A Nobel prize for breaking through the hurdles placed by economists

This year’s Nobel Prize in Economics has been shared by Bill Nordhaus and Paul Romer for “integrating innovation and climate with economic growth.” That is one way to thread the needle to link these fine recipients and I applaud the Nobel Committee for finding a way to do it. That said, there is a real reason that Nordhaus and Romer should be linked and it turns on the way they have made their ideas persuasive — not to the general public or even politicians but to economists.

Back in the 1980s, both climate policy and science/innovation policy faced significant barriers moving forward. In each case, the main constituents who were holding up such policies were economists — they were trained in textbook tools of economics and had very strong influence throughout governments due to their ability to frame arguments. In the case of climate policy, while the science pushed for action, the big unknown was precisely what the economic cost of mitigating greenhouse gases would be. In the case of innovation policy, while the costs were known, the big problem was what the return would be. Thus, for each type of policy, economists who had won the push for cost-benefit analysis in government, were able to point out — somewhat accurately — that one-side of the equation was missing in each case. My personal opinion is that uncertainty should not necessarily be a barrier to action but when it comes to dealing with policy advocacy uncertainty is a weapon that can be used by special interests to generate inaction and, at the time, economists were the, perhaps unwitting, wielders of that weapon.

Let me start will Bill Nordhaus. If we choose to mitigate greenhouse gas pollution, it will impact all manner of activity in the economy. From energy to food production to transportation networks, the effects would be widespread and profound. They would impact on different regions differently. In other words, the economic impact was complex and hard to think through. And there was a possibility the costs could be overwhelming.

What Nordhaus did was embed climate change and climate policy into our general equilibrium models of economic growth. He then found ways to quantify the costs that everyone was hitherto conjecturing about. As it turned out, the costs were significant but nowhere near the doomsday assertions that interested parties opposed to climate policy were claiming. Even without technological change, there were existing ways economies could adapt to climate policy and, in the process, self-limit the costs that many were worried about. It moved the debate away from economic assertion and I guess pushed interested parties from “reasonable” arguments to “denialism,” thereby, exposing their naked interests more clearly. While progress has been far from what we would want, the progress that has happened can be attributed to this critical work.

Moving on now to Paul Romer. I have known Paul for 30 years since I was a graduate student. I was deeply interested in economic growth as an undergraduate and felt it had been neglected and was fortunate to be doing my PhD soon after Paul’s work had been published. It drove my interest further and into the fields of innovation and entrepreneurship that I have worked on since. There was even a time I contemplated an offer to join Paul’s education startup but that is another story.

Romer’s contribution is the inventing of what has become termed, endogenous growth theory. The first real theories of economic growth — starting with Robert Solow and Trevor Swan — examined how investment could generate growth and found that it could not explain the growth we had seen over the past two centuries. The missing component was technological change but they had no theory of it. It was well-known that science and innovation were not costless and so such activity would likely be driven by markets, competition and prices just as other economic activity was. But it was also known that these activities were special in that they generated positive externalities although some returns could be internalised through the use of formal intellectual property protection. Many people knew this was the missing ingredient in growth as documented by David Warsh’s terrific history of economic thought (including the contributions of Romer). As an undergraduate in Australia, even I saw this piece of the puzzle and, without knowledge of Romer and others, wrote my thesis about it leading to my very first published article.

I wasn’t the only one. Phillipe Aghion, Peter Howitt, Gene Grossman and Elhanan Helpman all saw it too and made their own separate contributions to endogenous growth theory. Those models, however, still, in many respects, had a microeconomic flavour that meant their main contribution would be to an understanding of how competition (and its potential limitors including patents) would impact on innovation in a growth context. This is very important but it was not as closely related to the growth puzzle that Romer was tackling.

Romer took his time making progress. His PhD thesis led to some technical advances that showed it was possible to have a balanced growth path — consistent with what we knew about economic growth — and also have a role for increasing returns. But to do things properly, the standard assumption of perfect competition was not going to cut it. And so in 1990 Romer published his most famous paper that (a) put the foundations of growth on a model of monopolistic competition (as those in trade theory and economic geography had done previously) and (b) divided the economy into a real and an ideas sector (something that no one had really done). In so doing, the Romer model was able to articulate and identify the key determinants of the returns to innovation.

The first was that the returns to innovation were limited by competition. Even with perfect patents, knowledge itself would promote entry and compete both for profits and scarce resources that limit the returns to past innovation and, as a consequence, to future innovation itself. The second was that by allocating resources — particularly science and engineering human capital — to the production of ideas, those limitations could be mitigated and economic growth itself would accelerate. In other words, front and centre for the promotion of economic growth was the direct promotion of science. Yes, science had been seen as a public good before. But now science was firmly seen as an engine of economic growth. Things that promoted the creation and, importantly, diffusion of scientific research were not just like the arts — there for consumption — but instead were an economy and indeed world-wide force for economic prosperity. To be sure, identifying the precise returns to any particular project would be difficult. But the idea that it is was critical to have a system for science and innovation promotion was now on a solid foundation.

As a person who was closely involved in economic policy in Australia on both the environment and innovation, it is difficult to understate how important Nordhaus and Romer’s work were. They were present in every, single policy discussion and tipped the balance towards action in cases where there were significant barriers and hurdles. In so doing, each showed how a careful accounting of economic forces can lead to progress, reduce uncertainty and make the case. That is what ties these two together and I am very pleased to see the Nobel committee recognising this long and sustained contribution to our knowledge and discourse.

