Non-rival ideas: Great for growth theory, but not for growth practice

This long post is drawn in part from prior work of mine on entrepreneurship and economic growth including "The Simple Economics of Technology Entrepreneurship: Market Failure Revisited."I was prompted to write it by this article in The Atlantic, which put me over the limit of exasperation with uncritical views of the actual contribution to the study of development made by "new growth theory." 

If nature has made any one thing less susceptible than all others of exclusive property, it is the action of the thinking power called an idea… He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me. That ideas should freely spread from one to another over the globe, for the moral and mutual instruction of man, and improvement of his condition, seems to have been peculiarly and benevolently designed by nature…

—Thomas Jefferson, Letter to Isaac McPherson, August 13, 1813

As anyone who has been within a mile of a macroeconomics course in the past two decades is well aware, the big idea in growth theory in the past 20 years is something called endogenous growth. This is the insight that economic growth to technological and organizational innovation doesn't come out of nowhere. It actually requires work and investment.

Yes, that's the big insight.

Anyhow, the device that allows societies to escape the inevitable boundedness of any given project or set of projects and grow far into the future is something call "increasing returns to scale." This property allows some outputs of human intiative--notably, new ideas--to add more to economic outcomes than it takes to produce them. Ideas are particularly interesting because they are, in technical parlance, "non-rival": one person's use of an idea does not diminish its usefulness to someone else. As Thomas Jefferson noted two centuries ago (see above): "He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me." Credit for this insight usually goes to Stanford economist Romer, on the based of set of more-or-less papers based on his dissertation that he published between 1986 and 1994.

This concept of non-rival ideas is intuitively obvious and seemingly interesting--even if it wasn't really Romer's. (Ref. the work of Karl Shell.) Only one problem: In it's usual application to growth, it's mostly wrong.

Here's why: While codified knowledge (books, published patents) may be non-rivalrous, in most cases it is either excludable (patents, documents protected by trade secret) or not directly applicable to production (basic research papers). The exceptional cases of published, unprotected "designs" are for obvious reasons, not likely to offer significant opportunities for entrepreneurs--unless combined with other information in novel and not easily imitable ways. (The phenomenon of "orphan drugs" is illustrative.)

Furthermore, patent protection is available to innovators in all industries, yet significant inter-industry differences exist in the extent to which patents allow persistence of profits. The differentiation is due to ease of imitability, which in turn relates to technological complexity. As MIT economist Rebecca Henderson and colleagues noted in a paper a decade ago:

[R]apid imitation of new drugs is difficult in pharmaceuticals for a number of reasons. One of these is that pharmaceuticals has historically been one of the few industries where patents provide solid protection against imitation. Because small variants in a molecule's structure can drastically alter its pharmacological properties, potential imitators often find it hard to work around the patent. Although other firms might undertake research in the same therapeutic class as an innovator, the probability of their finding another compound with the same therapeutic properties that did not infringe on the original patent could be quite small."

With regard to codified knowledge that is partially excludable, a critical issue is the extent to which partial imitation, or copying, preserves the quality of the original. In many, perhaps the majority, of economically important contexts, it will not.

In recent years economists, sociologists, geographers, and historians have addressed the transmission of knowledge, particularly increasing returns due to knowledge spillovers, in a large and varied literature. The empirical work on knowledge spillovers and parallel historical work have documented what the theorical work largely missed: the decline, during the twentieth century, of small scale craft-based production, and the corresponding rise of science based innovation and complex system development projects.

Consider Alfred Marshall's formulation of knowledge would be "in the air," frequently cited as the original articulation of the concept of knowledge spillovers. For craft-based production---glass making in Bohemia (Czech Republic), Champagne in Rheims (France), windmill production in Herning (Denmark)---there are solid reasons to believe that knowledge is "in the air." Masters share tacit knowledge with apprentices, whose core capability lies in replicating centuries-old techniques. New approaches are viewed with suspicion, and are accepted in to common practice only after considerable scrutiny. Science-based innovation and system development are another matter.

That Marshall's observations predated Romer's by nearly a century is of significance. The introduction of new products today (as opposed to a century ago) typically involves overcoming both technical and market risks. When products are based on truly novel technology, or create new markets, their introduction often requires new organizational forms. The knowledge that drives long term growth in a modern economy is thus detailed, highly technical, and context specific. It is an asset of the firm, whose development may be a consequence of explicit investments, "passive learning," or both. Ideas that are easy to copy will do not represent opportunities for entrepreneurs.

