ECONOMIC THEORY & PRACTICAL POLICY
WHY DID EASTERN EUROPEAN ECONOMIC PLANNING COLLAPSE WITH THE BERLIN WALL IN 1989?
The collapse of State Socialism in Eastern Europe in 1989 involved the overthrow of an economic orthodoxy that had it’s roots in the Marxist revolution in Russia in 1918.
It was replaced by democratic (glasnost) and capitalist (pereskroika) systems modelled on Western economies which had achieved self sustaining growth since the industrial revolution.
The 70 year ‘experiment’ had not delivered the desired economic growth. Economic theory explains the evidence as a failure of practical policy.
Centralised economic planning based on tax and spend suffers a double whammy of economic inefficiencies; tax is a burden and a distortion of efficiency and central spending decisions compound the inefficiency and inhibit technological innovation.
1 History of Economic Theory
a) mainstream orthodoxy
Prior to the 17th century people could only pick their way precariously through a complex world they couldn’t understand, accepting as God’s will whatever life might bring, which was usually oppression, fear and an early grave.
The Enlightenment, produced a wave of optimism as religious explanations were replaced by science in a revolution of thought; the Laws of Nature could be discovered.
Economics reflects the mood of the times and the science of Newton’s clockwork universe was applied to human activity systems, Jeremy Bentham’s (1789) ‘utilitarianism’ was typical –
policy proposals were evaluated by measuring their impact on a person’s happiness (utility) and adding them up to find the total happiness of society (the common good), beneficial proposals were then implemented.
However, there were problems –
where was the information? how was happiness measured? which options were evaluated? what about the rejected alternatives? who decided? different people are different? how were the proposals implemented? what if some people disagreed?
The success of measurement in the physical sciences deluded policy makers into ignoring these problems of complex social systems and the errors culminated in ideas about wealth distribution and not wealth creation.
Classical economists became interested in economic growth after the start of the industrial revolution and initially offered a market explanation.
Adam Smith (1776) suggested the ‘invisible hand’ of the price mechanism co-ordinated the growth benefits of trade through competition and diminishing returns. But importantly he also identified the increasing returns from specialisation and scale in 'the pin factory' where the division of labour is limited by the extent of the market.
Thomas Malthus (1798) was pessimistic about growth as the 'law of diminishing returns' and resource depletion would follow population increase.
David Ricardo (1819) explained how 'comparative advantage' delivered specialisation benefits from trade. However, he was also gloomy about diminishing returns and his 'Corn Model' suggested land owners would appropriate all the rewards.
Marx (1848) recognised the massive productive forces in the industrial revolution but assumed class capital was the driver and capitalist economic growth would destroy itself as wage earners were exploited.
John Stuart Mill (1848) brought all the threads together and reconciled diminishing returns and increasing returns into an 'S' shaped growth curve. Crucially diminishing returns would in the end trump increasing returns and scarcity not technology was the focus. Technology was too difficult and was not on the table - exogenous.
The focus was on Nation States and a theory of value based on diminishing returns from land, labour and capital. No wonder economics was the 'dismal science'.
Neo-classical economists developed a mathematical approach to the concept of the perfect market which co-ordinated economic growth.
Stanley Jevons (1871) produced an insightful theory of value through marginal analysis. Value was no longer determined by labour but 'economic man' was again confronted by scarcity not increasing returns.
Leon Walras (1874) put the mathematics together with a robust general equilibrium theory where individual micro decision making agents were rational and maximising when confronted with scarcity and choice. The price of tea depends on everything under the sun.
Vifredo Pareto (1906) introduced an important elaboration, a powerful definition of allocative efficiency and co-operative progress, where proposals were implemented if at least one person was better off without making anybody else worse off.
Alfred Marshall (1890) summarised the neo-classical tradition using the idea of marginal utility to integrate human behaviour on the demand side, and marginal productivity to explain the behaviour of firms on the supply side. His partial equilibrium model was encapsulated in supply and demand diagrams and distinguished between short and long term which was an important dynamic for his pupil John Maynard Keynes. Specialisation and competition co-existed and their were problems with monopolies, public goods and externalities.
