Category Archives: Great Thinkers

William Nordhaus, Paul Romer Win 2018 Economics Nobel Prize

Both of this year’s economics Nobel laureates have been on the short list for some time. Both are deserving, as David Henderson writes in The Wall Street Journal. Paul Romer is best known for his work on the nature of economic growth, and William Nordhaus for his environmental economics, as well as coauthoring, with fellow laureate Paul Samuelson, the 20th century’s most widely used economics textbook (a copy of the 18th edition sits on my shelf). In fact, my only surprise at hearing that Nordhaus won was that I mistakenly thought he already had.

Nominees are not always so deserving; the prize committee often uses the award to make a political statement. Paul Krugman, for example, the 2008 laureate, produced excellent scholarship earlier in his career on international trade. But he later ditched economics for political activism, to the point of famously switchingsides on policy issues based on which party proposed them. His strong partisanship almost certainly played a role in his prize—and its timing, announced in October of an election year.

More notoriously, the committee more or less had to give F.A. Hayek a prize due to the quality, quantity, breadth, and influence of his scholarship. But it felt the need to balance Hayek’s unfashionable pro-market views by co-awarding the 1974 prize to the anti-market Gunnar Myrdal, who publicly favored using eugenicsto improve the welfare state. Myrdal’s work led to more than 60,000 people being sterilized in his native Sweden, 90 percent of them women.

None of this should tar Nordhaus and Romer’s prize—I am not the only spectator who was surprised by the lack of political message their selections send. Their awards are merit-based, which speaks well both of their work and of the committee’s.

CEI scholars and fellow travelers will find much to disagree with in Nordhaus’ work—but in some ways he also echoes Julian Simon. The biggest criticism is that Nordhaus was an early advocate of a carbon tax. One sees its theoretical appeal to economists—it’s an attempt to create a missing market. But there are serious practical problems.

Nordhaus recently estimated that an ideal tax would be about $30 per ton of carbon emissions. But this sits inside a range of as low as $6 per ton to as high as $93 per ton. This 15-fold difference is a sophisticated way of saying “I have no idea.” Future estimates will also have to account for declining emissions in richer, and still-growing, countries without a carbon tax. And all this ignores public choice concerns. The politicians who would enact a carbon tax do not have strong incentives to act in the public interest, to put it mildly. Moreover, as Henderson notes, “the Nordhaus model shows that the cost of a policy to limit the temperature increase to only 2.7 degrees Fahrenheit by 2100 would have been $37.03 trillion—$16.4 trillion more than the cost of doing nothing after accounting for the damage done by carbon emissions.” So carbon tax opportunity costs are substantial, too.

But Nordhaus’ most famous article is brilliant, almost literally—it’s about light. It also captures the spirit of Julian Simon, as well as the larger reason why economics is worth understanding in the first place. In “Do Real-Output and Real-Wage Measures Capture Reality? The History of Lighting Suggests Not,” Nordhaus shows that macroeconomic statistics don’t capture the full spectrum of improvement in human well-being over history. His chosen example is artificial light.

Open fires were the dominant light source for most of human history. These often take a half hour for even an expert to build and require time-consuming wood foraging and chopping. The indoor air pollution wood and dung fires cause is still a leading cause of death in areas without electricity. Candles and fat- and gas-burning lamps came along later, and were a massive improvement. Electric light bulbs were even better. Even accounting for the fossil fuels they consume, these have a far lighter environmental footprint, are safer, and provide brighter, more consistent light with very low maintenance. Since Nordhaus’ 1996 article, the improvement has continued with LED technology that provides customizable color temperature and brightness, with less power consumption and longer bulb life. The process will almost certainly continue into the future.

Today’s better, safer light sources are also cheaper—much cheaper. Nordhaus calculates the first-generation compact fluorescent bulbs from 1992 were nearly 30,000 times cheaper, per lumen generated than the open fires our ancestors used. That’s not 30,000 percent, that’s 30,000-fold. And CFLs turned out to be a dud technology! Talk about first world problems. Current LED technology is even better. And this has improved the lives of more than just humans. Whales are grateful for the extinction of whale-oil lamps rather than themselves. Forests are grateful that campfires are today mostly an occasional novelty for wealthy city-dwellers, rather than the dominant global light source.

