New Growth Theory: Not New, and Not Useful

In a recent article in The Atlantic featuring Stanford University professor Paul Romer, Sebastian Mallaby opens with the following story familiar to all economists:

Starting in the late 1980s, [Paul Romer] produced a series of papers that changed the way his profession thinks about economic growth; his most celebrated contribution, published in 1990, “was one of the best papers in economics in 25 or 30 years,” in the estimation of Charles I. Jones, a colleague of Romer’s at Stanford. Before the Romer revolution, theorists had explained an economy’s growing output by looking at the obvious inputs—the number of hours worked, the skills of the workforce, the quantity of machinery and other physical capital.

But Romer stressed a fourth driver of growth, which he termed simply “ideas,” a category that encompassed everything from the formula for a new drug to the most efficient sequence for stitching 19 pieces of material into a sneaker. In statistical tests, the traditional inputs appeared to account for only half the differences in countries’ output per person, suggesting that ideas might account for the remaining half—and that leaving them out of a growth theory was like leaving the prince out of Hamlet. And whereas the old models had predicted that growth would slow as population expansion put stress on resources, and as new investment in skills and capital yielded diminishing returns, Romer’s New Growth Theory opened the window onto a sunnier worldview: a larger number of affluent people means more ideas, so prosperity and population expansion might cause growth to speed up.

Now, just for the record, this is nonsense. Every year I have to guide one or more doctoral students through the process of unlearning this little bit of mythology--and with it the notion that New Growth Theory constitutes some sort of great breakthrough in the history of ideas (or even just economics for that matter) which we should all applaud.

I'll explain as quickly as possible because the origin of ideas in economics is a topic of almost no interest to anyone, including me. But some clarification, for the record, is in order:

1) The first clarification is that Romer's contribution to the theory of economic growth was very specific and technical: He found out how to make the mathematics of an "endogenous growth model" work. He can rightly be credited with reviving a moribund field (economic growth theory), but it is an exaggeration to claim that he created the field, and simply incorrect to assert (as Mallaby does) that "before the Romer revolution, theorists had explained an economy’s growing output by looking at the obvious inputs—the number of hours worked, the skills of the workforce, the quantity of machinery and other physical capital."

To the contrary, the ideas and a fair share of the modeling behind the model Romer developed (initially for his dissertation and then in a handful of papers on which his fame primarily rests) had been worked out more than twenty years earlier by a group of economists notably including Karl Shell, Hirofumi Uzawa, and the great Kenneth Arrow. Read the work of Schookler, Nelson, Phelps, or many others from 1950 and 1960s (see e.g this classic volume) and earlier still the work of Joseph Schumpeter, and it is evident that, long before Paul Romer was born, scores of economists had written brilliantly on the topic of how ideas create growth and development. (This history is well understood by individuals who are close to the events in question--including Romer himself, obviously--and has been ably chronicled by David Warsh of the Boston Globe here and here [e.g. pp. 155-156]).

2) The second clarification is that, of the two ideas most closely identified with "New Growth Theory," one is wrong and the other is so obvious as to be of no practical use to policy-makers or businessmen.

Let's start with the idea that's wrong, namely, that because ideas are "non-rival" and "non-excludable," economically relevant innovations (Romer actually uses the term "recipes,' as I have in work with Karl Shell and Stuart Kauffman) are characteristically subject to "knowledge spillovers." In plain English "non-rival" means that one person's use of an idea does not keep another person from using the idea; "non-excludable" means that it is impossible to keep a person from using an idea once it is "out in the open;" and "knowledge spillovers" refers to the costless transmission of ideas that are non-rival and non-excludable.

This all sounds well and good, and versions of these few lines have led a generation of economists to buy into the notion that "knowledge spillovers" are somehow the fuel that drives development and growth. But the whole construction only makes sense in the lecture room. In fact, the ideas that actually propel growth and development are overwhelming uncodified, context-dependent, and transferable only at significant cost (econ-speak: tacit knowledge dominates, information asymmetries are the norm, and transactions costs are significant, see here and here). While "knowledge spillovers" of the type celebrated by Romer certainly exist, they are of marginal relevance in the practical work of economic growth and development. (Don't start talking to me about webpages and pirated music videos here--those are a different story altogether from production recipes.) For more, see my prior post on this topic, and also this absolutely brilliant (short and readable!) book by Robert Solow--or for that matter, Schumpeter's Theory of Economic Development.