The marginalist revolution explained the shape of the supply and demand curves. But it was all about existing resource allocation with unrealistic assumptions about perfect information and static equilibrium. It was interesting but said little about wealth creation and economic growth?
Keynesianism provided the theoretical justification for short term manipulation of the business cycle to avoid growth stagnation.
John Maynard Keynes (1936) developed the macro economics of aggregates and the business cycle, which was the issue of the moment. His consumption function and a generalised glut, with 'idle balances' and 'sticky wages' stopped growth and the market mechanism in their tracks. His ideas led to a generation of practical policy which focussed on manipulation of demand at the expense of long term supply. But growth proved to be fickle. 'Pump priming', 'beggar thy neighbour', 'picking winners' and the proliferation of 'moral hazard' was unconstitutional and there was nothing about the increasing/decreasing returns tension.
John Hicks (1939) led an important post Keynesian school and he developed a useful diagrammatic approach. The overview Walras and Marshall dreamed of.
Paul Samuelson (1941) codified the Keynesian macro / micro split into a textbook which was standard fodder for a generation of economists. Generally applied the mathematics of Le Chatilier's Principle to economics - 'When a constraint is applied to a system in equilibrium, the system will move in such a way as to remove or cancel out the effect of the constraint'.
Joseph Schumpeter (1939) insisted the real world was different. Increasing returns were everywhere and perfect competition impossible. His world was described by the 'gales of creative destruction' from the entrepreneurs but the message was unwanted as policy at the time was embroiled in economic depression and war.
Monetarism eventually exposed the inflationary consequences of Keynesianism.
Milton Friedman (1963) focused on the supply side. Keynes was dubious, game theory just a game and imperfect competition a delusion, it was back to Marshall and the invisible hand. But again technological innovation remained exogenous; an unexplored 'black box'.
Endogenous growth theory, emerged in the 1980's as mathematical tools offered opportunities to model the complex non-linear processes of human behaviour. The failure of Eastern Europe to achieve economic growth was beginning to be explained as evolutionary theory was integrated into economic orthodoxy.
Robert Solow (1956) started the ball rolling with 'growth accounting' which established technological innovation as overwhelmingly more important than other factors of production in driving economic growth. John Stuart Mill's exogenous technology was big and savings/capital investment small. Malthus's population growth, Ricardo's landowners, Marx's capital, Keynes's business cycle, were almost irrelevant, it was technology that mattered. The fight between capital and labour was over everybody shared the benefits of technology. But technology was still exogenous.
Paul Romer (1981, 1986, 1990) extended Solow's insight and new mathematics into an endogenous model confirming technological innovative as the driver of growth. The evolutionary process was effectively integrated into mainstream economic orthodoxy.
Mainstream neo-classical orthodoxy was opposed by two influential groups of economists.
‘Institutional’ economists stressed that human behaviour was far more complicated than simplistic rational man moving to a static equilibrium in response to prices. Thorsten Veblen (1889) criticised the approach by suggesting the behavioural role of 'conspicuous consumption', Abraham Maslow (1925) postulated a hierarchy of human motivations, Kenneth Galbraith (1950) introduced the complication of 'want creation' and Herbert Simon (1957) rejected rational calculation for a completely different decision making process; ‘satisficing’.
This reaction against neo-classical orthodoxy has continued with ‘new institutionalists’ like Robert Axelrod (1984) inspired by game theory, Oliver Williamson (1985) who examined firms in terms of the transaction cost of information and Nelson and Winter (1982) who focused on firms and their evolved ‘routines’. Douglass North (1993) was awarded a Nobel prize for his work on the role of institutions in securing economic growth.
This stress on the complexity of human behaviour undermined the credibility of mainstream economics but institutionalists had difficulty in providing a coherent theoretical explanation of economic growth. There appeared to be a myriad of causes and ceteris paribus never seemed to apply.
