Moving Day!

The Growth Economics Blog is moving to a new site. I’ve consolidated the blog with my personal website (research, class info) into growthecon.com

• RSS feed. There is a new RSS feed you’ll need to receive posts. Click the link to put the feed in your favorite RSS reader.
• Email subscribers. You should not have to do anything. I’ve exported the e-mails of everyone, and set up a MailChimp account that will forward you new posts as they come out. If you don’t see anything in a few days, check your spam or let me know at “dietz.vollrath+blog@gmail.com ” and I’ll get it sorted.
• Twitter. There should still be tweets for each new post, so if you find me @DietzVollrath, nothing to worry about.
• Comments. These are enabled on the new site, although you might need to put in your email/name the first time you post. Existing comments have been ported over to the new site.

I’ll be cross-posting on both sites for a limited time, hoping to catch anyone who misses out.

In case you’re curious, I bought the new domain name using money I received from Amazon links on my site. When I post an Amazon link, and you purchase anything, I get a small percentage. The amount I get is sufficient to buy pizza and beer about once a month. This Christmas the Roman History Reading List generated more action, and I blew it on buying the domain name. Thanks!

I also switched over because I wanted more control over the blog site and my own site. I got frustrated writing in Latex or Markdown, and then having to jump through hoops to get my posts ready for WordPress. I’m using Jekyll and Github on the new site, for those that are interested. It’s built totally on static text files, which is something that satisfies my Unix lizard-brain.

I’m sure that I have screwed something up, so if you find yourself unable to read the blog or link to old pages, just let me know. Thanks for reading.

The Declining Marginal Product of Capital

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

A few weeks ago I posted about the recent decline in capital per worker in the U.S. The short summary is that from 2009-2013 capital per worker has been shrinking, and this is at odds with most of historical experience. This shrinking capital per worker contributes to higher measured productivity growth.

The illustrious Areendam Chanda asked, in response, what the marginal product of capital looked like given the decline in capital per worker in this series. This is straightforward to calculate given the BLS data, and it shows what I think is an interesting pattern.

First, I calculate the MPK as

where is capital’s share of output. If the world is roughly Cobb-Douglas, this should describe for us the extra amount of output we could get from one additional unit of capital. This is an aggregate concept, and doesn’t necessarily map to any specific use of capital (e.g. the marginal product of a laptop can be different than the marginal product of a shovel). This is the marginal product of dumping an extra unit of homogenous “capital” into the economy.

Here’s the figure showing the time path from 1960 to 2013:

In terms of the recent decline in capital per worker, the uptick in the actual series (black line) from 2000-2013 makes some sense. Declining capital per worker should be associated with a higher return on capital. But what appears to be true is that the recent uptick in MPK is driven by a change in capital’s share in output. I plotted in gray an alternative MPK that assumes capital’s share is constant at 0.31 (a rough long-run average), and as you can see this continues the downward trend of the prior decades. The uptick is due almost entirely to the increase in capital’s share of output.

What seems far more interesting in this figure is the general drift downward in the MPK since 1960. I can come up with two different interpretations of this, which depend a lot on the time frame you consider.

Secular shift in MPK: Essentially, interpret this as evidence of some kind of sustained, secular change in the US economy. The drift down in the MPK isn’t consistent with the US being on a balanced growth path (BGP). As a quick reminder, traditionally a BGP is a situation where GDP per worker is growing at a roughly constant rate, the return on capital (MPK) is constant over time, and the share of output going to capital is constant over time.

And we almost always presume that the US is on a BGP. I will be telling my undergrads this in a week or so, I’m sure. Almost every growth model is written so that it delivers a BGP eventually, because people feel that this represents what we see in the data. And when they say “BGP” in their model, they almost always mean that the MPK is constant.

In a standard Solow model, the steady state is a BGP, and the model tells us what determines the MPK on that BGP.

where is capital’s share of output, is population growth, is productivity growth, is the depreciation rate, and is the savings rate. Note, this equation is for the MPK in steady state, not necessarily at any given point in time, but it is useful for thinking about what might drive the decline in MPK.