Nordhaus has often fallen into the blackboard economics trap that fells many a talented economist. But his article on the price of light teaches an important lesson that well deserves a Nobel. Official statistics understate human betterment. There is a vast tapestry of non-statistical improvements. Some of them can be quantified, such as the price of light over time. Others cannot, such as the incredible ease with which people can find music, movies, and books today, or the quality difference between a 1988 Camry and a 2018 Camry, accounting for inflation. There is a vast literature on this subject, and Nordhaus prominently influenced it.

Remember, human betterment is the core reason to study economics in the first place. People can’t become better off if they don’t know what causes the wealth of nations. GDP and other statistics are useful. But economists who focus too closely on them not only understate the amount of human betterment that sound economic policy enables, but they can misdirect their time and talents into areas that could possibly cause harm, not betterment.

Economist Don Boudreaux points to another Nordhaus article that makes a similar point about the importance of innovation and the entrepreneurial spirit that makes it possible: “nearly all—about 98 percent—of the benefits of technological innovation are captured, not by the entrepreneurs and businesses who introduce them, but by the general public.” The article, 2004’s “Schumpeterian Profits in the American Economy: Theory and Measurement,” invokes another name familiar in Competitive Enterprise Institute circles. It’s easy to see the billions of dollars that the Mark Zuckerbergs and Jeff Bezoses earn for themselves. By Nordhaus’ estimate, they create about 49 times more value than that for complete strangers such as you and me.

Paul Romer’s work, at its best, follows a similar theme. He is best known for his work on the nature of economic growth. It ties directly into what many economists, myself included, consider the most important graph of all time, pictured below.

People lived on the equivalent of three dollars a day for most of human history, from Mesopatamia through the Middle Ages and the Renaissance, up until about 1800 or so. Now, in the last one tenth of one percent of our species’ history, the average person in rich countries suddenly has fifty times that to live on. More than half of the world’s population, poorest countries included, now qualify as middle class. The proportion of people living in absolute poverty, defined as $1.90 per day or less, is now below ten percent for the first time in history. The absolute number of people in absolute poverty is declining, even as population increases. How the heck is this happening? Romer has helped improve our understanding of this important question.

Unlike cable news economists, Romer has an attention span longer than a fiscal quarter. This enables him to look at what the real engines of economic growth are, and what made today’s mass prosperity possible—and how it can continue to lift people out of poverty in the future.

Romer is not the first to say that technology, innovation, and change are the most important long-term factors driving growth. But many previous theorists, most prominently Robert Solow, thought economies tended to work towards a stable equilibrium state, until some outside technological shock, such as the electric lightbulb or the automobile, changes where that equilibrium point lies. The economy then lurches towards that new point, where it would remain mostly still until another shock comes along.

Romer argues that technological change is not an outside shock, it is built into the human condition. People innovate all the time, and always have—just look at the evolution of stone tools before anything like a modern economy ever existed. The proper concern for policymakers then, is enacting public policies that do not stifle the natural human impulse to change and innovate. Long-run institutional structures matter; whatever the Dow Jones Industrial Average did last quarter does not.

Romer prefers a government with a handsier approach than we do at CEI. But on those fundamentals, we very much agree. Property rights, freedom to trade, rule of law, limited corruption, and the usual Washington Consensus policies tend to work quite well. Countries with governments that more or less follow them are far more prosperous and free than those that don’t, as this year’s just-released 2018 edition of the Economic Freedom of the World report shows.

Romer’s shifting of technology in blackboard models from an exogenous variable to an endogenous variable seems like some ivory tower dispute of little consequence. But it is really about human nature, and human betterment. Despite our inborn tendency to innovate and exchange with each other, poverty is still our default state. A quick glance at the graph above makes this obvious enough. It is wealth and growth that need to be understood. One implication of Romer’s theory is that innovation, while impossible to predict, is very possible to suppress.

Regardless of one’s political leanings, the goal is nearly always the same: freedom and prosperity for as many people as possible. Nordhaus and Romer’s work, in their separate ways, tie into that common theme, and their Nobel reflects that. Congratulations to them both.