Yet to the extent that the knowledge developed by an incumbent firm is the solution to a complex problem, even slightly imperfect copying will likely lead to substantially degradation of performance. Active investment may be required to develop the "absorptive capacity" needed to make use of the information.

Whether knowledge about modern science based innovations is "in the air" or not is---literally and figuratively--immaterial. Only specialists will understand what it means.

A Response to "Why Sharing the Wealth Isn't Enough"

In his column today prompted by the Billionaire's Giving Pledge, Steven Pearlstein of the Washington Post kindly referred at length to an essay that Zoltan Acs and I published in The American Interest last Spring. Here's what Pearlstein had to say:

In an article last year in The American Interest, Philip Auerswald and Zoltan Acs of George Mason University suggested that the defining characteristic of American capitalism is not only an entrepreneurial culture that generates great wealth but also a philanthropic infrastructure that recycles that wealth in ways that create more opportunity, more growth and more wealth. This virtuous cycle, they concluded, is the "inner dynamic of American capitalism and the source of its prosperity." They contrast that to socialist countries, where philanthropy is weak and government takes on the recycling role, or less-developed countries, where oligarchs' fortunes are not recycled at all.

That's a pretty good summary. But Pearlstein isn't buying our case that philanthropic giving is a cornerstone of American capitalism:

Auerswald and Acs are known as institutionalists because of their focus on institutional arrangements and behavioral norms in explaining why economies work. Not surprisingly, their views have been embraced by business types and free-market conservatives who shamelessly use them to justify small government, low taxes and minimal regulation.

... Yes, philanthropy has been important, but so have unions, which ensured a fair distribution of corporate profits. So have antitrust laws that prevented successful companies from snuffing out entrepreneurial competition. So have norms of corporate behavior that made it socially unacceptable for top corporate executives to pay themselves 350 times what their workers made. And so have tax-supported schools, playgrounds and hospitals that were good enough to be used by rich and poor alike.

He goes on to point out that income inequality is increasing, the middle class is disappearing, and " it will take much more to revive the virtuous cycle by which wealth begets opportunity which in turn begets more wealth."

Considered in an historical context, I really don't disagree with much of what Pearlstein has to say. Indeed, I agree that "Sharing the Wealth Isn't Enough." Dewey the development of American public education? All for it. Unions, "the people who brought you the weekend"? Kudos.

But systems of public education are not distinctly American. Neither is organized labor. (Furthermore the same unions that once brought us the 40-hour work week have more recently shared culpability in bringing millions of U.S. manufacturing workers the less-desirable zero-hour workweek.)

What is distinctly American is a system of institutions--didn't really think of myself as an institutionalist, but I guess I am one--that allocates resources to successful entrepreneurial initiative, allows for the accumulation of wealth, and then--importantly--encourages the transfer of wealth back into the economy not only through consumption and investment (that was trickle down), but also through philanthropic giving. This is the process that brought us the National Gallery of Art, Harvard, Stanford, and now an expanding world of philanthrocapitalism that is funding some of the world's most promising entrepreneurial solutions to global challenges. But, of course, such a system does not arise out of nowhere. Political leadership and policy define the context and can be important drivers in advancing entrepreneurship and innovation. As Pearlstein himself has recently noted, even regulation and standard-setting--often incorrectly cast as an enemy of entrepreneurial initiative--can serve to drive innovation.

That's one thing. Another is that Pearlstein's lament about the hollowing-out of the American middle class--while accurate as stated--misses a bigger trend moving in the opposite direction. The fact is that, on a global scale and using measures that mean more than income, inequality has been shrinking dramatically. Skeptical? check out this 2007 talk by Hans Rosling (yes, I know I'm big into Hans Rosling right now):


The entirety of the experience of the United States over the last decade has been a sideshow to this larger global change, driven by increasing wealth in previously poor places (ref. e.g. Greenspan's "connundrum" and role of China's savings in our real-estate bubble).

Bottom line: Do I think that the U.S. at the moment could benefit from looking a tad bit more like Canada or (God forbid!) France? Along some dimensions, such as health care and standards for energy efficiency, I would say yes. But over the next quarter-century most of the world will benefit hugely from looking a lot more like the United States in at least this respect: building institutions to support entrepreneurs and celebrating philanthropists the put their wealth in the service of society.

People Are Not (Statistical) Noise

Bill Easterly had an interesting post yesterday about individual creativity and economic growth. It concludes

I learned from Herr Mozart that musical creativity, like economic growth, proceeds in fits and starts, and we should not be so obsessed with short term fluctuations.