‘Dynamic process’ economists also stressed that rational man with perfect information and an economy in static equilibrium were unrealistic assumptions.
A thread of process thinking gelled with Joseph Schumpeter (1934) who suggested that it was evolutionary ‘creative destruction’ which opened up the crucial role of technological innovation in forging economic growth.
The Austrian school had been constantly abrasive outside the mainstream and embraced the principles of evolutionary economics, particularly stressing –
an evolutionary theory of knowledge - in the face of scarcity, risk and uncertainty, competitive market processes enabled dispersed individual decision making agents to discover new value and achieve harmonious order through subjective assessments of the timing of their investments and the opportunity cost of each decision.
Frederick Hayek (1944) chipped away at economic orthodoxy, business cycle manipulation and socialist direction and control by confronting opponents with their lack of knowledge, which he described as ‘a fatal conceit’ and ‘the road to serfdom’. Economic growth is secured by evolutionary processes not by design.
The 'institutionalist' and the 'dynamic process' Austrian schools were largely voices in the wilderness, and endogenous growth theory is a relatively recent advance, during the 20th century practical policy in the East and West was based on neo-classical orthodoxy.
2 Neo-classical Practical Policy Diverges
The economic theory which underpinned a divergence of practical policy in the East and West during the 20th century can summarised with hindsight as conflicting interpretations of mainstream neo-classical theory.
a) perfect markets
The neo-classical perfect competition model of the market was neat and provided the justification for practical policy in West.
Allocative and productive economic efficiency is achieved as -
prices determine the quantities consumers purchase, price equals marginal utility, otherwise, as ' maximisers ', consumers would buy something else
prices determine the quantities firms produce for sale, price or marginal revenue equals marginal cost, otherwise, as 'price takers' and profit ' maximisers ', firms would make something else
The perfect market is a decentralised co-ordination system –
reallocation of output goods and services cannot make any consumer better off without adversely effecting others, for all consumers p = mu
reallocation of input resources cannot make any firm better off without adversely effecting others, furthermore, marginal cost is minimised because at prices above minimum costs excess profits are made, and below minimum costs losses are made, ensuring investment flows into or out of the industry until costs are minimised, mc = minimum
firms produce the quantities of products consumers wish to buy at minimum cost, more output would cost more than the value to the consumer, less output would cost less to produce than the value to the consumer, mu = mc
Incredibly the price mechanism co-ordinates the complex actions of consumers and suppliers, adjusting supply to demand at minimum cost, the outcome is allocatively and productively efficient. Firms reduce costs to maximise profit and customers benefit, p = mu = mr = mc.
This is a counter intuitive paradox, not designed benevolence but an unintended consequence of profit seeking in competitive markets.
b) market failure
Marxist and Eastern European policy reflected a rejection of the underlying assumptions of perfect markets and endorsed the concept of market failure.
Market failure is a technical term applied to specific problems with the perfect competition model associated with equity and efficiency, and it is the justification for policy intervention.
Allocative and productive efficiency is distorted by –
public goods, like defence and law and order where the same unit of output is consumed by everyone –
consumption is without depletion (none rival) so marginal cost is zero
consumption cannot be restricted (none excludable) so marginal revenue is zero - goods and services which can be consumed by everyone without depletion cannot be marketed, mu > p
externalities, like pollution incur 'social' costs which are not reflected in market prices and result in over-supply, p < mc
merit goods, like education and health where others benefit from your consumption, these general benefits are not reflected in market prices and result in under-supply, p < mu
monopoly, market manipulation where major suppliers, without competitors, have the power to raise prices above marginal costs, p > mc
inequitable distribution of wealth, incomes determined by the marginal productivity of labour and capital are the result of, and result in, competitive markets, a self-sustaining inequality - a moral consensus demands an equitable treatment of people in similar situations and a redistribution from those who can afford to those who need –
horizontal equity, a democratic concept - everyone is different, avoid discrimination
vertical equity, a marginal utility of money concept - everyone contributes differently, avoid discrimination
NB. Regulating inequality is a political misunderstanding of the role of diversity in evolution and a calamitous failure to distinguish between successful positive sum wealth creation and zero sum theft & cheating. Thomas Jefferson - 'all men are created equal with certain inalienable rights; life, liberty & the pursuit of happiness' - was not a plea for clones but a plea not to discriminate against individuals because they belong to an identifiable group.
