that gets made very often: social policies will lower growth. I said this was wrong, and a number of responses I got questioned my reasoning. So this post is meant to spell out the logic more clearly, and point out why precisely I think that Strain’s argument (and others like it) is flawed. Consider this an uber-response to comments on the site, some e-mails I got, and the discussion I had with my neighbor (who probably won’t read this, but whatever).

First, we need to be clear that we have to distinguish the effect of social policies on innovation from the effect of social policies on growth in GDP. They need not be identical, which I’ll get too in more detail below. So to begin, let’s think about the effect of these policies on innovation, which is what Strain and others acknowledge is the source of improvements in living standards.

I’m an economist, so I think of the flow of innovations as responding to incentives. When the value of coming up with a new idea goes up, we get more new ideas. Simple as that.

What’s the value of an idea? That depends on the flow of net profits that it generates. The profits of owning an idea are

\displaystyle  \pi = (1-\tau)(\mu-1)wQ \ \ \ \ \ (1)

where {\tau} is the “tax rate”, and this tax rate is meant to capture both formal taxation and any other frictions that limit profits (e.g. regulations).

{\mu>1} is the markup that the owner can charge over marginal cost for their idea. {(\mu-1)>0} is therefore the difference between price and marginal cost. The more indispensable your idea, the higher the markup you can charge. For instance, there are big markups on many heart medications because your demand for them is pretty inelastic. The markup on a new type of LCD TV is very low because there are lots and lots of almost identical substitutes.

{w} is the marginal cost, which here we can think of as the wage rate you pay to run the business that produces the good or service based on your idea. {Q} is the number of “units” of the idea that you sell (pills or TVs or whatever). Together, {wQ} represents “market size”. If the wage rate or quantity purchased go up, then your absolute profits rise. The effect of {Q} makes sense, but why do profits rise when wages rise? Because of the markup. If your costs are higher, the price you can charge is higher too.

The profits from an idea are the incentive to innovate. So anything that makes {\pi} goes up should generate more ideas. My issue with Michael Strain’s article, and others like it, is that when they think of “progressive social policy”, they think only of the cost {\tau} of funding that policy. So there is a direct trade-off between funding these social policies and innovation (and possibly growth).

My point is that those social policies have direct, positive, effects on market size, {w} and {Q}. Profits should be written as

\displaystyle  \pi = (1-\tau)(\mu-1)w(\tau)Q(\tau). \ \ \ \ \ (2)

If we raise {\tau} to pay for social policies that educate people or raise their living standards, there is a positive effect on market size. The wage goes up, either directly because we have higher-skilled workers, or indirectly because they have some kind of viable outside option.

Further, the size of the market increases because people appear to have non-homothetic preferences. That is, they buy a few essential goods no matter what. They only spend money on other goods once those essentials are dealt with. With non-homothetic preferences, the distribution of income matters a lot to the size of the market for your idea. If lots of people are very poor, or if the cost of essentials is very high, then they have little or no money to spend on your idea, and {Q} is small. If you provide them with more income or make essentials cheaper, they have more income to spend on your idea, and {Q} goes up.

To be clear, I think that the positive effects of {\tau} on {w} and {Q} outweigh the direct negative effect of {\tau}. That’s what I mean when I say progressive social policies are good for innovation, and why I said that there is not a direct trade-off between funding social policies and innovation (and possibly growth).

That doesn’t mean that funding social policies is always positive. There is a Laffer-curve type relationship here, and if {\tau} were too high the incentives to innovate would go to zero and that would be bad. But the innovation-maximizing level of {\tau} is not zero.

As an aside – there are plenty of costs that comparies or innovators have to pay that would have no direct benefit for wages or {Q}. Think of useless red tape regulations. I’m all for getting rid of those. But getting rid of red tape is not something that requires us to sacrifice social policies. It does not cost anything to remove red tape.