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Economics Is Everywhere – Richard Feynman Edition

Economics is everywhere. Physicist Richard Feynman, while working at Los Alamos laboratory, re-discovered Adam Smith’s division of labor after some computer troubles and apparently didn’t even know it (he never mentions Adam Smith or the division of labor in this story):
In this particular case, we worked out all the numerical steps that the machines were supposed to do–multiply this, and then do this, and subtract that. Then we worked out the program, but we didn’t have any machine to test it on. So we set up this room with girls in it. Each one has a Marchant [old-timey calculator]: one was the multiplier, another was the adder. This one cubed–all she did was cube a number on anindex card and send it to the next girl.
 We went through our cycle this way until we got all the bugs out. It turned out that the speed at which we were able to do it was a hell of a lot faster than the other way, where every single person did all the steps. We got speed with this system that was the predicted speed for the IBM machine.
-Richard Feynman, Surely You’re Joking, Mr. Feynman!, p. 126.

A Bit Drastic, But at Least They Correctly Identified the Problem

A barbarous solution to the barbarous problem of over-legislation:

A Locrian who proposed any new law stood forth in the assembly of the people with a cord round his neck, and, if the law was rejected, the innovator was instantly strangled.

-Edward Gibbon, Decline and Fall of the Roman Empire, p. 1435.

I personally prefer peaceful solutions that reform the institutional rules that make over-legislating and over-regulation possible in the first place. But before the days of Douglass North and James Buchanan, this was apparently what people had to work with.

An Economist’s Love Letter to Books

 
“No university will ever have at one time four economists of the quality of Adam Smith, David Ricardo, Irving Fisher, and Alfred Marshall, to say nothing of a dozen of their best colleagues—but they can all reside in one’s library. Their subtle minds are ever ready to instruct and tease and baffle.”
 
George Stigler (U. Chicago, 1982 Nobel laureate), Memoirs of an Unregulated Economist, p. 219.

Douglass North, 1920-2015

Many great economists live long lives. James Buchanan, Milton Friedman, F.A. Hayek, Ludwig von Mises, and Gordon Tullock all lived into their nineties. Ronald Coase died a centenarian. Sadly, Douglass North has joined that august club at age 95. Keynes’ prediction about the long run once again proves correct.

North’s ideas and influence will live even longer than he did; consider that his successful rebuttal to Keynes. North won the 1993 economics Nobel for his work as an economic historian, and for showing the importance of institutions in economic development. He also played a large role in inspiring the New Institutional Economics (NIE) movement, which has its own scholarly society.

What are institutions? North and the many economists he influenced use the word in a particular way. For example, the Competitive Enterprise Institute is an institution (it’s even in our name), but not in the Douglass North sense. For North, institutions are more like the rules of the game. In baseball, three strikes and you’re out is a baseball institution—again, in a very different sense than how the Yankees or Cubs are baseball institutions. How would a pitcher’s behavior change if the rule was four strikes per out, or two? How would a hitter behave differently if foul balls were automatic outs? That’s what Doug North’s research approach was about, except on a much larger historical scale.

One of North’s most famous papers is “The Role of Institutions in the Revival of Trade: The Law Merchant, Private Judges, and the Champagne Fairs.” It is set in 12th century France, and coauthored with Paul Milgrom and Barry Weingast, themselves distinguished economists. France had no functional national court system in the 12th century, and a dearth of professional judges and lawyers. Even so, informal markets, called Champagne fairs, opened up and spontaneously evolved their own institutions. Even without help from up on high, people found ways to make things work.

These spontaneous Champagne fair institutions ranged from how stalls were allocated to norms for bargaining and haggling, all the way up to the creation of private courts for resolving disputes. It’s a real-life illustration of Hayek-style spontaneous order. North adds the insight that the institutions that evolved in the Champagne fairs guided peoples’ behavior in certain directions. Different institutions would have guided behavior differently.

Over time, successful institutions displaced unsuccessful institutions, in an ongoing social evolutionary process. This insight continues to influence scholars in many disciplines, not just in economics.