unstable macro economic management, prices don’t automatically adjust to the business cycle, the economy is not responsive and gets ‘stuck’, resulting in prolonged recession –
‘sticky’ wages do not fall with unemployment
‘excess’ capacity holds employment down
‘animal spirits’ depresses investment
Thus the neo-classical perfect competition model does not reflect reality because of invalid assumptions, p <>mu <> mr <> mc
The response to market failure was correction by policy intervention. In the East policy intervention was almost total and dramatic. In the West there was an uneasy compromise.
Neo-classical economic theory was apparently justifying two very different practical policies.
There was a further problem, the resolution of the policy conflict was difficult because of the nature of economic analysis.
3 Economic Analysis
Scientific proof in physics can settle arguments. In economics proof is elusive.
The difference between the physical sciences and the social sciences is significant –
a) cause and effect models, the physical sciences are traditionally described by linear mathematics, however, in human activity systems cause and effect is a problem because complexity is changing and variables are interconnected –
knowledge is tacit, dispersed, incomplete, inaccurate and selective
alternatives are random and innovative
decisions involve different people, with different experience, with different perspectives, at different times, in different environments
response options are limited, flexible and competitive
These problems are typical of all evolved situations and counter intuitive conclusions follow –
cause and effect is meaningless, any initial cause is merely a random variation, meaning comes from survival success
system complexity is not only a data problem but also incomprehensible in principle
variables are emergent properties of interacting agents exhibiting characteristic behaviour but difficult to grasp, bottom up phenomena and not top down designs
prediction as a test of theory is impossible because interconnectedness and learning result in non linear mathematics without solutions
cause and effect reasoning in physical science is a special case useful only where variables can be isolated
economies are not the rational static equilibrium systems of neo-classical theory
The future is unknowable, there is no means of controlling the choices of others and there are only a limited set of responses but we do have options and we do choose.
But evolutionary economic explanations are not cause and effect.
b) evolutionary models
The thread of understanding led from Darwin (not Newton), to Mendel and the inheritance of information, to Watson and Crick and genetic information, to Maynard Smith and 'evolutionarily stable strategies', to Axelrod and the evolution of co-operation, to Kauffman and self organisation, to cognitive science and patterns in the brain and finally through to the Austrian economists and the computer simulations by Nelson and Winter and at Santa Fe.
Currently the theoretical understanding largely emanates from the institutes and universities in the West but the practical understanding is most acute in Eastern Europe where the consequences of misunderstanding cause and effect models have been most dramatic.
Evolutionary economics has progressed radically, particularly following the advent of Personal Computers and explorations of non-linear models, there are few assumptions –
the laws of physics – particularly the 2nd law of thermodynamics which inexorably erodes order, introduces constant variation and acts as a continuous cost – but the application of energy streams to dissipative systems far from equilibrium can produce self organisation and the emergence of novelty
evolutionary processes –
replication and inheritance of information
variety production and random diversity
differential survival for sifting value
development as population dynamics in hostile environments
human agents – pattern recognition and generating systems, themselves products of evolution, not rational calculators, but different individual people coping with the struggle by inherited culture, blind instinct and by generating and pre-testing ideas in imaginations and more recently in scientific experiments. People 'satisfice' –
building on past patterns of success
choosing between options available at the time
experimenting to discover added value
cooperating with others to enhance value
retaliating to protect value and
learning from the outcomes.
Economists incorporate these assumptions into models where –
environments are scarce, risky and uncertain – creating survival pressure
agents follow simple local rules – ‘satisficing’
rules are of structure, not content – complexity ‘emerges’
variables interact – models are interconnected networks
there is feedback and learning – continual iteration of inherited success
These models are non-linear and don't produce predictable outcomes, simulations have to be iterated to discover the emergent patterns. The patterns are not random, order and co-operation emerge spontaneously.
