Wednesday, August 02, 2006

More Comes From Knowing More

Nick Schulz reviews one of the books on my summer reading list in today's Wall Street Journal. For those folks that don't have the time to read Warsh's book, I would recommend reading Mr. Schulz's review.


More Comes From Knowing More
August 2, 2006; Page D10

For a long time, economists believed that much of their job was to analyze a world of scarcity, the grim business of harvesting limited resources and distributing too few goods to too many people. And then there was the matter of decreasing returns to additional investment. Such returns were once "a familiar topic in economics," David Warsh tells us in "Knowledge and the Wealth of Nations." After all, "even the richest coal vein plays out."

Decreasing returns and scarcity animated the doomster wing of economics, of which Thomas Malthus was the principal architect. It was he who lamented overpopulation so famously, even ahead of Paul Ehrlich, and predicted bouts of "periodical misery" to adjust human numbers downward, putting them, at least now and then, in equilibrium with the world's limited riches.

Mr. Warsh, a former economics reporter for the Boston Globe, does not intend to mock earlier theories of political economy but to tell the story of their gradual refinement over time -- especially as "one system of thought replaces another." He notes, for instance, that anti-Malthusian concepts central to the understanding of modern economic growth -- abundance and the notion of "increasing returns" -- came to compete with the scarcity school of thought. It is axiomatic to us, not least because of technology's marvelous effects, that "the same amount of work or sacrifice produces an increasing quantity of goods." But it was an idea that required special attention when it was first considered plausible.

The worry at first was that, in theory, increasing returns -- where they proved possible -- would create monopoly power. In Adam Smith's famous pin factory, division of labor and specialization yielded increasing returns. But why wouldn't the pin factory, or any other enterprise generating increasing returns, increase itself (so to speak) at the expense of every other enterprise of lesser aptitude and slower growth? Monopoly power would then undermine the competition that, in Smith's view, put markets on their virtuous path.

It remained a worry -- and a conceptual conundrum -- for a long time to come. Fifty years ago, the economist George Stigler framed the problem this way: "Either the division of labor is limited by the extent of the market, and, characteristically, industries are monopolized; or, industries are characteristically competitive." If they are indeed characteristically competitive, then the monopoly-threatening aspect of Adam Smith's view is, as Mr. Stigler noted, either "false or of little significance." Like many modern economists, he sided with the reliably competitive nature of industrial growth, and the fate of modern economies has borne him out.

[The Wealth of Nations]
By David Warsh
(W.W. Norton & Co., 426 pages, $27.95)

But what about growth itself -- especially the sustained economic growth that we now take for granted (however sluggish it may be at times)? At an informal academic conference in Buffalo, N.Y., in 1988 -- assembled by Jack Kemp, then a member of the House -- the Stanford economist Paul Romer presented a paper that ultimately turned the economic thinking on its ear. In Mr. Romer's work, as Mr. Warsh puts it, "the concept of intellectual property was, if not exactly 'discovered,' then formally characterized for the first time in the context of growth." Mr. Romer saw that knowledge was "both an input and output of production."

Thus instead of land, labor and capital -- the traditional inputs of economic theory -- it was "people, ideas and things" that mattered, driving technological change and entrepreneurial creativity. "No longer were the advantages of technical superiority to be understood as a case of 'market failure,'" Mr. Warsh writes. "They were part of the rules of the game." Such superiority was by its nature temporary -- i.e., nonmonopolistic. New knowledge constantly trumped old, and the law (rightly) gave ideas only limited property-protection.

More and more, economists came to see that it was knowledge that made the difference in modern societies -- e.g., in software, drugs, industrial processes, biotechnology and other parts of the economy where the upfront costs were large, the payoffs enormous and the benefits widespread. Economists inevitably turned their attention to the institutions or invisible structures -- constitutions, customs, property rights, cultural sentiments (like trust) -- that help to generate knowledge and sustain its effects.

In his admirably compelling account of economic thinking over time -- from Adam Smith to the present day -- Mr. Warsh shows a certain partiality to abstract mathematical theory. He might have given more credit to the thinkers such as Friedrich Hayek, the great philosopher of freedom and opponent of central planning; or to historians such as Joel Mokyr, who has chronicled the effects (as the subtitle of one of his books has it) of "technological creativity and economic progress"; or to popularizers such as George Gilder, who has documented (and celebrated) the role of knowledge in economic growth, especially in our computer age.

Mr. Warsh does, though, quote the great British economist Alfred Marshall, who observed as early as 1890 that "knowledge is our most powerful engine of production; it enables us to subdue nature and force her to satisfy our wants." More than a century later, knowledge is still the true wealth of nations.

Mr. Schulz is editor of TCS Daily.


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