The steady decline in the MPK over time is consistent with declining (because capital’s marginal product is lower when there are fewer people around), declining (slower productivity growth), and higher (more savings). In this story we are transitioning from the immediate post-war era of relatively rapid population and technological change, to a new era of relatively low population and technological growth.

It’s worth remembering here that the MPK is calculated using the BLS data, which excludes the government sector and the residential housing stock. So this represents a decline in the non-residential-housing MPK.

Return of MPK to Long-run trend: But from a long, long-term perspective, maybe the decline in MPK since 1960 is just a reversion to a steady state value? The MPK should be roughly a proxy for the return on capital. One other rough proxy for that is the earnings yield on the S&P 500, which represents how much you get in earnings for buying a “unit” of capital by purchasing a basket of stocks. The figure below, which I grabbed from Brad DeLong’s site, plots this earnings yield from 1880 until today.

From this it seems to me that the earnings yield has a “normal” level of about 6%, and that while there are sustained deviations from this value, it always appears to head back to 6%. The first figure shows that MPK has been declining from 1960 until now, matching the decline in the earnings yield from rouhgly 1970 until today. Was the MPK just on walkabout, and is coming back to its long-run BGP level? And no, I’m not terribly worried about the fact that the MPK is always higher than the earnings yield. They are both proxies, so the fact they don’t agree on levels isn’t terribly meaningful.

The earnings yields suggests that what is abnormal about the figure for MPK is the high values in the 60’s and 70’s, not the low values now. The S&P evidence is consistent with that, although the match-up is imperfect. Why was the MPK so high in the 1960’s, while the earnings yield didn’t rise until the 1970’s?

Regardless, in this interpretation, the steady state MPK has stayed roughly the same, but for some reason we deviated in the 60’s and 70’s to having a high MPK. Perhaps it was atypical shocks to productivity (over and above the regular trend growth rate ), or atypical shocks to population growth (Baby Boomers?), and we’re now coming back down to normal.

The caveat here is that the S&P earnings yield might be a bad comparison for the MPK. But given that the MPK is ex-residential-housing-capital and ex-government, perhaps not.

I don’t know that there is a way to distinguish between the two stories, not without doing more research that I don’t have time to do right now. Without taking a firm stand on this, one important point here is that the explanation depends crucially on what you take to be “normal”. And that depends in part on how far back you graph the data. The S&P data suggests a different story than the MPK series (and the MPK series doesn’t go back any further because the BLS doesn’t have the requisite data any further back). I guess it is a caution that the starting point of your data series is not necessarily the same thing as the “starting point” of the economy.

Do You Need More Money for Economic Growth to Occur?

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

 

TL;DR version: No.

This is another entry to file under “notes for undergrads” and/or “explaining things to your neighbor”. A very common question I get about growth is: how does growth occur if there is not any “more money” in the economy. Another common question I get is: how is it economic growth if spending on one product just replaces spending on another?

These questions come, I think, from continued confusion about (a) nominal versus real GDP, (b) nominal GDP versus the stock of money, and (c) absolute versus relative prices. In short, things an economist might call money illusion. In the defense of students and my neighbors, it isn’t terribly easy to think in relative prices and real terms when every single transaction you undertake involves absolute dollars.

Let’s start with an economy that produces exactly 10 cans of Budweiser, and nothing else, in a year. They each sell for $1, meaning that nominal GDP in this economy is $10 for the year. What is real GDP? Well, we already really know the answer – it’s 10 cans of Budweiser.

Real GDP is measured in “real units”. That’s obvious in this example, because the real units are obvious – cans of Bud. To do this more formally, we find real GDP by dividing nominal GDP by a price index. In this case, the price index is easy to figure out. It’s $1 per can of Bud. So real GDP is $10/$1 per can of Bud = 10 cans of Bud.

