Good Economics for Hard Times

by Abhijit V. Banerjee

  The fact that two brilliant minds come to such radically different conclusions about growth highlights what a vexing topic it has been. Of all the things economists have tried (and mostly failed) to predict, growth is one area where we have been particularly pathetic. To name just one example, in 1938, just as the US economy was going back into high-growth mode after the Great Depression, Alvin Hansen (who was not a nobody; he was the co-inventor of the IS-LM model most students of economics will remember from their first macroeconomics class, and a professor at Harvard) coined the term secular stagnation to describe the state of the economy at the time. His view was that the American economy would never grow again because all the ingredients of growth had already played out. Technological progress and population growth in particular were over, he thought.16

  Most of us today who grew up in the West grew up with fast growth or with parents used to fast growth. Robert Gordon reminds us of our longer history. It is the 150 years between 1820 and 1970 that were exceptional, not the period of lower growth that followed. Sustained growth was virtually unknown until the 1820s in the West. Over the period 1500 to 1820, annual GDP per capita in the West went from $780 to $1,240 (in constant dollars), a paltry annual growth rate of 0.14 percent. Between 1820 and 1900, growth was 1.24 percent, nine times more than in the previous three hundred years, but still much less than the 2 percent it would hit after 1900.17 If Gordon is right and we end up with a 0.8 percent growth rate, we would simply be returning to the average growth rate over the very long run (1700–2012).18 This is not the new normal; it is just normal.

  Of course, the fact that sustained growth over a long time, the kind we saw over most of the twentieth century, was unprecedented, does not mean it could not happen again. The world is richer and better educated than ever before, the incentives for innovation are at an all-time high, and the list of countries that could lead a new innovation boom is expanding. It could well be the case, as some technology enthusiasts believe, that growth explodes again in the next few years, fueled by a fourth industrial revolution, perhaps powered by intelligent machines capable of teaching themselves to write better legal briefs and make better jokes than humans. But it could also be, as Gordon believes, that electricity and the combustion engine brought about a onetime shift in how much we can produce and consume. It took us some time to reach this new plateau and there was fast growth along the way, but we have no particular reason to expect this episode will repeat itself. Nor, we might add, do we have definitive proof it won’t. Mostly, what is clear is that we don’t know and have no way to find out other than by waiting.

  THE WAR OF THE FLOWERS

  Abhijit’s parents did not really believe in toys. He spent long afternoons playing war games with flowers. The buds of the ixora, with their long stems and pointy heads, were the enemy, purportedly throwing stones at his foot soldiers, the long and fleshy leaves of the portulaca. The tuberoses were the health workers, operating on the casualties of war with toothpicks and bandaging them with soft petals of jasmine.

  Abhijit remembers these as some of the most pleasurable hours of his day. That should surely count as well-being. But none of his enjoyment was captured by the conventional definition of GDP. Economists have always known this, but it deserves emphasis. When a rickshaw puller in Abhijit’s native Kolkata takes the afternoon off to spend time with his lady love, GDP goes down, but how could welfare not be higher? When a tree gets cut down in Nairobi, GDP counts the labor used and the wood produced, but does not deduct the shade and the beauty that are lost. GDP values only those things priced and marketed.

  This matters because growth is always measured in terms of GDP. The year 2004, when TFP growth, after jump-starting in 1995, slowed down again, is when Facebook began to occupy the outsized role it currently plays in our lives. Twitter would join in 2006 and Instagram in 2010. What is common to all these platforms is the fact that they are nominally free, cheap to run, and wildly popular. When, as is now done in GDP calculations, we judge the value of watching videos or updating online profiles by the price people pay, which is often zero, or even by what it costs to set up and operate Facebook, we might grossly underestimate its contribution to well-being. Of course, if you are convinced that waiting anxiously for someone to like your latest post is no fun at all, but you are unable to kick the Facebook habit because all your friends are on it, GDP could also be overestimating well-being.

  Either way, the cost of running Facebook, which is how it is counted in GDP, has very little to do with the well-being (or ill-being) it generates. That the recent slowdown in measured productivity growth coincides with the explosion of social media poses a problem, because it is entirely conceivable that the gap between what gets counted as GDP and what should be counted in well-being widened exactly at this time. Could it be there was real productivity growth, in the sense that true well-being increased, but our GDP statistics are missing this entire story?