The explanatory power of evolutionary economics is startling, human behaviour emerges as –
choices in an environment of scarcity, risk and uncertainty - cooperative activities emerge as economically beneficial –
specialisation – scale – synergy – science – investment – imitation – innovation and also all the key variables associated with economic policy emerge –
prices - employment - interest rates - exchange rates - balance of payments and growth
This does not 'prove' that the maths describes the physical reality of markets, but that is an issue of philosophy for all science, however the evidence for evolution inexorably mounts …
Economists use evolutionary models to try to understand economic activity not to prescribe it. Unfortunately people expect economists to predict, seeking instructions about how to create wealth. Alas science itself, through complexity theory, has destroyed the myth, there can be no specific prediction, there are no levers to pull, no buttons to press, no one can ‘legislate’ wealth.
Evolutionary models can explain what we see in the real world; they cannot predict what we will see. Instead there are only patterns. Patterns of economic growth in Western market economies and patterns of Government failure in Eastern European command economies.
4 The evolutionary dynamic discovery process
The key to understanding evolutionary models of economic growth is to see the market as a process for continuously processing information and discovering survival value as technological innovation better than competing alternatives.
a) markets ‘as if’ a control loop
The evolutionary model, is blind to intentions, but acts ‘as if’ a control loop where the –
nature of prices and profits is a sensor, a signal, an information transmission system
safeguard of competition is a set point, competing alternatives offering variety and diversity
individuality of reality is an algorithm, customer choice decisions sifts value
magic of property is an actuator, firms investment responses change population dynamics as firms differentially survive
The counter intuitive consequences are –
widely dispersed, tacit, incomplete, selective, inaccurate and subjective information is continually processed through the price mechanism
every competitive innovative alternative is a candidate for approval
diverse individual customers back their own judgement and sift value
poor investments responses die and good investments survive to fuel economic growth
This evolutionary model avoids the unrealistic assumptions of perfect competition model. The Walrasian auctioneer, Smith's 'invisible hand', Ricardo's trade benefits, the 'gravitation' of prices and profits to marginal costs and Pareto's allocative and productive efficiency become statistical tendencies in population dynamics.
Not only does the evolutionary control loop model of the market demonstrate the benefits of markets but it also questions the vain hope that government action can do better.
b) government failure
To be effective Government command must involve the same elements of control as the evolutionary model, but the sensors, set points, algorithms and actuators are missing.
Spending ignorance -
without prices and profits there is an information deficit
without the safeguard of competition better alternatives are untried
without individual choice, the common good is an imposition
without private property the discovery of technological innovation is not rewarded.
In the absence of an evolutionary control loop, all the expected spending problems emerge, for example -
the welfare state suffers as -
universal benefits for poverty, health, unemployment, skills, education and lifestyle are all interconnected person specific evolved variables and quite impossible to isolate and measure for collective policy action
contingent benefits result in adverse selection and moral hazard as means testing traps honesty, saving and effort
public goods and all free goods result in free riders, excess demand, queues and uncontrolled waste
nationalisation results in the familiar knowledge and incentive problems of command, managers can resist instructions to act in the public interest and training can't make them efficient
monopolies enjoy legal protection for their exploitation otherwise better alternatives will always threaten as innovative technology evolves
comprehensive education and national curricula restrict the necessary diversity and competition for evolutionary discovery and parental choice
the National Health Service experiences escalating demand with intractable funding issues, the shortage of competing alternatives inhibits life saving technological innovation and patients are denied choice for their different health/lifestyle risks
externalities and merit goods when regulated produce distortions as production costs do not reflect social costs when property rights are absent and costs not internalised
the Common Agricultural Policy suppresses supply and demand leading to regressive hidden taxes on food. Subsidies for inefficient farmers transfers wealth to rich farmers who exploit technology to produce surpluses ‘crowding out’ the manufacturing and services sectors and 3rd world countries with comparative advantage
