Good Economics for Hard Times

by Abhijit V. Banerjee

  Despite this consensus, a memo from the government’s treasury department on the fiscal impact of the bill assumed (without any stated justification) an increase in 0.7 percent in annual growth rates from reducing taxation.59 How could they get away with a statement that had nothing to do with what anybody seriously believes? One answer, of course, is that it was not the only instance where the administration asserted a non-truth to support its decision. But we suspect that part of the reason the public so easily bought into the idea that tax cuts for the wealthy lead to economic growth is that they have heard this particular message for so many years, from so many prominent economists of a previous era. In those days, evidence was scarce and it was normal to argue from “first principles” based on intuition and no data. The repetition of this mantra by generations of serious economists has given it the soothing familiarity of a lullaby. We still hear it every day from a gaggle of business experts, who even today feel unconstrained by the data. It is now part of the “common sense.” When we asked respondents in our survey the question similar to the one asked by the IGM booth panel, 42 percent of respondents agreed or strongly agreed with the proposition the tax cut would increase growth within five years (only one economist did). Twenty percent of our respondents disagreed or strongly disagreed.

  It did not help that nine conservative academic economists, mostly with solid reputations but also part of this older generation, wrote a supporting letter to the administration arguing that growth would go up and “the gain in the long-run level of GDP would be just over 3 percent, or 0.3 percent per year for a decade.”60 It was immediately pointed out that this letter was based, once again, on first principles and a very selective reading of the empirical literature.61 But it was so much in line with what the public and the press expect from economists that it sounded perfectly legitimate.

  Once again, this underscores the urgent need to set ideology aside and advocate for the things most economists agree on, based on the recent research. In a policy world that has mostly abandoned reason, if we do not intervene we risk becoming irrelevant, so let’s be clear. Tax cuts for the wealthy do not produce economic growth.

  DEFORM BY STEALTH

  While the tax changes at least are happening in the public eye, there is another very major transformation in the US economy that could have a direct bearing on growth: the increasing concentration of economic activity. The driver of long-run growth, in the Solow and the Romer models, is technological innovation. It is because people constantly invest in new products or new better ways of doing things that TFP grows, and the economy grows with it. But, as Aghion and Howitt reminded us, innovation does not come out of nowhere; someone needs to have a financial incentive to invent something new.

  Companies that innovate need access to markets to sell their products. And some evidence suggests this is becoming increasingly difficult for new entrants. At the national level, most sectors (including technology, but not only) are increasingly dominated by a few companies. A 2016 report by the Council of Economic Advisers, for instance, finds that the share of the top fifty corporations in the national revenue of each of their sectors increased across most sectors between 1997 and 2012.62 This concentration is largely accounted for by a growing share of the “superstars,” partly the result of a fairly liberal attitude on mergers in the United States.63 For example, the share of the top four companies in a sector’s revenues has increased in every sector. In manufacturing, the top four accounted for 38 percent of revenues in 1980 and 43 percent in 2012. In retail trade, the share more than doubled, moving from 14 percent to 30 percent.64

  It is not entirely clear that this increased concentration has been bad for consumers. Depending on the data source and computation methods, some economists find huge increases in markups65 (the difference between what a firm charges and its costs) but others do not.One thing that has protected consumers is that in the retail sector there has been concentration at the national level but not at the local level. When Walmart or other superstores come to town, they displace some mom-and-pop operations. But this does not make the market less competitive for the final customers and superstores offer more varieties, often at cheaper prices.66 And Amazon has actually fostered intense competition among sellers on its platform.67

  But the problem with the increased concentration at the national level is that to the extent it reflects a decline in the competition faced by these behemoths, it may actually lead to reduced innovation because it creates higher barriers for new entrants to disrupt an industry. In the logic of Aghion and Howitt, the promise of (temporary) monopoly power, through a patent, spurs innovation, and this innovation in turn results in the new technologies everyone will eventually be able to use. This is what causes growth. But if monopoly is guaranteed forever anyway, innovation and growth may slow down; a monopolist can sit on their hands and never invent anything new. Some evidence suggests something like this is happening now. In particular, a study found that when a large planned merger and acquisition in a sector narrowly fails to happen for some unpredictable reason (the judge was not lenient enough or the deal fell through), the sector remains more competitive for several years afterward. These sectors with “near misses” see the entry of more new firms, more investment, and more innovation. This result does suggest that the relatively low growth in TFP may in part be explained by the increase in concentration.68

  GOING GLOBAL

  Even if the increase in industry concentration is partly responsible for the slowdown of growth in the United States, it would be unreasonable to conclude that breaking up monopolies will single-handedly restore fast growth. After all, growth has also been sluggish in Europe, and European regulators have been much more aggressive against monopolies. This illustrates, once again, the only clear lesson of the last few decades. We don’t understand very well what can deliver permanently faster growth. It just happens (or not).