Also I would not dare apply the words “random” or “lucky” to The Marriage of Figaro. Bursts of creativity, like bursts of rapid growth due to, say, entrepreneurial breakthroughs, may be temporary but they are not “random” in any mechanical sense. They reflect the best of humanity’s purposeful activity, and they stay with us forever even if the original creative moment is fleeting.

Bill's post is written at the level of analogy, which is fine. But there is in fact a real-world connection between individual creativity and change at the scale of particular communities or even entire societies. The nature of that connection is not only an interesting puzzle to ponder, but in my view the fundamental question in the study of economic development.

There are at least two ways of posing the question. The first is: Are people just noise? Creativity fluctuates at level of individual, but simple laws of statistical aggregation might seem to imply that societal outcomes should be smooth. They are not. So why does the law of large numbers not apply in cases of discontinuous societal change prompted by individual action? How is it that small-scale fluctuations in talent and creativity, both among people and within a single life, end up having large-scale impacts?

There a lots of answers in theory to this version of the question--herding & other types of increasing returns, chaotic dynamics, self-organization. There is also a rich tradition of addressing something like the same question in philosophy and literature (best in my view: second epilogue to War and Peace and Nietzsche's "Philosophy of History"). I also started in this direction using a culinary, rather than musical metaphor, a while back. These ideas could the be subject of multiple future posts, essays, or books...or, maybe, none at all. Because I don't think that this version of the question is the most interesting.

The interesting version of the question is a much more practical one, namely: Are entrepreneurs just noise? Easterly's earlier post re. system change suggest that they just might be. His link bait for that post: "The most important thing I can ever say: development is NOT about solutions, it IS about problem-solving systems."

An excellent recent post by @penelopeinparis gives solution-finders a bit more credit:

I don’t know for sure, but I suspect that when a bunch of crazy French doctors decided to create Doctors without Borders during the Biafra war, everyone around them must have thought they were absolutely off their rockers.

What about Henri Dunant, the idealistic businessman whose disgust with the horrors of Napoleonic wars lead to the creation of the Red Cross? (Did you catch that? Henry Dunant was a businessman with no experience in anything remotely connected to humanitarian aid)

There are several types of aid entrepreneurs; a fact that sometimes seems to get lost on critics and supporters of NGO entrepreneurs alike. Not everyone is an Henri Dunant, Bernard Kouchner or Greg Mortenson,...

The real question, for me, is how do we support the kind of innovation that does create positive change, all the while weeding out all the useless and potentially harmful amateurish initiatives?

I fully concur that this is the real question. Indeed, the direction @penelopeinparis appears to be going is, well, music to my ears.


UPDATE: @bill_easterly offers this pithy rejoinder via Twitter: "My response on giant potential scale: hello nonrival ideas"

People + Employment = Prosperity

Hans Rosling makes the population connection...

Alice Amsden makes the employment connection

Falling population growth rates---a plus for development---tend to respond more to changes in paid employment than to changes in poverty alleviation.

Conclusion:

People + Employment = Prosperity

The Truth About "Free Markets" and "Market Failure"

[I]t is possible to conceive of better worlds that the one in which we live. But the problem is to devise practical arrangements which correct defects in one part of the system without causing more serious harm in other parts.

—Ronald Coase, "The Problem of Social Cost"

These days everyone has an opinion as to what's wrong with "free markets" and what government should go about it.

On one end of the spectrum are those who remain persuaded that government intervention in the economy inevitably distorts private incentives, and thus that "free markets" function best when they are left alone. In other words, "If it ain't broke, don't fix it."

On the other end are these who believe that government must act assertively to curb market excesses and rein in corporate power. In other words, "It is broke. Fix it now."

A technocratic middle reconciles these two extreme viewpoints by invoking the concept of "market failure." The logic is presumably simple: a role for government exists if, and only if, a market failure exists. The burden to policy lies in establishing the nature of the market failure, and then specifying the mechanisms by which it can be corrected.

Unfortunately, none of these three rules of thumb is of much use as a guide to policy making in a world where markets are as temperamental as a tent-full of toddlers and market failures are as abundant as a bankrupt banker's bonus bag.

This is a problem. To illustrate with an analogy, let's say that the issue under consideration were treating cancer, instead of fixing markets. Suppose scientists understood what cancer is, and how to treat it. What if, instead of working with a definition based on science, every doctor decided to make up her own definition of cancer. For one doctor, it would be any illness that makes people suddenly lose weight. For another, it would be any illness resulting in death. Using the first definition, healthy people would be treated with chemotherapy. Using the second, treatment would only be offered to patients when already dead. Not good.

