This resistance to the idea that a country’s balanced growth rate is not easily influenced by policy is perhaps to be expected. But it misses the subtlety of Solow’s thinking, in multiple ways. First, Solow is asking what drives technological upgrading in countries already at the cutting edge. Presumably the flow of new ideas is a big part of growth for these countries, and it is not clear why ideas should stop at the border. A new product invented in Germany could be simultaneously developed for production in several other countries, possibly by local subsidiaries of the mother company. Productivity would then go up more or less equally in all these countries, even though the invention came from only one of them.
Second, he is talking about growth after countries get to their balanced growth path, and while this might have already happened for some of the richer countries, it is probably a long way away for the ones where capital is still scarce. By the time Kenya or India gets to Solow’s balanced growth path, they necessarily would be much richer and be using many or all of the latest technologies. Their current technological backwardness could just be a symptom of their lack of capital.
Finally, and this might be the hardest piece to wrap one’s head around, countries on the way to the balanced growth path could actually be upgrading their technologies faster than those already there. Of course, the most showy breakthroughs, the self-driving cars and 3D printers of the day, will always be in the more advanced countries, but most technology upgrading is just moving from day-before-yesterday’s technology to yesterday’s. This is typically easier than pushing the frontier, precisely because it has already been done and we know exactly how to do it. It is a matter of pulling things off the shelf rather than coming up with something new.
For all these good reasons, Solow deliberately opted to punt on what drives differences between the balanced growth rates of different countries. He simply assumed the rate of improvement in TFP was a product of mysterious forces that had nothing to do with the countries, their culture, the nature of the policy regime, and so on. This meant he had very little to say about what we can do about long-run growth once the process of accumulation of capital has run its writ and the return on capital is low enough. Solow’s was what economists call an exogenous growth model, where the word “exogenous,” meaning driven by outside effects or forces, acknowledges our inability to do anything about the long-run growth rate. Growth, in short, is beyond our control.
GIVE ME A LEVER26
It was a combination of the evidence that many poor countries were not growing and the Solow model’s inability to say something useful about how to affect long-term growth that eventually made economists look elsewhere. They desperately wanted to be able to say something about what could help countries grow. As Robert Lucas, one of the doyens of the Chicago school of anti-Keynesian macroeconomics and one of the most influential economists of our times, confessed in his much quoted Marshall lecture in 1985, he would like to know “if there is some action a government of India could take that would lead the Indian economy to grow like Indonesia’s or Egypt’s? If so, what exactly? If not, what is it about the ‘nature of India’ that makes it so? The consequences for human welfare involved in questions like these are simply staggering: once one starts to think about them, it is hard to think about anything else.”27
But Lucas had more than just an aspiration to offer. He was also arguing that we are missing something important, and that the reason why India was poor could not all be because of a shortage of skills and capital. He recognized that India had less capital and skills than the United States, maybe because of its colonial history or the caste system. But to explain the enormous difference in GDP per capita between two countries based solely on lack of resources, those resources would have to be extraordinarily scarce. And if they were so scarce they should be very valuable. For example, the one tractor available would be used very intensively on hundreds of fields prepared by thousands of workers; the rental rate on this tractor would be extremely high. Based on this logic, Lucas computed that if the difference in GDP between the United States and India was to be explained by the scarcity of capital in India and nothing else, capital would have to be so scarce that its price (what is paid to the owner of the resources that finance the machines in the economy) would have to be fifty-eight times higher in India than it was in the United States.28 But in that case why wouldn’t all the capital in the United States move to India, he wondered. Since it evidently did not, he concluded the price could not in fact be that high. In other words, the intrinsic productivity of capital must be less in India than in the United States to explain why, despite its obvious scarcity, capital in India does not earn the kinds of astronomical returns that Lucas’s computation would predict—or to put it in Solow’s terms, TFP must be much lower in India.
Lucas was, perhaps unsurprisingly, being too optimistic about the functioning of markets. We now know that we live in a sticky economy where nothing moves very fast, and certainly not from the United States all the way to India. Nonetheless, some version of his basic insight has been rediscovered by many others who keep hitting up against the TFP puzzle. For one, if you simply try to explain the cross-country variation in GDP by the amount of resources in different countries, you will quickly realize that even though poor countries are indeed desperately short of skills and capital, their GDP per capita is even lower than this lack of resources would predict.29 In other words, poor countries are poor in substantial part because they make less good use of the resources they have, and even within poor countries some do better than others with the same resources. The question is why?