One confusion with real GDP is that the BEA and economic textbooks insist on talking about it in terms of dollars. That is because the price index they use is not something like “$1 per can”, but is something like “$1.37 per $1 of output in 2005”. So real GDP is $10/$1.37 per 2005 dollar = 7.3 units of 2005 dollars, which would be reported as “$7.3 (2005 dollars).” But despite being reported in terms of dollars, real GDP has nothing to do with money.

I sometimes think that we should save our effort at coming up with good price indices, and just use something like the price of a can of Bud, or a pair of Levi 501 jeans, as the price deflator in national accounts. Because then real GDP would be reported in real, tangible units, and would save us from confusing it with a nominal number. For example, if the price of a can of Bud was $0.50, then real GDP in the US for 2014 would be $17,615 billion/ $0.50 per can on Bud = 35,230 cans of Bud. Nominal GDP through Q3 2015 is $18,060, so that’s real GDP of 36,120 cans of Bud, a 2.5% increase in real GDP from 2014. I’m laboring this point because when it comes to explaining how growth works, this confusion between nominal and real concepts becomes a problem.

Let’s go back to our simple 10-can economy, with a price per can of $1, and see how growth works.

Growth through expanding production of existing products: This is the easiest to explain. Something happens at Anheuser-Busch that lets them produce even more cans of Bud with their given inputs. Perhaps they water it down even more than it already is. Whatever the reason, the economy produces 12 cans of Bud this year. We know that real GDP went up, from 10 cans to 12 cans.

But let’s walk through how to do this calculation using nominal GDP and a price index. Think of two possibilities

• Nominal GDP stays constant. That is, nominal GDP is still $10. Then it must be that the price of a Bud fell to $0.83. The supply curve of Bud shifted out, and hence the quantity of Bud went up and the price of Bud went down. Real GDP is $10/$0.83 per can = 12 cans of Bud. For the given flow of money through the economy – which does not have any necessary relationship to real GDP – the price of a can of Bud must adjust to make supply equal demand.
• The price of Bud stays constant. Let each can still be $1. The it must be that nominal GDP is $12, and real GDP is $12/$1 per can = 12 cans of Bud. Here, the supply curve of Bud has shifted out, but apparently the demand curve shifted out as well, leaving the price unchanged and the quantity higher. Why would this happen? Who knows, and who cares. It’s possible. For a given flow of money through the economy, the price of a can of Bud must adjust to make supply equal to demand.

Note that it is irrelevant whether nominal GDP goes up or stays constant (it could even fall). Whether nominal GDP rises or not is completely irrelevant to whether real GDP goes up. If we could observe the real quantity of cans consumed, we wouldn’t need nominal GDP at all. But we don’t actually observe the number of cans of Bud consumed. All we observe is nominal GDP and the price of a can of Bud. So when the BEA reports a nominal GDP of $10, and a price of $0.83 per can, we divide and infer that real GDP is 12 cans of Bud.

If your question now is where people get the “extra money” to afford 12 cans of Bud when their price stays at $1, take a moment to meditate on the equation . We’ll come back to that in a few paragraphs.

Growth through addition of new products: This one will stretch the mind a little more, but the same principles are going to hold. Rather than Bud watering down their beer even further, we’re going to introduce a new beer into the market. Someone – and God bless them – invents Real Ale Coffee Porter. In response, people with functioning taste buds buy 5 cans of Coffee Porter, and everyone else still buys 5 cans of Bud. So we’ve still only got 10 cans of beer being sold. Is this economic growth, meaning that real GDP is higher?

It depends on relative prices. If those cans of Coffee Porter are more expensive than cans of Bud, then this represents real economic growth. Why? Because if the relative price of Coffee Porter is higher than that of Bud, then the relative marginal utility of Coffee Porter is higher than that of Bud. Assuming that utility for both has typical properties (declining MU), then we know the MU of the 5th can of Bud is higher than the 10th can. And since Coffee Porter has a higher MU than that, it follows that we are better off in utility terms. More intuitively, if we weren’t better off, then why were we willing to substitute away from Bud even though Coffee Porter costs more?