  Robert Gordon is entirely dismissive of this possibility. In fact, he reckons Facebook is probably responsible for part of the productivity slowdown—too many people are wasting time updating their status at work. This seems largely beside the point, however. If people are actually much happier now than they were before, who are we to pass judgment on whether it is a worthwhile use of their time and therefore whether it should be included in well-being calculations?19

  INFINITE JOY

  Can the missing value of social media compensate for the apparent productivity growth slowdown in rich countries? The difficulty of course is that we have no idea how much value to assign to these free products. But we can try to estimate what people would be willing to pay. There are attempts to do this by looking at, for example, how much time people spend browsing on the internet as a proxy for how much they value it. The idea is that people could be working and earning money instead. If we follow this approach, the average annual value of the internet for an American went from $3000 in 2004 to $3,900 in 2015.20 If we were to add this missing bit to the 2015 GDP, one could explain about one-third of the $3 trillion of “lost output” in that year (compared to what the GDP would have been if the post-2004 slowdown had not happened).21

  One problem with this way of getting at the consequences of the internet is that it assumes people have the option of working longer hours for more money instead of spending time on the internet. But this is not true for most people with nine-to-five jobs; instead they need to find ways to keep themselves amused (or at least out of trouble) for another eight hours or so every day. If they spend time on the internet, all this means is they like it more than reading a book or hanging out with friends or family. If they are not particularly sociable and don’t like books, this is hardly a ringing endorsement; it may be worth much less than $3,900.

  However, there is also the opposite problem. Take someone who cannot imagine life without the internet, who needs an hour of Twitter fix every morning. That first hour brings almost infinite joy. But by the end of that hour all the enemies have been nailed, and every clever twist of phrase has been processed and passed on. What is left for the second hour is much more ho-hum, so much so that there is never a third hour. Compare that person with someone who also spends two hours desultorily responding to Facebook posts by or about friends half-forgotten and “friends” they would like to forget. In the data both will show up at the same place, valuing the internet at the price of two hours of time. But obviously they are different, and treating them the same may lead us to vastly underestimate the value of the internet.

  Faced with the possibility that we could be either massively overvaluing the internet or the other way around, scholars looked for other ways to measure its value to consumers. In particular, there were several randomized control trials of what happened when the experimenter (with the permission of the participant) blocked access to Facebook (or social media more generally) for a random group of individuals for some relatively short period of time. The biggest of these experiments, which involved more than
two thousand participants paid to deactivate Facebook for a month, found that those who stopped using Facebook were happier across a range of self-reported measures of happiness and well-being and, interestingly, no more bored (perhaps less). They seemed to have found other ways to keep themselves amused, including spending more time with friends and family.22

  When Facebook access was restored after the experiment, those who spent a month without it were slow to return to their Facebook habit, and after several weeks were spending 23 percent less time on the app than they had before the experiment. Consistent with this, the estimate of how much they would need to be paid to give up Facebook for a second month was substantially lower at the end of the first month (after experiencing life without Facebook) than before.

  All of this seems very consistent with the view that Facebook is addictive in the sense that it is hard to imagine life without it, but when you do give it up, things are not obviously worse. However, it is interesting that after the month of abstinence, the experimental subjects still wanted to be paid to give up Facebook; they did not simply feel grateful to be rid of it. The researchers assumed this was because they actually missed it, if less than they had expected, and therefore concluded Facebook generates over $2,000 of well-being per user.

  How does this square with the fact that getting cut off made people happier on average? In part of course, like all averages, it hides the fact that some people really enjoy Facebook. Moreover, it is likely that what was costly for the participants was in part being the only one among their friends who was now off Facebook, and this inconvenience probably got worse the longer one was absent (it is okay to take a sabbatical from your social connections, but checking out totally is costly). If Facebook did not exist, the problem would not be there.

  Where does that leave us? Not quite at a resolution. What we can say with some confidence is that Facebook is not the obvious win for all mankind as its devotees would have it, though people still value it more than they pay for it, at least in the current configuration where all their friends are on Facebook, Instagram, and/or Twitter. Could it be that if we valued these new technologies at their “real value,” growth would appear to be much faster? Probably not, based on the evidence at hand.

  What we can say with some confidence is that there is nothing in the available evidence promising a return to the kind of fast growth in measured GDP that characterized the Trente Glorieuses in Europe and the golden years in the United States.

  SOLOW’S HUNCH

  This should not come as a complete surprise. Remarkably, at the height of postwar growth, in 1956 Robert Solow wrote a paper suggesting growth would eventually slow down.23 His basic point was that as per capita GDP goes up, people save more, and therefore there is more money to invest, and more capital available per worker. This makes capital less productive; if there are now two machines in a factory where there was only one, the same workers will have to operate both at the same time. Of course, a single factory can hire more workers if it gets more machines. But the whole economy cannot (assuming migration remains unchanged), once its reserve of underused workers is exhausted. Therefore, the extra machines bought with the additional savings will have to be worked with fewer workers. Each new machine and as a consequence each additional unit of capital will contribute less and less to GDP. Growth will slow down. Furthermore, the lower productivity of capital lowers its financial return, which in turn discourages savings. So eventually people will stop saving and growth will slow down.