Paul Romer, a PhD student of Lucas’s, was one of the people inspired to respond to Lucas’s passionate plea that we have to find a better way to explain growth. What made it a challenge was that Solow’s answer rested on perhaps the two most basic ideas in economics. First, that capitalists invest in the pursuit of high returns; when and where returns go down, capital accumulation tends to go down as well. Second, that as capitalists as a class accumulate more and more capital, the productivity of capital becomes lower because there are not enough workers to work with it. In economics this is known as diminishing returns. It has a long pedigree. French economist Anne Robert Jacques Turgot, who was briefly France’s finance minister and one of the many experts who tried unsuccessfully to head off France’s headlong descent into the economic chaos that eventually precipitated the French Revolution, wrote about it in 1767.30 Karl Marx took it as a premise. As he saw it, this was why capitalism was doomed: the insatiable greed of the capitalist class in the pursuit of more and more capital will drive the return on capital into the ground (in Marxist parlance this is called the “falling rate of profit”) and precipitate the crises that eventually end capitalism.31
The assumption of diminishing returns makes a certain amount of intuitive sense. What is the point of acquiring new machines if there are no workers to operate them (or new engineers to program them, or salesmen to sell the products)? Of course, there are also counterexamples. Amazon clearly derives a lot of its ability to cut costs from the volume of its sales. Setting up the kind of storage and delivery systems it is famous for would not make sense if there were not a constant flow of demand for everything it sells, and to finance that it needs lots of capital. Amazon at a hundredth of its size could not possibly make money. In fact, Amazon made little or no money until it grew very large, and then profits soared. In July 2018, Amazon’s profit reached 2.5 billion dollars.32
Economists of Solow’s generation were aware of the possibility of increasing returns, which is how economists describe the idea that bigger is better (and the source of Amazon’s present dominance). But one obvious implication of increasing returns is that the biggest firms should be the most profitable, and therefore the best situated to undercut the others and push them out of the market. Such markets are doomed to end up with monopolies. This is indeed what is happening with the online retail sector. But while we do see some industries where t
here are also a small number of dominant players (social networks and hardware stores are both in this category), most important markets—cars, clothes, and chocolate, for example—have many firms. It is for this reason that economists have tended to shy away from theories that rely too heavily on increasing returns.
Romer wanted to stick with the idea that a single firm was still subject to the law of diminishing returns. His insight was that all we need to undo the Solow effect is to be able to assume that as a whole an economy with more capital also has a more productive capital stock. This could be true even if every firm faced diminishing returns and there was therefore no tendency for firms to become monopolistic behemoths. To explain how this might happen, Romer invited us to think of the production of new ideas in a place like Silicon Valley, though his paper was written years before Silicon Valley achieved its iconic status.33 Firms in Silicon Valley are very similar to the firms in Solow’s world except in one important way: they use less of what we usually think of as capital (machines, buildings) and more of what economists call human capital, essentially specialized skills of different kinds. Many Silicon Valley companies invest in clever people in the hope they will come up with some brilliant and marketable idea, and sometimes this indeed happens.
The usual forces of diminishing returns are present in these companies as well. Too many temperamental geniuses and not enough drudges to manage the cash and make sure the gaming during work hours remains in check, and you have a disaster on your hands. What is different, Romer argues, is the overall environment of the Valley. Ideas can be heard and overheard everywhere, in the coffee shops and wheatgrass bars, in parties and public transport. One stray thought expressed by someone you will never meet again might prompt another, and all of it cumulates into a set of ideas that have remade the world. What matters is not just how many smart people you work with, but also how many smart people you are competing with, or just happen to be around in the Valley as a whole. Silicon Valley, in Romer’s theory, is what it is because it brings together the best minds of the world in an environment where they can cross-pollinate each other. The increasing returns here are at the level of the industry, the city, or even the area. Even if every firm faces diminishing returns, doubling the number of high-skilled people in the Valley makes all of them more productive.
Romer argues that the same goes for all successful industrial cities: Manchester in the middle of the eighteenth century, New York and London during various periods of financial innovation, Shenzhen or the Bay Area today. In all of these places, he would claim, the force of diminishing returns that comes from the scarcity of land and labor (labor becomes scarce in part because land is scarce and therefore living in these places is so expensive) was defeated by the exuberant energy that comes out of learning from each other and coming up with new ideas. As a result, high growth can keep going forever as more and more high-skilled people come together, even without help from Solow’s mysterious exogenous productivity growth.
Getting rid of diminishing returns at the level of an entire national economy also helps us explain why capital does not flow to India. In Romer’s world, capital earns roughly the same return in India and in the United States, even though there is much less capital in India, because the standard law of diminishing returns helping India in Solow’s model is compensated for by the faster flow of ideas in richer economies. The question is whether this is just a clever intellectual maneuver, a comforting story we tell ourselves, or whether the force Romer emphasizes looms large in the world.