Now as to the idea at the core of New Growth Theory that is so obvious as to be useless, it is the one featured by Mallaby: "Romer stressed a fourth driver of growth, which he termed simply 'ideas,' a category that encompassed everything from the formula for a new drug to the most efficient sequence for stitching 19 pieces of material into a sneaker."

Let's be real here: Was Paul Romer really the first person to figure out that new ideas don't just fall out of the sky, but actually require effort and investment to develop? Of course not! My guess is that you would have had a very hard time finding a single individual involved in corporate research and development or technology entrepreneurship in 1986--when Romer published his first "seminal" paper-- that believed that the ideas that drove the growth and development of societies just sort of happened on their own. Indeed, consider this observation by Ralph Flanders, co-founder of America's first venture capital firm, written fully 40 years before Romer published his work:

The continued maintenance of prosperity and the continued increase in the general standard of living depend in a large measure in finding financial support for that comparatively small percentage of new ideas and developments which give promise of expanded production and employment and an increased standard of living for the American people. We cannot float along indefinitely on the enterprise and vision of preceding generations. To be confident that we are in an expanding, instead of a static or frozen economy, we must have a reasonably high birth rate of new undertakings.

Is our bar for scholarship so low that ideas obvious to everyone but scholars can constitute great advances in knowledge? I really hope not.

All of this matters because the slavish and uncritical repetition of the New Growth fable (ref. Mallaby article above) has led even the most thoughtful economists to believe that this fable somehow corresponds to reality and the ideas of New Growth Theory are of practical relevance. A recent post by Bill Easterly serves as an illustration:

Response to RT @auerswald People r (Not) Statistical Noise http://bit.ly/bAwtpQ:

on objection that small bursts of creativity can have very large effects. Um, yes, it’s called non rivalry of ideas (and music scores). Many people can simultaneously use the same idea/score. And everyone wants to use the best ones. So the scale effects can be Gigantic. I guess I had noticed I’m not the only one who likes Mozart.

Easterly misses what macroeconomists customarily miss: that the process by which "small bursts of creativity" have large effects has a name, and it is not "non-rivalry".  It is entrepreneurship.

Entrepreneurship involves the search for ideas that are in fact, rivalrous and excludable (at least temporarily) out of which ventures with proprietary value can be created. The impediments to entrepreneurship that matter most are not lack of appropriability of returns (as New Growth Theorists almost invariably preach) but rather the everyday battles involved in communicating ideas, building trust, and making deals (more here and here.)

Of course, the most remarkable achievement on Paul Romer's vita is that he is economist who has also managed to become a successful entrepreneur himself--having founded and sold the online economics teaching company, Aplia, which I have used in my own courses. So Romer certainly knows all this, and can't be held responsible for the creation of fables in which he is a featured player.

But to everyone else: enough with the New Growth Theory already. It wasn't new even 30 years ago, and it's not useful now.

ADDENDUM: Lest my macroeconomist friend--oops, that should "friends"--think me too ungenerous, here are five papers and one book written about economic growth in the past three decades that I do think contain real insights of conceivable value to business strategist or policy-makers:

• Robert Lucas, "Making a Miracle" because of its integration of insights regarding firm learning curves and its clear articulation of the fact that sustained growth requires the constant innovation of new goods and services
• James Schmitz, "Imitation, entrepreneurship, and long-run growth," great paper addressing limits to appropriability of knowledge in entpreneurship and implications for growth theory
• Robert Solow, Learning from Learning by Doing, absolutely brilliant summary of the drivers of growth and how they have been represented by economists (including insightful critiques of the "New Growth" literature)
• Claudio Michelacci, "Low Returns in R&D Due to the Lack of Entrepreneurial Skills," a rare paper in the growth literature to explicity address the role of entrepreneurs in converting basic science inventions into market-ready innovations (see this for description of the practical realities)
• & best of all, Martin Weitzman, "Hybridzing Growth Theory" and "Recombinant Growth," for linking combinatoric possibilities (ref. Schumpeter's characterization of entrepreneurship) to growth, and connections to earlier, highly prescient work by Weitzman on the Soviet Economy.

These are but a few among many others, of course.