But wait, there’s more. The speed of innovation in an economy – {g_A} – is going to be governed by something like the following process

\displaystyle  g_A = \frac{R(\pi,H)}{A^{\phi}} \ \ \ \ \ (3)

where {R(\pi,H)} is a function that describes how many resources we put towards innovation, like how much time is spent doing R&D, or how much is spent on labs. That allocation depends on profits, {\pi}, which dictate how lucrative it is to come up with an innovation. But it also depends on the stock of resources available to do innovation, and here I think specifically of the amount of human capital available, {H}. Social policies can not only raise {\pi} indirectly, but can directly act to raise {H}. Education spending is the obvious case here. But policies that lower uncertainty (income support, health care coverage) allow people to either undertake risky innovation projects themselves, or work for those who are pursuing those projects, because they don’t have to worry about what happens if the risk fails to pay off. Social policy can act directly to raise {H}. Which means that social policies can, for two reasons, raise the growth rate of innovation, {g_A}. Even if the effect on profits is zero, innovation can still rise because the stock of innovators has been increased.

Aside: The term on the bottom, {A^{\phi}}, is a term that captures the effect of the level of innovation, {A}, on the growth rate, {g_A}. If you are of the Chad Jones semi-endogenous growth opinion, then {\phi>0}, and this means that the growth rate will end up pinned down in the long run, and social policies will have a positive level effect on innovation. If you are of the opinion that {\phi=0}, then policies have permanent effects on the growth rate. It isn’t important for my purposes which of those is right.

What does this mean for GDP growth? I said in the prior post that it isn’t clear that GDP growth is the right metric. We really want to encourage innovation, not necessarily GDP growth. Why? Because growth in GDP, {g_Y}, is just

\displaystyle  g_Y = g_A + g_{Inputs}. \ \ \ \ \ (4)

If we raise {g_A}, then what happens to {g_Y} depends on what happens to {g_{Inputs}}. We might imagine that {g_{Inputs}} remains constant, so {g_Y} rises when {g_A} goes up. But there is no reason we couldn’t have {g_{Inputs}} fall while {g_Y} remains constant. What if we take advantage of innovations to only work 30 hours a week? Then GDP growth could remain the same, {g_{Inputs}} falls, and yet we’re all better off. Or if innovation allows us to dis-invest in some capital (parking garages?) while still enjoying transportation services (self-driving cars?). GDP may not grow any faster, but we’d be better off by using fewer inputs to produce the same GDP growth rate.

The point is that the right metric for evaluating the effect of social policies is not GDP growth per se, it is the rate of innovation. It is {g_A} that dictates the pace of living standard increases, not {g_Y}. In lots and lots of models, we presume that growth in inputs is invariable, but that doesn’t mean it is how the world actually works.

Strain completely ignores the possible positive impacts of social policies on the growth of innovation, and that is what I’m saying is wrong about his essay. We can have a reasonable discussion about what the right level of {\tau} is to maximize the growth rate of innovation, but that answer is not mechanically zero. There is no strict trade-off between innovation growth and social policies. Which means there is even less of a strict trade-off between GDP growth and social policies.

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Progressive Social Goals and Economic Growth

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

Someone pointed me towards this Washington Post essay by Michael Strain, of the AEI, on “Why we need growth more than we need democratic socialism“. It’s something of a rebuttal to Bernie Sanders’ positive statements regarding the social democratic systems that are in place in Denmark, Sweden, and several other countries. Strain takes issue with this, suggesting that we cannot purse the progressive social goals that are part of this social democratic system because we would sacrifice economic growth, and that would be bad. The TL;DR version of my post is that Strain is wrong. Wrong about the nature of economic growth, and wrong about the effect of progressive social policies on growth.

To start, Strain engages in some ham-fisted hippie-punching. Except he’s punching Swedes and Danes, so I guess he’s Scandanavian-punching?

Yes, yes, while it didn’t turn out so well under Stalin and Mao, something of the dem-soc variety may work for the good people of Scandinavia.