  This logic operates in both directions. Capital-scarce economies grow faster because new investment is highly productive. Rich economies, which are, in general, capital abundant, tend to grow more slowly because new investment is not as productive. One implication of this is that any large imbalance between labor and capital should get corrected. Economies overabundant in labor grow faster, and since incomes grow faster, savings do as well. So these economies accumulate capital faster and become more capital abundant. By the reverse argument, economies with too much capital relative to labor accumulate capital more slowly.

  As a result, a sharp divergence between the rates of growth of capital and the labor force is not sustainable over the long haul because if, say, capital grows faster than the labor force, then the economy will have too much capital relative to labor, which will slow down growth. There can be imbalances in the short run (as we are witnessing today in the United States where the share of the GDP paid to the labor force is falling24), but in the long run there is a natural tendency for economies to stay close to a balanced growth path, where labor and capital grow at roughly the same rate, and so does human capital—the part of capital embodied in the skills of the workers, for very much the same reason. Solow argued that GDP (which is after all the product of labor, skills, and capital) would also grow at the same rate as well.

  Now, the growth of the effective labor force is determined by past fertility and how much people want to work, both factors that seemed to Solow to be more driven by demography than economics, and therefore more related to a country’s history and culture than to the current state of its economy or economic policy. However, there is also the improvement of TFP—if one worker becomes so productive that he can do the work of two, because of improvements in technology, then the effective labor force would have doubled. Solow assumed such transformations were also unrelated to contemporary economics and policies of the country, in effect placing the growth rate of the effective labor force outside the realm of economics. This is why he called it the “natural rate of growth,” and from his theory, we know that GDP must also grow at the same rate as the effective labor force in the long run; that is, at the natural rate.

  A number of implications follow from Solow’s theory. First, growth is likely to slow down after a phase of fast growth that follows a dramatic transformation, once the economy is back on the balanced growth path. This is clearly consistent with what happened to Europe after 1973. After the wartime destructions, capital was scarce and Europe had a lot of catching up to do; by 1973 the era of catch-up growth was over. In the United States, the kind of investment-driven growth Solow had in mind clearly slowed down after the war, but conveniently its place was taken by rapid TFP growth until 1973. Since then, as we already discussed, there has been a slowing trend even in the United States. Interest rates have been falling throughout the West, reflecting, it seems, an abundance of capital, exactly as in the Solow model.

  CONVERGENCE?

  The second implication of Solow’s theory, and perhaps the most striking, is what economists call convergence. Countries scarce in capital and relatively abundant in labor, like most poor countries, will grow faster because they have not yet reached their balanced growth path. They can still grow by improving the balance between their labor and capital. As a result, we would expect the difference in GDP per worker across countries to be reduced over time. All else being the same, poorer countries will catch up with their richer counterparts.

  Solow himself was careful to stop well short of promising this. If a country has a lot of labor and very little capital, which is how many poor countries start out, then only a fraction of the labor force will be employable at a wage sufficient to ensure their subsistence (there may be nothing for the others to do), and as a result the country will not benefit much from its labor abundance. Convergence, if it happens at all, may be very slow.

  Notwithstanding Solow’s warnings, this vision of an orderly transition from dire poverty to relative wealth as the countries catch up and then go on to the nirvana of balanced growth, combined with the promise of global convergence in living standards, provided such a comforting narrative for progress under capitalism that it took some thirty years before economists started noticing the model did not fit reality all that well.

  To start with, it is not true that poor countries as a rule grow faster than richer ones. The correlation between GDP per capita in 1960 and subsequent growth is very close to zero.25 How does this square with the f
act that after the war Western Europe caught up with the United States? Solow had a possible answer. What his model actually says is that countries that are otherwise identical will head toward each other. This could be why Western Europe and the United States, which are very similar in many ways, converged toward each other. On the other hand, in Solow’s world countries that are naturally thriftier than others and invest more of their output will be richer in the long run. Moreover, for a while, before settling down to grow at the natural rate, initially poor countries that invest more will also grow faster as they converge toward this higher level of GDP per capita.

  Could the lack of investment be the one reason the developing world differs from Western Europe and the United States? As we will see, the answer seems to be no.

  GROWTH HAPPENS

  The third and most radical prediction from Solow’s model is that the growth rate of GDP per head among the relatively rich countries, once the economy reaches balanced growth, may not be very different. Essentially, in Solow’s world these differences must come from differences in TFP growth, and Solow believed that, at least for these rich countries, TFP growth should be more or less the same.

  In Solow’s view, as mentioned above, TFP growth just happens—policymakers don’t have very much control over it. This was something many economists were not entirely happy about. Given that growth rates are the language in which the league tables of international competition are written, there was something rather off-putting about Solow’s refusal to offer some assurance that TFP would be higher for countries that pursue “good” economic policies. Was he just being deliberately quixotic? After all, don’t we see many more of the latest technologies being deployed in the richer countries?