Similarly economists know what market failure means. However, at least some legislators in charge of its treatment exhibit a persistent disregard for the term's correct definition. As a consequence, where some may see potential government programs everywhere they turn, others only see them when conducting economic post-mortems--of which we have witnessed more than the usual number in the two years.

In its usage by economists, market failure is a concept that is defined in terms of "perfect competition." Contrary to caricature, perfection in this context here means a state of the world that is fundamentally unattainable, not one that is ultimately desirable. The conditions defining perfect competition are numerous: everyone is small relative to the market (no monopoly); all information is public (no secrets); there is no uncertainty or inter-dependency (no surprises); and transactions costs costs are zero (no lawyers). In another words, a fantasy land.

The entire point of creating such an idealized, fundamentally unrealistic model of markets was to provide a stable point of reference for the study of the real world, in all of its astounding diversity and complexity. Indeed, after the early 1970s, economists more or less stopped studying perfect competition. There was nothing left to study. Attention turned almost entirely to another topic: market failure. And what is market failure? Quite simply every situation that isn't perfect competition.

The first takeaway, then, is that the "market failure" test for government intervention is a misleading one. Market failures so permeate economic reality that "correcting" every one of them to arrive at a frictionless, riskless, perfectly efficient alternate reality is a dangerous fantasy.

The second takeway is those who seek naively to equate "free markets" with economic efficiency are engaged in horse-and-buggy reasoning that has no place in any serious, 21st century discussion of economic challenges and their solution. From the standpoint of economic theory backed up by decades of empirical analysis, there is absolutely no reason to presume that "free markets"--markets in which, for example, business opportunities exist and companies pursue them--are "efficient." This is because, under conditions of rigorously defined "perfect competition," business opportunities simply do not exist; there are no proverbial $20 bills lying on the sidewalk. Consequently, even in the total absence of any government intervention, substantial inefficiencies in market outcomes are to be expected whenever participants in markets don't share the same information, the practices of firms differ, and the environment is characterized by significant uncertainties.

To paraphrase the Nobel laureate Ronald Coase, well-designed policy must begin with a situation approximating that which actually exists. The situation that exists in any real-world market is one rife with "market failures." From such a starting point, a change in the market environment created by government may move the market either towards, or away from, efficiency (to say nothing of equity!). It certainly is possible to conceive of worlds in which market failures were less dominant. But the problem is to devise practical arrangements which correct defects in one part of the system without causing more serious harm in other parts.

Unsure? Ask your doctor.

(More to follow on the closely related topic of why "business-friendly" and "entrepreneur-friendly" environments are not the same.)

The Smartest People in the Room

I'm a person of simple pleasures. For instance, I count any day a success when I have the opportunity to use the word "eviscerate." Take Thursday. That was the day when I wrote this blog post about Presidential Study Directive 7 (PSD-7). In additional to employing the word "eviscerate," the post expresses considerable enthusiasm for the direction of the global development rethink currently going on at the White House.

Yesterday NYU development luminary Bill Easterly had the kindness to not only take notice of the post but also to point out to me that I managed to misrepresent a blog post by Aid Watch staffer Laura Freschi as one by the Maestro himself. (Arrghh. Guilty! Though, in my defense, how was I to know that anyone under the age of 50 could so persuasively convey the jaded air of a veteran development insider? Easterly trains his people well!)

It turns out that Easterly is considerably less sanguine than I am about the potentially transformative potential of PSD-7:

Professor Auerswald (sorry for my teasing you in this post), you do seem to have a theory of social change in which promises about government intentions to someday change priorities are a major force. My experience of many years of observing such statements is that they are more like New Year’s resolutions that are repeated every year.

My rebuttal to this? My counter-attack? None whatsoever. Easterly is right. My last post is probably mostly wishful thinking. What is the likelihood that awareness of the exigencies and opportunities of the moment will be enough displace entrenched bureaucracies and transform decades-old habits of thinking? What is the likelihood that an esoteric administrative exercise like PSD-7 will turn out to have made a difference in the lives of actual human beings? Even people like me who were actually born in Washington DC (yes, some of us exist) recognize the obstacles that stand in the way of such outcomes.