This is a breathtakingly ridiculous connection to draw. Strain is lumping Stalin’s USSR and Mao’s China together with post-war Denmark and Sweden. These are economies and political systems fundamentally different in kind, not in degree. I’m fairly sure calling Stalin or Mao’s system “democratic” would be a stretch. “Socialist” is also wrong for their economies. I know, it’s confusing, they used “socialist” right there in the name of the USSR! Sometimes labels are wrong. Chilean sea bass ain’t Chilean or a bass.

The USSR and China were committed communist countries, with a lack of private ownership, and centrally planned economies. In contrast, Denmark and Sweden have free, fair elections, a free press, freedom of assembly, freedom of religion, and do not deliberately let giant swathes of their population starve. Oh, they also happen to have marginal tax rates of about 50% at the top, free health care, child care, and education. Which, sure, makes them exactly like the USSR or China under Mao.

Now that we’ve dealt with that, we can actually look at what Strain has to say about growth.

For one, demographic pressures are pushing the potential growth rate of the economy below its historic average. The nation is headed for a period of naturally slower growth, which means that we need to take pro-growth policies even more seriously now than in previous decades.

Why? If the economy is naturally slowing down due to demographic changes, then what precisely is the issue I am worried about? No one gets utility from the growth rate. If we have people getting utility from retiring, and the growth rate is lower, then explain why I should care. Is this an argument that the demographic pressures will put a greater burden on those still working to pay for Social Security and Medicare? Then we should be having an argument about the optimal tax rate, or benefits, or eligibility ages.

True, public policy cannot deliver 6 percent growth, no matter how great a deal Trump makes with the economy. But policy can get rid of a bad regulation (or 20) here, encourage people to participate in the workforce there, make savings and investment a bit more attractive, make entrepreneurship and innovation a bit more common, make the government’s footprint in the economy a bit smaller — on the margin, a range of policies can increase the rate of economic growth. And when you add up all those marginal changes, good policy can make the economy grow at a non-trivially faster rate.

If by “non-trivially” you mean by about 0.2% faster a year, then I might believe that. But notice that Strain tries to sound reasonable (“public policy cannot deliver 6 percent growth”), but never bothers to try and say how much pro-growth policies can actually raise the growth rate. Does he think pro-growth policies – and what precisely are those, by the way – mean growth of 3%, 4%, or 5%? The answer is that it would be a little over 2%, just a smidge higher than growth is today. And that is assuming that Strain’s non-specified growth policies actually have an incredibly massive effect of potential GDP. There is no magic fairy dust to make growth accelerate dramatically. It’s even plausible that pro-growth policies that raise the profit share of output to induce innovation would lower measured productivity growth simply due to how we calculate that productivity.

And the measured growth rate of GDP doesn’t even matter, really. What matters is the availability of innovations that improve living standards. Strain almost gets this right in the next quote:

Over the past two centuries, growth has increased living standards in the West unimaginably quickly. Many more babies survive to adulthood. Many more adults survive to old age. Many more people can be fed, clothed and housed. Much of the world enjoys significant quantities of leisure time. Much of the world can carve out decades of their lives for education, skill development and the moral formation and enlightenment that come with it. Growth has enabled this. Let’s keep growing.

No, innovation has enabled this. So let’s keep innovating. The fact that all these welfare-improving innovations contributed to a rise in measured GDP to rise does not mean that causing measured GDP to rise will raise welfare. Innovations can allow us to produce more with the same inputs (raising GDP) or allow us to produce the same amount with fewer inputs (possibly lowering GDP). Strain confuses measured GDP growth with innovation. They are not the same. What we want, as he says, is policies that foster innovations that improve human living standards. Whether they also happen to raise GDP growth rates is a side issue. Think of it this way. If the BEA came out tomorrow and said they had discovered that they had mistakenly understated GDP by $1 trillion a year since 1948 due to a calculation error, would your living standard be instantly higher? No. But if tomorrow someone announces that they’ve invented a 60% efficient solar panel, that would change your living standards.

Growth facilitates the flourishing life. By creating a dynamic environment characterized by increasing opportunity, growth gives the young the opportunity to dream and to strive. And it gives the rest of us the ability to apply our skills and talents as we see fit, to contribute to society, to provide for our families. A growing economy allows individuals to increase their living standards, facilitating economic and social mobility.