local government and regional policy distort economic efficiency if central funding results in local oversupply. In the absence of poll taxes and economically efficient policies people vote with their feet and move from high tax to high benefits areas
It appears Governments confront much more formidable obstacles than markets, but not only is effective spending a evolutionary chimera, it is also impossible to sensibly tax –
Tax distortion -
average tax rates are a burden, partially offset by public expenditure benefits but bureaucracy and compliance costs and X-inefficiency result in a welfare loss - this is an unavoidable consequence of all taxation although there may be a positive income effect as the work incentive increases to recoup losses
marginal tax rates are an excess burden, a unrecoverable loss of welfare as people are forced to substitute less desirable alternatives - the incentive to work is reduced as the price of leisure has effectively decreased
fiscal neutrality and poll taxes avoid economic distortion but their universal nature make them politically difficult - although empirical evidence shows tax has little effect on work effort, big welfare loss effects of substitution could be cancelled by income effects
avoidance is legal, people change their behaviour and the formal tax incidence is not the effective incidence, distortions are compounded by 'capitalisation' of taxes, feet voting, free riders and tax exporting
progressive tax by ability to pay is easily avoided as income is difficult to define – cash, capital, wealth, income in kind, DIY, satisfactions and obligations are all interconnected substitutes
regressive tax by benefits received is easily manipulated as poverty is difficult to define – households or individuals, relative or absolute, depth or duration or capabilities
But the problems don’t end here …
Economic analysis of human behavioural patterns has led to a better understanding of public sector actors. The chances are government that will not act in the public interest.
Politicians are elected to ‘do something’, indulging in the mirage of ‘designing outcomes’ with ‘other people’s money’, acting ‘as if’ to maximise votes resulting in an over supply of remedies.
Public choice theory identifies five problems –
log rolling – reciprocal support for uneconomic grandiose projects, a ratchet of distortions?
pork barrelling – unethical interest group bribery and corruption, no honesty?
dependency – contribution inhibiting demoralisation, no effort?
alienation – participation inhibiting helplessness, no savings?
divisiveness – 51%v 49% – polarisation of politics, undemocratic elected dictatorships, tax winners and losers?
All the advantages of the market 'as if' control loop and the disadvantages of tax and spend policies are reflected in the economic growth divergence of Eastern and Western Europe / US.
Evolutionary concepts are now used by game theorists and the non-linear complexity scientists, but the thinking is permeating all economic science.
Neo-classical theory is not wrong but it seems to be a special case of an evolutionary process where people act ‘as if’ to maximise utility and productivity for survival, but in reality the process is blind and experimental.
Paul Romer has been most successful in integrating complex human behaviour, typified by the entrepreneur's discovery process, into mainstream economics albeit through the increasing returns of monopolistic competition and not the diminishing returns of general equilibrium.
5 Policy Implications
An important conclusions from evolutionary economics is that market co-operation and order deliver survival benefits but it is not deterministic, we do have policy choices.
The policy problem is how best to encourage the growth of knowledge and at the same time ensure the benefits are widely shared.
a) endogenous growth theory
Technological innovation, or 'know how', delivers wealth creation and economic growth, but it is not a neo-classical exogenous variable, it is institutionalised into properly functioning markets.
The key insight of endogenous growth theory is that the overwhelmingly important factor of production is technological innovation which has some characteristics of a public good where markets can't work. Incentives for discovery and property rights may result in under supply.
The chronology of endogenous growth theory is instructive -
Kenneth Arrow (1962) recognised that the allocation of resources to the production of 'know how' was not Pareto Efficiency, the general equilibrium pricing was a problem because 'know how' -
has to be discovered and is risky and uncertain to obtain, it cannot be designed or planned
is difficult to hang on to and easily copied so returns cannot be appropriated
has to be acquired as a whole it is indivisible and you have to pay up regardless of how much you use but once you have it you could used it over and over again … '
there is a 'Learning Curve', a law of increasing returns, perfect competition and market pricing is impossible making endogenous treatment is difficult.