As Easterly is, I believe, aware from any one of my six previous posts calling into question the coherence--indeed the very existence--of his own theory of social change (1, 2, 3, 4, 5, and 6), I do not in fact hold the view that the United States government (USG) is likely to be a "major force" in global development. If anything, I would say that the causality is reversed: the point of my post, and a core point of this blog, is that global development will almost certainly be the major force affecting the United States in the next quarter century, whether the USG plans effectively for this eventuality or not.

So what was it about Freschi's post that motivated me to drop deadlines on that particular day and go on the offensive? It's pretty simple: I find it more than a bit depressing when The Smartest People in the Room refuse to leave the room in which they are the Smartest People. For instance, from Easterly:

I vaguely remember that I was invited to a meeting with a US government big shot on development whose name I’ve forgotten, to take place in Washington. I failed to do my patriotic duty, using the lame excuse that the meeting was two days before Christmas, and I unreasonably treat the days around Christmas as belonging to Family Zone.

After a lifetime working on development, might not Easterly have made it a priority to influence the most sweeping review of priorities in global development undertaken by his country's government in a decade, if not longer? After all, the government of the United States may not be much to Bill Easterly, but it's got more resources at its disposal than he does. No way to find an alternate time? Schedule a call? Write an email? Post a direct Tweet? Undertake a pinkie lift?

No. None of the above. Just not worth the time.

(Note: Bureaucrat appears to have been working two days before Christmas. Not everyone has the benefit, as Easterly and I do, of living by the academic calendar.)

In any process that involves difficult decisions with uncertain outcomes, those seeking solutions should welcome, even celebrate, the views of astute critics (in this case, Easterly). But when critics hold themselves apart from engagement in anything that might resemble positive action, one is sorely tempted to make sausage of their studied detachment.

Step 1: Eviscerate...

What it Means to "Elevate Development"

The White House process aimed at redefining U.S. development policy for the 21st century (known internally as Presidential Study Directive 7, or PSD-7) is coming to a close. Earlier this year some colleagues and I had the opportunity to offer input to Gayle Smith in the National Security Council, who was tasked with leading PSD-7, which we did.

On Monday Foreign Policy blogger Josh Rogin leaked a copy of the document that is coming out of PSD-7. Item one on the proposed new agenda for global development policy, as advanced in this draft, is this:

Moving forward, the United States will foster the next generation of emerging markets by enhancing our focus on broad based-growth and democratic governance.

To begin with, consider here what is not listed first on the nation's development agenda: "Poverty alleviation." "Nation-building." "Global threats." "Counter-terrorism." And other code words allegedly relating to "development" that are based alternately about fear & condescension.

Notice further that in this sentence "broad-based growth" is listed before "democratic governance." What does that mean? It means that the people who wrote this draft get it: expanded economic opportunity precedes democratic change. Both together lead to increased prosperity. That is development. (Elaboration here.)

Now as a counter-point, Bill Easterly [actually, Aid Watch staffer Laura Freschi, see below] offered his comments today. He focused on administrative structure:

The most significant change in the draft is the creation of interagency committee reporting to the President to run US development policy.

He wants to know what it means to “elevate development” as a “key pillar of US foreign policy.”

Here's my attempt at an answer to that question. "Development" today refers to the process by which the majority of the world's population is joining the global economy. It is a process whose momentum is going to overtake and obliterate puny debates about "aid" (pro and con) and eviscerate stale discussions about donor coordination and accountability.

"Elevating development" means taking (at least some!) decision-making away from those alleged development experts who pay no attention to entrepreneurship and global business (the actual drivers of development) and instead continue to devote their energies to making failed approaches less failed. (Yes, I am talking about pretty much every "development economist," Easterly included.)

It means that people who have not been accountable or serious about advancing actual development may potentially lose their authority, and then their jobs, because this is too big an opportunity for this country to be entrusted to people not determined to make the most of it. It is not only too big for one agency. It is also much too big for the entirety of the U.S. federal government--which, incidentally, will have succeeded if manages to remain relevant to global development in the next quarter century, much less dominant.

That is what this process is about. That is what the draft PSD-7 memo from the White House is about.

Now if you don't care about the role of the U.S. government in the world today, don't read this memo. If you do, its message is worth considering carefully. There is not an organization in this country that would not benefit from its own PSD-7 process, and that wouldn't also be moving forward if it similarly found a way to "elevate development" in its strategic planning.

Correction: ... Ummm ... well... as it turns out Bill Easterly didn't quite exactly write the post that I attribute to him in this blog post. As kindly pointed out to me by Bill, the post was actually written by Aid Watch staffer Laura Freschi. Apologies to Bill... and to Laura!