Which suggests that if Coffee Porter and Bud sold for the same amount, then we aren’t any better off. In this case it’s a perfect substitute, and the choice of 5 of each is just random. It’s the difference in relative prices that a new product introduces that defines it’s contribution of real growth.

So eocnomic growth is just about things getting more expensive? No. Note that I didn’t say anything about the absolute price of Bud or Coffee Porter – because that is irrelevant for real GDP. So long as Coffee Porter is more expensive than Bud, we’ve experienced real growth. That holds if Porter costs $2 to Bud’s $1, or $20 to Bud’s $10, or $0.02 to Bud’s $0.01.

Once we’ve established that there is a relative price difference, then the same questions about nominal GDP from before come up. Let’s say that we observe that Coffee Porter costs twice as much as Bud. How do we calculate real GDP?

• Nominal GDP stays constant. It must be that Bud costs $0.67, and the porter is $1.33, so nominal GDP is $10 (multiply it out and you can see it). What is real GDP in this case? Sticking with our standard of using the price of Bud, real GDP is $10/$0.67 per can of Bud = 15 cans of Bud. It is as if our economy produced 15 cans of Bud, where before it only produced 10. There is real GDP growth due to the introduction of Coffee Porter – even though all Coffee Porter does is replace consumption of Bud and total beer drinking stays constant at 10 cans.
• The price of Bud stays constant. If Bud still costs $1, then the porter is $2. So nominal GDP is $15 (again, just multiply it out). What is real GDP? $15/$1 per can of Bud = 15 cans of Bud. Real GDP has gone up. It is irrelevant what the nominal price of Bud is, we observe real GDP growth because the introduction of Coffee Porter introduced a relative price difference.

Notice that if all the BEA reports to me is nominal GDP and the price of Bud, I can infer real GDP regardless of what exactly happens. Our  “Bud-based” measure of real GDP goes up to 15. I don’t actually have to observe the number of cans purchased.

This example of adding a new product brings up one issue with price indices, which is product replacement. If – as would be logical if people tasted them – the introduction of Coffee Porter completely eliminated Bud from the market, then we cannot calculate real GDP. There will be no price of Bud to divide nominal GDP by. And we can’t just use the price of Coffee Porter, because yesterday all we had was Bud, and there was no price for Coffee Porter. One of the reasons we use more sophisticated price indices (that combine the price of Bud and Coffee Porter in some way) is so that we always have a price index to use. But that sophisticated price index, by putting things in “2005 dollars” or something like that, creates confusion between real GDP and nominal GDP. Always think of real GDP as being “cans of Bud”, rather than in dollar terms.

Now, If you are still wondering where people get the “extra money” to buy the Coffee Porter in this example, then the next section is for you.

Where does the extra money come from? Nowhere. There is no extra money. Nominal GDP is not a measure of “how much money we have”. Nominal GDP is the flow of dollars through the economy. The stock of money is, well, a stock. In all the examples above, what is the stock of money? You can’t answer that question, because I never said anything about it.

Let’s say that this economy has a stock of 4 one-dollar bills. Here’s the transactions flow in this economy in the initial stage, with only 10 can of Bud consumed:

1. Person A starts with the $4. (Nominal GDP is zero)
2. Person A buys 4 Buds for $4 from person B. (Nominal GDP is $4)
3. Person B buys 4 Buds for $4 from person C. (Nominal GDP is now $8)
4. Person C buys 2 Buds for $2 from person D. (Nominal GDP is now $10)
5. Person D ends up with $2 and person C with $2. (Final nominal GDP is $10)

Then next period we start again, only now C and D hold the money stock. The money stock is always $4, and it gets turned over and over, resulting in $10 of nominal transactions, or GDP. (No, it doesn’t matter that the circle isn’t closed here, with different people ending up with the actual dollars.) Real GDP is 10 cans of Bud.