GROWTH STORIES
Before we get to that, it is worth pointing out something the careful reader might have already noted: as soon as we started talking about the theory of economic growth, the conversation just got a whole lot more abstract. Both Solow and Romer are telling stories about what happens to entire economies over long periods of time. To do so, they are telescoping an incredible amount of real-world complexity into as few building blocks as possible. Solow, for example, gives a central role to the idea of economy-wide diminishing returns. Romer, for his part, puts his money on the flows of ideas between firms, but we never get to see the ideas themselves, just their supposed benefits at the level of the entire economy. Given the sheer diversity of occupations, enterprises, and skills that constitute an economy, it is very hard to get a feel (let alone an empirical counterpart) for any of these very broad concepts. Solow wants us to think of what happens in an economy when the total capital available to it goes up. But economies typically don’t accumulate capital; individuals do. Then they decide what to do with that capital: whether to lend it out, start a new bakery, buy a new house, and so on. Each such decision changes many things; house prices may go up, bread prices may come down, good pastry chefs may become harder to come by. Solow wants to reduce all that complexity to one change: the change in the availability of labor relative to capital. Likewise, when a city gets an influx of tech people, many things change—you get better espresso, for one, and many low-income residents get pushed out—but Romer highlights just one key thing: the exchange of ideas. Both Romer and Solow may well be right in their guesses about what really matters, but it is difficult to map their abstractions into the real world.
To make matters worse, the data, which has been our main recourse so far, cannot help us very much here. Because the theories operate at the level of entire economies, our tests will need to compare different economies (countries or, at best, cities) rather than individual firms or people. As we discussed in the chapter on trade, this is always a challenge since economies tend to be different from each other in any number of ways, making them hard to compare.
Moreover, even if we were willing to draw conclusions from the comparison of entire economies to each other, it is not clear what we would learn. Take the idea of diminishing returns at the level of the economy. We want to test whether capital is less productive in a country that ends up with some extra capital. The problem once again is that countries don’t accumulate capital, individuals do. Those individuals may then invest that capital in firms. Those firms buy machines and buildings and so on, and then try to hire workers to make use of their newly installed capital. This increases competition in the labor market, forcing the firms to settle for fewer workers than they would want, which is what depresses productivity of capital. Now suppose we do observe that an inflow of capital made capital less productive. How can we be sure that the reason this happened is the one Solow has in mind? After all, it could be that the capital was invested in the wrong place and that is what made it unproductive. Or that it was never invested at all. Perhaps if it were invested properly, the return on capital would actually go up (and not down as Solow would have it).
Finally, a lot of the claims in growth economics are about what happens in the long run. In the long run, growth slows down in Solow’s world; it does not in Romer’s. But how long is long enough? Is it enough to observe a slowdown? Or could that just be a temporary blip, a piece of bad luck to be reversed soon enough?
So at the end of the day, although we will try to stitch together the best evidence for these theories, the result will be tentative. We have already seen that growth is hard to measure. It is even harder to know what drives it, and therefore to make policy to make it happen. Given that, we will argue, it may be time to abandon our profession’s obsession with growth. The most important question we can usefully answer in rich countries is not how to make them grow even richer, but how to improve the quality of life of their average citizen. It is in the developing world, where growth is sometimes held back by an egregious abuse of economic logic, that we may have something useful to say, though, as we will see, even that is very limited.
THE MILLION-DOLLAR PLANT
The key ingredient of Romer’s happy narrative was the spillovers: the idea that skills build on each other and that putting skilled people together in one place makes a difference. Clearly, this is something people in Silicon Valley believe. There are many parts of California prettier th
an Silicon Valley, and most are cheaper. Why do companies still want to locate there? States and cities in the United States and elsewhere offer large subsidies to attract firms. In September 2017, Wisconsin gave at least $3 billion in fiscal advantages to Foxconn to have it invest $10 billion in an LCD manufacturing plant.34 This is $200,000 for every job they promised to create. Similarly, Panasonic received more than $100 million to move its North American headquarters to Newark, New Jersey ($125,000 per job), and Electrolux was given $180 million in tax abatements to start a new plant in Memphis, Tennessee ($150,000 per job).35 The most recent example of this competition was the very visible scramble to attract Amazon’s second headquarters, HQ2. Amazon received 238 proposals from different locations before choosing Arlington, Virginia, and New York City.36 These 237 or 238 cities (depending on whether New York finally withdraws or not) clearly believe in spillovers.
Apparently, Amazon does too. In choosing the location for HQ2, Amazon listed a preference for (among other things) “metropolitan areas with more than one million people” or “urban or suburban locations with the potential to attract and retain strong technical talent.”37
Amazon’s theory seems to be that being in a “thick” market, a market where there are lots of sellers, in this case of skilled labor, is valuable, presumably because it is easier to find, retain, and replace workers.
Romer’s theory, you may recall, was more about informal conversations that occur when many people working on related topics are together. There is some evidence for such spillovers. We know, for example, that inventors are more likely to cite patents from other inventors in the same city, suggesting they were more likely to be aware of them.38
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