  But if growth in rich countries is not about to explode, what will these countries (and, soon enough, middle-income countries like China or Chile) do with their increasingly abundant capital? The business community, which is sometimes smart enough not to buy into the ideological messaging it offers the rest of us, has been for some years focused on another way out for the abundant capital in its hands. We noticed this about twenty years ago, when, all of a sudden, businesspeople, perhaps sensing they could not count on reliable economic growth in the West, started to quiz us about the countries we knew best, which are all in the developing world. We had become inured to the slightly uncomfortable expression that appeared on the faces of most businesspeople as soon they found out what we do, which is study poor countries—they clearly wanted to find someone else who knew something more useful to them, and were trying to figure out how quickly they could dump us without causing offence. But, suddenly, a couple of decades ago, poor countries became interesting.

  They were interesting because some of them were growing fast, and any place growing fast needs investment, and that investment was a potential antidote to the specter of diminishing returns haunting the rich countries’ financiers. One way to prevent growth from slowing down is to send capital to the countries where productivity is high. That won’t help workers in rich countries, since the production won’t take place in their country, but at least national income will keep growing because capital owners will be paid well for their investment abroad.

  SOME GOOD NEWS

  Of course, for most economists and many businessmen, growth in poor countries is also important because of its implications for human welfare. The last few decades have been rather good for the world’s poor. Between 1980 and 2016, incomes for the bottom 50 percent of the world’s population grew much faster than the next 49 percent, which includes almost everybody in Europe and the United States. The one group that did even better was the top 1 percent, the rich in the already rich countries (plus an increasing number of superrich in the developing world), who collectively captured an amazing 27 percent of total growth in
the world GDP. For comparison, the bottom 50 percent received only 13 percent of global growth.69

  Nevertheless, perhaps fooled by the fact that they only see the rich getting richer, nineteen out of twenty Americans think world poverty has increased or stayed the same over this period.70 In fact, absolute poverty rates (the fraction of those living under $1.90 a day at PPP) have been halved since 1990.71

  This is undoubtedly in part due to economic growth. When people are extremely poor, it takes very little growth in their incomes to lift them up. Thus, even though they often got only the crumbs, those crumbs were enough to push them above $1.90 per person per day.

  This might be because the particular definition of extreme poverty we have been using sets too low a bar. But the story of the last three decades is not just one of poverty going down; we also see large and important improvements in the quality of life of the poor. Since 1990, the infant mortality rate and the maternal mortality rate were cut in half;72 as a result, more than a hundred million child deaths have been averted since 1990.73 Today, barring major social disruption, nearly everyone, boys and girls, has access to primary education.74 Eighty-six percent of adults are literate.75 Even deaths from HIV-AIDS have been declining since their peak in the early 2000s.76 The gains in income for the poor have not just been paper gains.

  The new “sustainable development goals” propose to end extreme poverty (those living under $1.25 a day) by 2030, and it is quite conceivable this target will be met, or at least we will get close if the world continues to grow anywhere near the way it has been growing.

  IN SEARCH OF GROWTH’S MAGIC POTION

  This shows how important economic growth remains for the very poor countries. For those who believe in either the Solow model or the Romer model, extreme poverty of the kind we still see in the world is a tragic waste, because there is an easy way out. In the Solow model, poor countries have the scope to accelerate their growth by saving and investing. And to the extent poor countries do not in fact grow faster than the richer ones, the Romer model tells us this has to be a consequence of their bad policies.

  As Romer wrote in 2008: “The knowledge needed to provide citizens of the poorest countries with a vastly improved standard of living already exists in the advanced countries.”

  He goes on to offer his growth masala:

  If a poor nation invests in education and does not destroy the incentives for its citizens to acquire ideas from the rest of the world, it can rapidly take advantage of the publicly available part of the worldwide stock of knowledge. If, in addition, it offers incentives for privately held ideas to be put to use within its borders—for example, by protecting foreign patents, copyrights, and licenses; by permitting direct investment by foreign firms; by protecting property rights; and by avoiding heavy regulation and high marginal tax rates—its citizens can soon work in state-of-the-art productive activities.77

  This sounds like the usual right-wing mantra: low taxes, less regulation, less government involvement in general, except perhaps in education and in protecting private property. And by 2008, when Romer wrote this passage, this was familiar ground and we already knew enough to be skeptical.

  During the 1980s and the 1990s, one of growth economists’ favorite empirical exercises became cross-country growth regressions. The game is to use the data to predict growth based on everything from education and investment to corruption and inequality, culture and religion, the distance to the sea or to the equator. The idea was to find what in a country’s policies could help predict (and hopefully affect) its economic growth. But that literature eventually hit a brick wall.