If we have the case where Coffee Porter gets introduced, things look like this.

1. Person A starts with the $4. (Nominal GDP is zero)
2. Person A buys 2 Porters for $4 from person B. (Nominal GDP is $4)
3. Person B buys 4 Buds for $4 from person C. (Nominal GDP is now $8)
4. Person C buys 2 Porters for $4 from person D. (Nominal GDP is now $12)
5. Person D buys 1 Bud for $1 and 1 porter for $2 from person E. (Nominal GDP is now $15)
6. Person D ends up with $1 and person E with $3. (Final nominal GDP is $15)

No “new money” is necessary. Real GDP is 15 cans of Bud. The same $4 gets recycled over and over again, this time used to purchase both Buds and Porters. Different people end up with money stock at the end. We could easily write out an example where the growth occurred because of just an increase in the number of Buds. And if you prefer that nominal GDP not increase, you can easily go back and work out the same set of transactions, lower the absolute prices, and get nominal GDP to come out to exactly $10. And yes, I made up these examples. But I just need to show you that it is possible to get economic growth even though there is no new money in the economy.

Economic growth occurs either because we produce more of existing things, or because we introduce new things that that are more valuable than the old things we produced – which shows up in relative price differences. The level of absolute prices is irrelevant. The level of nominal spending is irrelevant. The stock of money is irrelevant.

For any modern economy, it is effectively impossible for there to be “not enough money” to let growth occur. The economy as a whole can always turn over the money stock faster to allow for the extra transactions if necessary. Whether that turnover involves you, and means that you can afford to buy some Coffee Porter, is a different question, and involves your own productivity and/or ownership of a Bud- or Coffee Porter-producing machine.

 

Calculating Growth Rates

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

I’m prepping for my undergraduate growth course this semester (which uses an AWESOME book, by the way). We don’t require calc from our econ majors at UH, so I have to ease them into a few things during the course. One of those is using logs to both visualize and then analyze economic growth. This post is some notes I started working on to help introduce students to the concepts.

If you’re teaching, this might come in handy. If you’re interested in growth, but a little shy about math, this might be helpful. If you literally have nothing better to do, it will kill about 10 minutes and/or help put you to sleep.

We’re interested in living standards, as measured by real GDP per capita. We don’t concern ourselves a lot with the absolute value of real GDP per capita, as that number depends on exactly how we construct price indices, base years, etc.. What we care about is how fast economies grow. This is like saying that we don’t care whether you start at 150 pounds or 68 kilograms; but if your weight grows by 5% per year we know you are going to get fat.

To visualize those growth rates, and to do some crude analysis, we invariably plot real GDP per capita in logs. When I say log, I mean the natural log. There are lots of cool explanations of how natural logs work, but this post is not one of them. For now we’re going to take it on faith that natural logs work the way I say they do.

Take the natural log of GDP per capita in each year, and graph it against the year itself. The figure below, for India, is an example, where real GDP per capita is plotted using the grey line.

Natural logs have a few great properties for our purposes. Using them means that every step up the y-axis is an identical percent change in real GDP per capita. Going from 7.0 to 7.5, for example, is a 65% increase in real GDP per capita. Going from 7.5 to 8.0 is also a 65% increase in real GDP per capita. This is true even though from 7.0 to 7.5 is going from $1,096 to $1,800 in GDP per capita and going from 7.5 to 8.0 is going from $1,800 to $2,980. By plotting things in natural logs we can see the percent increases, rather than the absolute increases.

Even more fun is that because of this property, we can pick off the average growth rate between two years relatively easily. The average growth rate between two years is just the slope of the straight line connecting the two end points. In the figure for India, I’ve overlaid the calculation of the growth rate for several sub-periods, as well as the average growth rate from 1950 to 2010.