Oh, come on. This is vacuous drivel. Replace every instance of the word “growth” here with the word “liberty”, or “dignity”, or “patriotism”, or “human rights”, or “unicorns” and this paragraph is true. Replace it with “universal free college” and you’ve got Bernie Sanders’ stump speech. This paragraph is the equivalent of Gary Danielson saying “LSU would be helped by a touchdown on this drive.” It’s meaningless.

If we are interested in raising living standards for everyone, which Strain is saying he is for, then we need to promote the introduction and diffusion of innovations. Is there some either/or choice between promoting innovation and progressive social policies? Do we have to sacrifice innovation if we pursue progressive programs? No and no.

What we know about innovation is that it depends on market size and the stock of people who can do innovation. See any of the econosphere’s recent run of posts on Paul Romer’s original work on endogenous growth. By pursuing the progressive policies Strain is so wary of, we can positively affect both market size and the stock of innovators.

First, the policies let relatively poor families access the existing set of innovations, and the diffusion of these welfare-improving innovations accelerates. Think of Whole Foods. Whole Foods is an innovation in access to relatively healthy food. (Yes, some specific items are just overpriced bulls***, and some specific items are not healthier than other brands, but in general Whole Foods and stores like it make a healthier diet more accessible. I’m married to a nutritionist, I’ve had this conversation more than once.) Many poor families eat unhealthy food because it is cheap. Those progressive social programs give these families the purchasing power to access the innovation that is healthier food. Innovations are useless if no one can afford them.

Second, the incentives for innovation are based on the size of the market. Practically, this means that innovation is geared towards producing ideas for people with money. A concentration of income into a small group means innovation is skewed towards that group. Hello, Viagra. If we’re lucky, perhaps the innovations being sold to that small group have some spillovers in producing innovations that are available for the mass of people. But if you expand purchasing power of the mass of people, this raises the incentives to innovate directly for this mass of people. Rather than hoping we get lucky, the market will actively work to produce innovations that improve welfare of most people, not simply the small group with the most purchasing power. Under certain conditions, a concentration of income actively slows down innovation because there simply aren’t enough people with sufficient purchasing power to make it worth innovating (see Murphy, Shleifer, Vishny).

Finally, those progressive social policies that Strain is worried about expand the stock of people who can do innovation. Kids in poor families who receive income support do better in school. Support for vocational school or college raises the supply of people who are capable of innovation. Alleviating income uncertainty through health insurance and income support means that individuals with risky business ideas can pursue them without fearing they won’t be able to take their kids to the doctor.

So it is important to focus on another of the many fruits of economic growth: It provides the money to make targeted spending programs possible. In a nation as rich as ours, no one should fall too far — no one should go hungry, everyone should have a baseline level of education, no one should be bankrupted by a catastrophic medical event. Slow growth impedes progress toward social goals that require targeted spending, both because of the political climate it fosters and because those goals, even only those that are advisable, are expensive.

This, again, presumes that there is an either/or choice between growth and progressive social policies.

Hungry people are less productive. Uneducated people are less productive. People bankrupted by catastrophic medical events are not productive. Reaching those social goals is as much a contributor to growth, as growth is to achieving those social goals. These social goals are not a black hole into which we dump money. They have ramifications – positive ones – on our economy. If Strain wants the U.S. economy to grow faster, then invest in it. Invest in it with better educational opportunities, the elimination of extreme poverty, and the alleviation of the uncertainty associated with medical care. Educated, fed, securely healthy people are productive innovators.

Chad Jones on Paul Romer’s Contribution to Growth Theory

NOTE: The Growth Economics Blog has moved sites. Click here to find this post at the new site.

I’m very pleased to host a guest post by Chad Jones celebrating the 25th anniversary of Romer (1990). Enjoy!

If you add one computer, you make one worker more productive. If you add a new idea — think of the the computer code for the first spreadsheet or word processor or even the internet itself — you can make any number of workers more productive.