Another famous paper about England’s 17th century Glorious Revolution, also coauthored with Barry Weingast, makes the case that checks on royal power made modern life possible. In the short run, a weaker king made people’s property rights more secure. No longer could the king just take what he wanted. Now he had to deal with a strong Parliament. Successfully removing James II, the last of the Stuarts, and replacing him with the more amiable William and Mary made Parliament a credible counterweight to royal ambition.

This new institution, which we now call separation of powers (note that John Locke’s Treatises came out at precisely this time), made modern commerce and the Industrial Revolution possible. There is obviously much more to the story of modernity, but North told an important part of the tale.

North also laid out his institutional approach in a number of books. To his credit, they are all short. One of them particularly influenced me as a student: Understanding the Process of Economic Change. Here, North goes a level deeper than the Champagne fair or Glorious Revolution articles.

Yes, institutions matter. Societies with secure property rights, the rule of law, and so on tend to be wealthier than societies that don’t. But where do those institutions come from? How do they emerge? How do institutions evolve over time? The general theme is that the institutions that best fit a given society’s circumstances emerge organically, from the bottom up. They can’t be planned and imposed from the top down. They just kind of happen, as unsatisfying as that is to say. They also change over time. What works in one time and place may not work in another, so institutions must be allowed to evolve over time. Legislation and social conventions that worked for railroads or horses might not work for self-driving cars. It is a brilliant performance.

One final point to make: economics is about human cooperation and voluntary exchange. It is quite literally a social science. Douglass North understood that point as well as anyone. Fred Smith and I have recently spent a good deal of time encouraging economists to move beyond the Homo economicus blackboard caricature and study Homo sapiens as well. Douglass North needed no such reminder. Nor do his numerous students who work every day to carry on his impressive intellectual legacy. As long as North’s career was, his influence will last far longer.

More to Markets than Wealth

From p. 92 of James Buchanan’s 2005 essay collection Why I, Too, Am Not a Conservative:

I have often noted how much better it would have been had Adam Smith entitled his treatise ‘the simple system of natural liberty’ rather than The Wealth of Nations, since his very title called direct attention to the aggregate of value generated, despite Smith’s intent and purpose.

Adam Smith’s intent and purpose, of course, was to describe and defend what he called the simple system of natural liberty. The fact that this system enables efficient wealth creation is a good thing, but a second-order benefit.

Buchanan’s intent and purpose is point out that, like Smith’s choice of title, many classical liberals only care about the wealth aspects of markets. This focus is a mistake. Markets’ virtues run far deeper, in a way that can resonate deeply with people of nearly all philosophical persuasions.

This is because market orders are almost completely subjective. Different people have different preferences, and want different things. Because markets treat people as equals, very different people are free to cooperate and exchange with each other however they want, so long as they respect others’ equal rights to do the same. That way you can get the bundle of goods you want, I can get the very different bundle of goods I want, and so on.

Compare this to an election where your choice is between one politician with one bundle of policies, or his opponent with a second bundle of policies. You can’t pick and choose the positions you like from each candidate, and discard the ones from each that you don’t. It’s an all-or-nothing deal.

Markets are more than wealth creation engines. They are dignity creation engines. You can choose how you eat, dress, live, work, and play in a way that top-down systems cannot, or will not, provide. Politics doesn’t work that way, but markets can, when they’re allowed to.

This, Buchanan argues, is markets’ true appeal. The fact that so many classical liberals focus instead on efficiency is as poor a salesmanship job as he saw in his long lifetime.

In a way, it is classical liberals’ own fault their views are unpopular.

Who Really Benefits from Economic Freedom?

From p. 40 of Don Boudreaux’s short new volume The Essential Hayek, in which Don performs the valuable service of putting Hayek’s most important ideas in plain, accessible English:

[P]eople often regard the case for economic freedom to be chiefly a case for the freedom of business. This is a mistake. At root, the case for economic freedom is a case for the freedom of consumers.

You can download a free copy of the book in PDF format here. The Fraser Institute, which published the book, also put together an accompanying website with videos and other materials.

I highly recommend reading at least the first two chapters, in which Don takes a Leonard Read/I, Pencil approach to books, paper, and ink. It’s as clear and vivid an explanation of Hayekian spontaneous order as I’ve ever seen, and it reads quickly and easily.