From 1950 to 2010, as an example, connect the two end points, and find the slope of the line. You could do this mathematically as follows

For the other sub-periods, you do the same thing, just using the end points from those time periods. So from 1950 to 1975, growth average 2.0%, from 1975 to 1985 if average -3.0%, and from 1985 to 2010 it averaged 5.2%.

Why those particular sub-periods, and not others? Solely because they looked like obvious break points. There is no formula for deciding what sub-periods to calculate. It just seems intuitive that “something different” happened around 1985, for example, that sets that period apart from the others. But you could calculate the growth rate from 1972 to 2003 if you wanted to. You want to argue with me that the 1985 to 2010 period should be broken up again into pre-2003 and post-2003 sub-periods? Okay. I can’t tell you you’re wrong.

The three sub-periods I did calculate have the feature that their average growth seems very close to the actual growth. That is, the actual path of GDP per capita doesn’t stray very far from the straight line we used to calculate the average growth from 1950 to 1975, for example. What do I mean by “very far”? Nothing technical, just eye-balling it.

Compare those three sub-periods, though, to the whole stretch from 1950 to 2010. We calculate average growth at 2.5%, but the straight line that gives us that answer lies well above the actual real GDP per capita for almost the entire period. Average growth from 1950 to 2010 doesn’t give us a very accurate picture of what the growth experience of India was like in history, where there really appear to be three separate periods.

That doesn’t mean 2.5% is wrong. It is exactly the average growth rate from 1950 to 2010. If you started at real GDP per capita of $798 in 1950, and applied 2.5% growth to that, you’d end up with

which is just rounding error away from the actual value of $3,596. But the path from 1950 to 2010 looks a lot different at 2.5% average growth every year, compared to the actual path real GDP per capita followed in India in this time span.

Regardless, we’ll be interested at times in precisely those periods when the average growth rate is very close to the actual growth rate of real GDP per capita (the straight line is close to the gray line). 1950 to 1975, as we said, or arguably 1985 to 2010. These periods could represent what we’ll call “balanced growth paths”, or BGP’s.

We’re interested in BGP’s because our theories of growth are going to suggest that, in the absence of any fundamental change, a country will tend to end up on a BGP. That is, without any major shock to a fundamental characteristic of the economy, an economy will tend to have actual growth close to average growth. Further, if we see different BGP’s, then this indicates that something fundamental did change.

What the picture from India says is that the period from 1950 to 2010 was not a BGP for India. 1950 to 1975 could be one, and then in 1975 something fundamental was just different. What something was it? We cannot tell from this figure. We’d have to dig into other data on India to decide, and our theory might tell us likely candidates to explore. In 1985 something again appears to have fundamentally changed, as again India switched to what looks like a new BGP. And again we’d have to explore other data to decide what changed.

Just to be complete, what we see in the figure is necessary, but not sufficient, to establish that India was on a BGP. That is, there are other conditions that are also necessary to classify a period of time as being “on a BGP”, and there may be other reasons that India was not on a BGP from 1975 to 1985, for example, even though actual growth was close to average growth. But as a start, looking at a figure like this tells us where we should start looking.

To be even more complete, just because most of our theories suggest countries will end up on a BGP in the absence of a major shock doesn’t mean they are right. Our theories could be completely wrong. Maybe nothing fundamental changed in either 1975 or 1985, and all that happened was that India got really unlucky for a few years. Perhaps we are making too much of these extended runs of similar growth rates.

IQ and Economic Growth

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

I finally got around the writing up a review of Hive Mind, by Garett Jones. Short version is that the book is excellent, and well worth reading. I’ll get into more detail below, but the book explores the importance of cognitive skills (as measured by IQ) for economic development.

There are several reasons to like it. First, the book has absolutely no fat on it. This is a model of concise explanatory writing. Most books that try to bring recent research to the public end up bloated. Not this one. Five stars for clarity here.