However Arrow was optimistic that institutions will evolve to help and he developed a theory of social choice, public choice, helping governments wrestle with the problems of moral hazard and adverse selection.
Arrow / Debreu (1959) developed a general equilibrium model using topological proof and contingent claims not calculus. Originating in earlier Von Neuman work. This mathematics was embraced throughout the economics profession.
Robert Lucas (1971) pushed the mathematics further borrowing dynamic programming and recursive methods from rocket science. This was not optimal control but game theory. Decision making was based on rational expectations and adaptation. This insight was also applied to a wide range of human behaviour by others, notable Gary Becker and James Buchannan / Gordon Tullock (1965) who applied the same principles to politics.
Rational expectations and adaptation, trying to figure out the future, try something, if it works do it again, if not we test something else, eventually progressing, decisions depend on those that had gone before, including unexpected events, long chains of choices, amid changing circumstances, what you do depends on what others do, do the best you can from where you are, with constant revision, don't plan the whole journey step by step, improvise, do things on the fly, making allowances for the unknown unexpected twists and turns that always occur … life was decentralised and uncertain … would you buy a second hand car from this man? These were all the characteristics of 'satisficing' and evolution.
Dixit /Stiglitz (1977) developed a model of monopolistic competition, suggesting increasing returns and imperfect competition can co-exist in a general equilibrium but with leadership 'lock in' and competitor 'lock out'.
Paul Krugman (1985) used the monopolistic competition model to investigate international trade, where comparative advantage included first mover specialisation and scale. This was Qwerty economics, with specialisation and scale effects.
Paul Romer had three attempts to develop a robust model of endogenous economic growth.
In 1981 his model identified increasing knowledge and falling costs from spillovers
For Van Neuman, technology breeds constant returns, AK, 'as if by magic'. Serendipitous discoveries followed naturally from progress in science, and science itself developed according to its own logic and at its own pace. But Romer preferred Solow, technology was exogenous but at least it grew.
Romer's growth was unending, he added Lucas to Solow. As we actively learn from the dynamic of science, the more you learn the faster you learn new things, a virtuous circle, the dismal science was optimistic, increasing returns, growth was speeding up !
Once a firm got going, increasing returns would squeeze out competition but with 'spillovers' others could get in on the act and Marshall's perfect competition would be preserved and growth was endogenous.
By 1986 Romer knew spillovers were not enough, the market fails, innovation is not rewarded and spillovers are quickly appropriated by the State or competitors. There will tend to be a systematic under investment in 'know how'.
He now suggested it was specialisation that was delivering increasing returns to knowledge. Knowledge was exploding as entrepreneurs everywhere invested in commercial R&D. Knowledge was being actively sought, the secret could not be passive spillovers.
Robert Lucas (1985) replaced Romer's knowledge with 'human capital'. People were investing in human capital through education and training. Spillovers came from deliberate decisions to acquire knowledge and furthermore folk are 40% more productive from synergies from working with others. From group interactions, social activities, in cities and in companies. People pay big money to live in cities.
There were bandwagon effects, path dependency, network externalities but there was no convergence, Eastern Europe remained poor.
In 1990 Paul Romer was sure the problem of divergence was due to differing entrepreneurial incentive systems. Increasing knowledge, falling costs and monopolistic competition implied government intervention but governments consistently got it wrong. It is incentives created by the market that affect profoundly the pace and direction of economic progress.
It was the idea of intellectual property that enabled rewards from spillovers and specialisation to be appropriated. 'Know how' was not completely a public good. Intellectual property and its derivatives; patents, secrecy, first to market, product differentiation, were providing the incentives.
The smooth convexities of perfect competition and general equilibrium (Arrow/ Debreu) were replaced by 'lumpy' fixed costs and monopolistic competition (Dixit/Stiglitz). New innovations were driving growth. Many firms were specialising and scrapping to secure a steady stream of innovations, knowing any advantage would be temporary.