The essential contribution of Romer (1990) is its clear understanding of the economics of ideas and how the discovery of new ideas lies at the heart of economic growth. The history behind that paper is fascinating. Romer had been working on growth for around a decade. The words in his 1983 dissertation and in Romer (1986) grapple with the topic and suggest that knowledge and ideas are important to growth. And of course at some level, everyone knew that this must be true (and there is an earlier literature containing these words). However, what Romer didn’t yet have — and what no research had yet fully appreciated — was the precise nature of how this statement comes to be true. By 1990, though, Romer had it, and it is truly beautiful. One piece of evidence that he at last understood growth deeply is that the first two sections of the 1990 paper are written very clearly, almost entirely in text and with the minimum required math serving as the light switch that illuminates a previously dark room.

Here is the key insight: ideas are different from essentially every other good in that they are nonrival. Standard goods in classical economics are rivalrous: my use of a pencil or a seat on an airplane or an accountant means that you cannot use that pencil, airplane seat, or accountant at the same time. This rivalry underlies the scarcity that is at the heart of most of economics and gives rise to the Fundamental Welfare Theorems of Economics.

Ideas, in contrast, are nonrival: my use of the Pythagorean theorem does not in any way mean there is less of the theorem available for you to use simultaneously. Ideas are not depleted by use, and it is technologically feasible for any number of people to use an idea simultaneously once it has been invented.

As an example, consider oral rehydration therapy, one of Romer’s favorite examples. Until recently, millions of children died of diarrhea in developing countries. Part of the problem is that parents, seeing a child with diarrhea, would withdraw fluids. Dehydration would set in, and the child would die. Oral rehydration therapy is an idea: dissolving a few minerals, salts, and a little sugar in water in just the right proportions produces a life-saving solution that rehydrates children and saves their lives. Once this idea was discovered, it could be used to save any number of children every year — the idea (the chemical formula) does not become increasingly scarce as more people use it.

How does the nonrivalry of ideas explain economic growth? The key is that nonrivalry gives rise to increasing returns to scale. The standard replication argument is a fundamental justification for constant returns to scale in production. If we wish to double the production of computers from a factory, one feasible way to do it is to build an equivalent factory across the street and populate it with equivalent workers, materials, and so on. That is, we replicate the factory exactly. This means that production with rivalrous goods is, at least as a useful benchmark, a constant returns process.

What Romer appreciated and stressed is that the nonrivalry of ideas is an integral part of this replication argument: firms do not need to reinvent the idea for a computer each time a new computer factory is built. Instead, the same idea — the detailed set of instructions for how to make a computer — can be used in the new factory, or indeed in any number of factories, because it is nonrivalrous. Since there are constant returns to scale in the rivalrous inputs (the factory, workers, and materials), there are therefore increasing returns to the rivalrous inputs and ideas taken together: if you double the rivalrous inputs and the quality or quantity of the ideas, you will more than double total production.

Once you’ve got increasing returns, growth follows naturally. Output per person then depends on the total stock of knowledge; the stock doesn’t need to be divided up among all the people in the economy. Contrast this with capital in a Solow model. If you add one computer, you make one worker more productive. If you add a new idea — think of the the computer code for the first spreadsheet or word processor or even the internet itself — you can make any number of workers more productive. With nonrivalry, growth in income per person is tied to growth in the total stock of ideas — an aggregate — not to growth in ideas per person.

It is very easy to get growth in an aggregate in any model, even in Solow, because of population growth. More autoworkers mean that more cars are produced. In Solow, this cannot sustain per capita growth because we need growth in cars per autoworker. But in Romer, this is not the case: more researchers produce more ideas, which makes everyone better off because of nonrivalry. Over long periods of recent history — twenty-five years, one hundred years, or even one thousand years — the world is characterized by enormous growth in the total stock of ideas and by enormous growth in the number of people making them. According to Romer’s insight, this is what sustains exponential growth in the long run.

Additional Links

The Romer (1990) paper
Romer’s blog entries on the 25th anniversary of the 1990 paper
Chad’s slides on “Growth and Ideas” (and a more in-depth paper)