Onto the content. There are really two parts to the book. First, Jones establishes that “cognitive skills” are in fact highly correlated with economic development, and a subsidiary part of this is establishing that IQ is just one of many ways of measuring “cognitive skills”.

I’m not going to go into a lot of detail here. Like I said, the book is very lean and you can easily read Jones’ own words on this. Let me summarize by listing his own five main channels for how IQ is related to economic development. In italics next to the channel are a few comments of my own on them.

1. High IQ’s are related to higher savings rates. But we have evidence that savings rates don’t actually vary a whole lot across countries, and that what variation there is explains little.
2. High IQ’s are related to more cooperation. For my money, the most important channel. Economic development looks a lot like people choosing the “cooperate” equilibrium in a repeated game. High IQ may be a marker for people willing to play this move, and to play it first, and often, even though the other players could take advantage of them.
3. High IQ’s are related to market-oriented policies. Perhaps it is that high IQ people believe in their own ability to succeed?
4. High IQ’s are related to using team-based technologies. I think I would lump this in with cooperation.
5. People like to conform. This isn’t about IQ itself. But if you have lots of high IQ people with those other traits, then even those without high IQ’s will try to conform. A critical mass of high IQ people may be sufficient to reach the good equilibrium.

Let’s be clear here about the role of high IQ’s. They are a marker, not necessarily a cause, of these behaviors and traits. Jones is clear on this, and is not making some strong causal claim. Rather, think of all these traits (including high IQ scores) as a package of traits that tend to come together. Call these traits “cognitive skills”, as they typically involve some kind of ability to do abstract thinking.

An interesting note here is that lots of what the labor literature calls “non-cognitive skills” are what, I think, Jones would lump under cognitive skills. For example, patience is something that some refer to as a non-cognitive skill, but for Jones it is part of the package of abilities that come along with relatively high IQ levels.

The wrong conclusion to draw from Jones’ book is that there is some kind of fixed genetic difference in intelligence across countries that explains why some are rich and some are poor. These traits are malleable, as evidenced by the “Flynn Effect” of rising IQ scores over time. Cognitive skills certainly are related to economic development, but they are better seen as a more refined measure of human capital than years of schooling. You can invest in cognitive skills the same way that you can invest in years of schooling. One possibility might be more extensive pre-schooling that teaches those “non-cognitive skills” that are associated with IQ.

By the way, Feyrer, Politi, and Weil have a paper coming out on how iodizing water helped raise IQ scores in the US. There may be direct public health measures that could materially impact cognitive skills and IQ in developing countries.

The second part of the book delves more specifically into Jones’ research on the returns to IQ, or cognitive skills. Namely, why is there such a small premium on IQ within countries, but such a large premium to IQ across countries? Again, I’m not going to lay into a lot of detail here, he does a nice job in the book explaining the theory here. Let me try to give you the basic intuition.

High-IQ places are able to take on “fragile” production processes, where even one mistake ruins the output (e.g. a semiconductor or a hit movie). Economists often call these “O-ring” processes, after the Challenger disaster. Having lots of high IQ people means you have lots of high productivity, fragile, production processes, and this creates demand for other, non-fragile, production processes (e.g. retail). The high demand for the non-fragile process means that wages are relatively high for the low IQ people who can work that sector. Hence there is little difference in wages between the high-IQ people and the low-IQ people. But the average wage is incredibly high, because the economy engages in these productive, fragile production processes. So high IQ countries are very rich compared to low IQ countries.

Let me add that this disconnect of the within-country return to a trait (IQ, years of education, etc..) and the cross-country return to the same trait is littered all over the growth literature. Sometimes we think about these positive spillovers/externalities, but for the most part we do not. One nice thing about Jones’ book (and prior research) is that he does think about these things seriously. Even if you don’t buy the first part of the book, it is worth reading the second part (substitute “high-skill” or “high-education” in everywhere you see “high-IQ” and you’ll be fine).

I’ll be assigning parts of this to my undergrads this semester. It should be a fun day of class.