  There were two problems. First, as Bill Easterly, a vocal skeptic of the ability of “experts” to give any recipe for economic growth, has convincingly shown, growth rates for the same country change drastically from decade to decade without much apparent change in anything else.78 In the 1960s and the 1970s, Brazil was a front-runner in the world growth tables; but starting in 1980, it essentially stopped growing for two decades, before resuming in the 2000s, and stopping again after 2010. Lucas’s poster child for a country that failed to grow, India, started to grow faster more or less exactly when Lucas wrote the famous piece we quoted above, where he was puzzling over why growth in India was so low. For the last thirty years, India has been one of the growth stars of the world. Growth in the countries Lucas wanted India to emulate, Indonesia and Egypt, on the other hand, tanked. Bangladesh, famously described by Henry Kissinger as a “basket case” in the 1970s, has grown at a rate of 5 percent per year or more for most years in the 1990s and 2000s, and at above 7 percent in 2016 and 2017, which puts it among the twenty fastest growers in the world.

  Second, perhaps more fundamentally, these efforts to discover what predicts growth make very little sense. Almost everything at the country level is partly a product of something else. Take education, for example, one factor emphasized in the early cross-country growth literature. Clearly education is in part a product of the effectiveness of the government in running schools and funding education. A government good at delivering education is probably good at other things as well; maybe the roads are better in the same countries where teachers show up to work. If we find growth is faster where education is higher, it could be due to these other policies it tends to be bundled with. And of course it is likely that people feel more committed to educating their children when the economy is doing well, so perhaps growth causes education, and not just the other way around.

  More generally, both countries and country policies differ in so many different ways that in effect we are trying to explain growth with more factors than the number of countries, including many we may not have thought of or cannot measure.79 Consequently, the value of these exercises depends very much on how much faith we have in our exact choice of what we put in them. Given that we have very little to justify any of these choices, we think the only reasonable position is to forget the entire project.

  That does not mean we have not learned anything. Some of the most surprising results came from efforts to cleanly separate cause and effect. A classic pair of papers by Daron Acemoglu, Simon Johnson, and Jim Robinson (affectionately known as “AJR”) contains the most striking of these.80 They showed that countries where, in the initial years of European colonization, mortality among the early settlers was high still tend to do badly today. AJR argue that is because Europeans preferred not to settle there; instead they set up exploitative colonies where the institutions were designed to allow a small number of Europeans to lord it over vast numbers of natives who labored to grow sugarcane or cotton or to mine diamonds that the Europeans would then sell. By contrast, the places that were relatively empty to start with (think of New Zealand and Australia, for example) and where settler mortality from malaria and other such diseases was low, were the places where Europeans settled in large numbers. As a result, these places got the institutions the Europeans were then developing and that would eventually provide the basis of modern capitalism. AJR show that settler mortality several hundred years ago is an excellent predictor of, say, how business friendly contemporary institutions are in a particular country. And the countries that had low settler mortality once upon a time and are business friendly today tend to be substantially richer.

  While this does not prove being business friendly causes growth (it could be the culture the Europeans brought, or the political traditions, for example, or something else entirely), it does imply that some very long-run factors have a lot to do with economic success. This broad insight has been confirmed by a number of other studies, and indeed it is in some ways what historians have always insisted on.

  But what does all this tell us about what countries can actually do here and now? We learn that if you want high growth in the modern era, it is useful to have been largely empty and have had less malaria in the period between 1600 and 1900, and to have had large numbers of Europeans settle in your country (though that may have been cold comfort if you happened to be a nativ
e resident of the country at the time). Does it mean countries should try to attract European settlers in today’s very different world? Almost certainly not. The brutal indifference to local custom and lives that allowed settlers to promulgate their institutions in the pre-modern period is not likely to be available today (thank God for that).

  What this also does not tell us is whether it would help to set up a particular set of institutions today, because the evidence emphasizes institutional differences that have their roots in events that took place several hundreds of years ago. Does it mean institutions need to be developed over several hundred years for them to be effective? (After all, the US Constitution of today is a very different document than when it was written, enriched by two hundred years of jurisprudence, public debate, and popular involvement.) If so, must the citizens of Kenya or Venezuela just wait?

  Moreover, it turns out that among countries at roughly the same level of business friendliness, none of the conventional measures of good macroeconomic policy (such as openness to trade, low inflation, etc.—the kinds of things Romer wanted countries to adhere to) seem to predict GDP per capita.81 Conversely, while it is true that countries with “bad” policies grow slower, they are also more likely to have “worse” institutions by the measures used in this literature (less business friendly, for example), and therefore it is not clear if they are doing poorly because of policies, or because of some other side effects of their poor institutions. There is little evidence of policies having independent traction, over and above the effects of institutional quality.