Prediction Machines

My book with Ajay Agrawal and Avi Goldfarb is out now. It is called Prediction Machines: The Simple Economics of Artificial Intelligence.

We have written some pieces that provide little excursions into the book.

Also, we had a book launch and a video of it is available here.

Suffice it to say, if you like the material in this blog, it is a safe bet that you or your robot partner will like this book.

Boehmermann vs Erdogan – an update

You might remember the case of German comedian Boehmermann and the poem with which he demonstrated what you could, by then-German law (paragraph 103 StGB, the Criminal Code), *not* say about high-office holders abroad. Because the poem targeted him, and since wanna-be dictators like him tend to lack a sense of humor, Turkish PM Erdogan fell into the trap and took Boehmermann to court, demanding at the same time that all traces of it, and the earlier brilliant song that motivated it, be removed by the German government. Much hilarity ensued. Also much publicity for both, the song (now at more than 12 million views on youtube alone) and the poem.

That obscure paragraph 103 StGB with which Erdogan tried to silence Boehmermann goes back to 1871 and had been invoked only a few times previously. Equally obscure, and absurd, was paragraph 104a which stipulated that the government must decide whether it allows the complaint to go forward under 103. Merkel copped much opportunistic criticism, mostly from spectacularly ill-informed media writerlings and pollies, for her considered decision to let the suit go ahead, arguing correctly that it was not her job to decide whether Boehmermann had run afoul of paragraph 103 StGB.

I predicted then – confidently, because clearly the poem was meant to illustrate what you were *not* allowed to say — that Erdogan did not stand a chance. And sure enough he never did.

It must have been quite the lesson for Erdowahn. Be it only for the additional wave of ridicule it generated.

As of January 1, 2018, that silly paragraph in the criminal code (StGB), is gone for good. A  pity really because teachable moments for wanna-be dictators are few and far between.

Lessons to be learned: First, in a functioning democracy, satire can be used to speak truth to power even if that power feels perpetually offended. Second, a bit of knowledge of what laws say carries a long way. Spectacularly ill-informed opinions about what ought to be done, not so much. Third, a bit of sound game-theoretic reasoning carries a long way. Almost always.

Congrats Andreas and Kyoung-hee

Andreas and Kyoung-hee
Andreas & Kyoung-hee

This past weekend was a very busy one for our fellow blogger Andreas Ortmann. He embarked upon a new research program, his most ambitious ever. It is completely ‘blue sky’ exploratory work and is going to cost so much that the Australian Research Council will not fund the project. The review panel also noted that it lacks a control sample, that it did not include planned repetition, and that the use of models was apparently not entertained. So yes, Andreas has just tied the knot with my ex-schoolmate from MIT, Kyoung-hee Yu. In a room filled with economist and management scholars who managed to get along without incident (probably because of the lawyers and an anthropologist who kept the truce), Andreas and Kyoung-hee began their journey together with lots of wine, a delicious cake, and lots of rejoicing. Congratulations Andreas and Kyoung-hee. May your journey together be filled with happiness.

Migrants v babies

In today’s Age, Ross Gittins argues the economic case for less immigration based on the impact on the environment and aggregate demand. But he commits a surprising sin: he fails to consider what the best way to manage aggregate demand and the environment would be as opposed to pointing out what immigration does to them. Indeed, he claims that immigration accounts for half of our population growth. But it is population growth that is the bigger issue. And the obvious solution is to curtail the other half of population growth — the so-called natural half. Let me edit his article accordingly:

immigration birth adds more to the demand for labour than to its supply.

That’s because migrant families with children add to demand, but only the individuals who work add to supply.

Migrant families with children need food, clothing, shelter and other necessities. They also add to the need for social and economic infrastructure: roads, schools, health care and all the rest.

Another factor is that their addition to demand comes earlier than their addition to labour supply. The rate of unemployment among recent immigrants babies is significantly higher than for the labour force generally.

Of course, I have to spot there because the rest is about skilled migration and let’s face it, babies ain’t skilled. So the case here is for reduced natural population growth as opposed to immigration.

Indeed, that case becomes stronger. Here is Gittin’s argument on the environment:

It’s obvious that one of the quickest and easiest ways to reduce the growth in our emissions — and make our efforts to cut emissions more effective overall — would be to reduce immigration.

It is not obvious at all. It is simply wrong. If people cause emissions and emissions are a global problem, then at first glance moving people from one country to another neither helps nor harms the environment.

More on vertical mergers

I note by way of interest that Henry Ergas has responded to my comments taking issue with some of his initial thoughts on the ACCC’s draft merger guidelines. He notes that my (i) argument that studies of vertical mergers may be biased towards seeing them as favourable may not be so strong (especially as bad mergers get through: something I argued was the case with AGL-Loy Yang) and (ii) that AGL-Loy Yang wasn’t a bad merger. I can see his point on (i) but that reduces but doesn’ eliminate such biases. On (ii), I refer back to my recent work with Frank Wolak that actually looks back at what happened after AGL-Loy Yang and confirms that the ACCC’s predictions of 20 percent price rises were largely borne out. In any case, I reiterate my view that it is precisely because vertical mergers have ambiguous consequences that merits the ACCC spending extra time being extra clear in how they will look at them and such emphasis is not misplaced. (By the way, one of these days Henry Ergas and I might agree on something. Will that mean we are both right or both wrong?)