The key to growth is 'know how' not physical factors of production (bits not atoms) and 'know how' is -
nonrival, used over and over without depletion to the extent of the market resulting in increasing returns
lumpy because it involves fixed costs and clusters associated with specialisation and division of labour
discovered, therefore risky and uncertain, making government design and entrepreneurial incentives a problem
partly appropriable as intellectual property, making investment in commercial R&D rewarding
temporary and dissipates as people learn
spread by tradition, the atoms spread welfare (comparative advantage) but the bits spread 'know how' as cultural learning
The production of 'know how' makes growth endogenous and monopolistic competition keeps growth rolling, a constant stream of innovation is necessary to secure temporary monopoly profits.
This was as described by Thomas Khun and Joseph Schumpeter, the dynamic evolutionary discovery process of science.
Generate and test, differential survival and spread in populations … main stream economics had merged with evolutionary economics.
Practical policy should be concentrated on enabling better markets –
the nature of prices and profit as essential information unavailable from alternative sources, encouraging price flexibility undistorted by taxes, in deregulated, flexible labour and capital markets - knowledge
the individuality of reality as people struggle to cope by choosing for themselves between competitive alternatives, encouraging diversity and choice so anybody and everybody can participate and contribute in enterprising innovations - human capital
the safeguard of competition as a plethora of options are candidates for consideration, encouraging unrestricted access to customers, contestable markets, competitive tendering and barrier free trade - in product markets customers are free to purchase better survival value elsewhere - anti trust free enterprise
the magic of property as a diversity of ideas and responses seek profit, encouraging the definition, protection and exchange of property rights, the right to buy, sell, control and benefit through privatisation, deregulation, asset sales and free movement of capital - in capital markets investors are free to invest in better survival value elsewhere - intellectual property rights
These evolutionary economic models answer two fundamental criticisms of competitive markets –
inequality is the essential result of evolution and the essential diversity necessary
for differential survival and evolutionary progress. Equality of outcome is
evolutionary unstable, stopping evolution in its tracks. And markets evolved
because of the benefits of reducing differences by trading
NB Regulating inequality is a political misunderstanding of the role of diversity in evolution and a calamitous failure to distinguish between successful positive sum wealth creation and zero sum theft & cheating. Thomas Jefferson - 'all men are created equal with certain inalienable rights; life, liberty & the pursuit of happiness' - was not a plea for clones but a plea not to discriminate against individuals because they belong to an identifiable group.
greed always leads to retaliation and ‘the irresistible opportunity to share excess profits with customers’. Evolution is blind to intention but if you don't survive others will
The fundamental morality underpinning markets is that cooperation is profitable and more profitable with scale advantages from increasing participation and contribution.
Equity and economic efficiency are not alternatives but parallel manifestation of the same evolutionary survival progress. And Kenneth Arrow received a Nobel prize in 1972 when he established the astounding conclusion that the 'top down' alternative was a mirage. The "Arrow Impossibility Theorem" pointed out that quite acceptable axioms on social choice orderings necessarily implied that a "dictator" would be involved - a single agent's own preferences over outcomes would dominate everybody else's!
Market institutions act ‘as if’ a control loop for an evolutionary process which generates technological innovation, wealth creation and economic growth.
Western Europe and the USA chose to exploit these benefits. Eastern Europe chose to 'correct' market failure and Marxist capital exploitation by inefficient government intervention.
The tax and spend of government practical policy is a double whammy for wealth creation and economic growth; tax distorts economic efficiency and spending plans disable the control loop, inhibiting information, innovative alternatives, customer value decisions and investment responses.
If evolution is the process which built the universe, then market co-operation can evolve 'as if' a control loop providing a powerful explanation for the failure of economic planning in Eastern Europe in 1989 and the relative success of Western market economies.
Sources and further reading – bibliography ...
The evidence mounts. New sources continue to be published confirming, supporting and expanding on the universal relevance of Darwinism and Evolutionary Economics.
john p birchall
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