Productivity Growth and the Diffusion Problem

The reason that my standard of living is higher than that of my grandparents, or my great-great-grandparents, isn\’t that I work longer hours or harder than they did. It\’s because I have the great good fortune to live in at a time when there have already been decades and centuries of technological and productivity improvements. In the long run, productivity growth is what allows the average standard of living to rise for a country.

There\’s a voluminous policy agenda on how to raise productivity, but a recent report from the OECD, \”The Future of Productivity,\” offers a new twist. The report argues that slower productivity in high-income countries is not because cutting-edge firms are slowing down in their productivity growth, but rather because other firms aren\’t keeping up. To put it another way, productivity growth isn\’t diffusing across economies. Here\’s a figure showing the pattern.

The panel on the left is for the manufacturing sector; the one on the right is for the services sector. The blue dashed line shows labor productivity for the \”frontier firms,\” with 2001 as the starting point. The frontier firms are the 100 most productive firms in each industry, from an international perspectives, with the underlying data coming from a commercial database called ORBIS. (The report has a discussion of strengths and weaknesses of this data.) The red lines show productivity gains for non-frontier firms. As the report summarizes (footnotes omitted):

GF [Global frontier] firms have become relatively more productive over the 2000s, expanding at an average annual rate of 3½ per cent in the manufacturing sector, compared to an average growth in labour productivity of just ½ per cent for non-frontier firms. While data limitations make it difficult to say whether growth has slowed relative to earlier periods, it is interesting that frontier growth remained robust after 2004, when aggregate productivity in advanced economies (e.g. the United States) began to slow. …Firms at the global productivity frontier are on average 4-5 times more productive than non-frontier firms in terms of MFP [multifactor productivity], while this difference is more than 10 times with respect to labour productivity (which includes capital intensity). … Firms at the global productivity frontier are typically larger, more profitable, and more likely to patent, than other firms. Moreover, they are on average younger, consistent with the idea that young firms possess a comparative advantage in commercialising radical innovations and firms that drive one technological wave often tend to concentrate on incremental improvements in the subsequent one. However, the average age of firms in the global frontier has been increasing since 2001. To the extent that this reflects a slowdown in the entry of new firms at the global frontier, it could also foreshadow a slowdown in the arrival of radical innovations and productivity growth. 

In short, this evidence suggests that the possibilities for productivity growth haven\’t slowed down, but that large parts of the economy are having a harder time putting the practices that lead to faster productivity growth into effect. What factors help productivity growth to spread? The OECD report argues:

Scope for diffusion depends on four key factors. First, global connections, via trade, FDI [foreign direct investment], participation in GVCs [global value chains] and the international mobility of skilled labour. Second, experimentation by firms – especially new entrants –with new ideas, technologies and business models. Third, the efficient reallocation of scarce resources to underpin the growth of innovative firms. Fourth, synergic investments in R&D, skills and organisational know-how – particularly managerial capital – that enable economies to absorb, adapt and reap the full benefits of new technologies.

In particular, I was intrigued by a figure showing that the importance of start-up firms over time has been diminishing not just in the US economy (as I\’ve pointed out here and here, for example), but in most other high-income economies, too. One of the primary ways for the spread of higher productivity is the creation and growth of high-productivity new firms and the shrinkage and exit of low-productivity competitors.

The Declining Number of Illegal Immigrants

The number of illegal immigrants in the United States rose very sharply through the 1990s and for almost the first decade of the 21st century, but the total peaked in 2009, and since then has declined somewhat. Jeffrey S. Passel lays out the evidence in his testimony submitted to
a hearing of the U.S. Senate Committee on Homeland Security and Governmental Affairs
on March 26, 2015.  Passel\’s testimony draws on two recent Pew reports, available here and here.)

Here\’s an overall figure, showing the total number of illegal immigrants. For those interested in methodology, these specific numbers are based on Census survey–specifically, the American Community Survey and the Current Population Survey. These surveys ask about whether someone is \”foreign-born,\” but don\’t ask whether they are in the United States legally. Thus, one can take the total number of foreign-born, subtract out the number of legal immigrants, and get an estimate of the \”unauthorized\” population. Of course, one can raise various questions about this methodology. However, it\’s also possible to cross-check these numbers in various ways: for example, by looking at estimates based on data from Mexico and on evidence from local US surveys. Taking the cross-checking into account, the estimates based on the Census surveys seem plausible.

Illegal immigrants make up about 5.1% of the US workforce. Here\’s a list of states where the total is at that average or above.  
Here\’s a table showing the industries in which illegal immigrants are more heavily represented. 
As I\’ve argued in the past, the drop-off in illegal immigration is likely due to a confluence of forces. 
1) The US economy was in recession from 2007-2009, and employment growth was slow for several year after that, so the economic \”pull\” attracting immigrants was reduced. 
2) Mexico\’s economy has performed better over time, with better prospects for well-paid jobs, as well as better performance in areas like education and healthcare. 
3) Mexico\’s demography has shifted with fewer women per children and an aging population, so the population of young adults who might be thinking about heading for the US has declined. 
4) US immigration enforcement is way up, both at the border and  in terms of deportations. 
I\’ll sidestep here the broader policy questions posed by immigration policy. But I will say that the key questions are somewhat different in a  situation in which the number of illegal immigrants is relatively low but expanding rapidly (as in the 1990s and start of the 2000s), compared with a situation where the number of illegal immigrants is relatively high but declining slightly (the situation now). In the earlier time period, it made sense to have a greater priority on finding ways to reduce the inflows of immigrants; now, it makes sense to have a greater priority on what should happen with the 5% of the US workforce that is already here without legal authorization. 

Keynes, Secular Stagnation, and Investment Shortfalls

The buzzword \”secular stagnation\” has come to refer to all sorts of arguments about why economic growth has been slow, ranging from concerns about a lack of technological opportunities, a lack of investment in education and infrastructure, the aftermath of the financial crisis when it becomes hard for firms to get the capital they need to invest, and when a lack of aggregate demand in an economy means that business don\’t feel that they have an incentive to invest.

But the original meaning of the term as put forward in 1938, as I discussed in \”Secular Stagnation: Back to Alvin Hansen\” (December 12, 2013), was a speech in which  Alvin Hansen expressed a concern that in the depressed economy of his time, with lower birthrates and a lack of discoveries of new resources and territories, the push of new inventions would not be enough to keep investment levels high and the economy growing. When Larry Summers resurrected the \”secular stagnation\” term in a series of speeches in 2013 and 2014 (for example, here), he emphasized the lack of incentives for investment, and offered as a possible policy solution a considerable expansion in infrastructure investment. I\’ve written previously about some of the potential explanations for \”Sluggish U.S. Investment\” (June 27, 2014).

For several decades after Alvin Hansen\’s 1938 speech, there was considerable concern among economists that it might be perpetually difficult for an economy to reach full employment, because of a tendency for demand to be insufficient. There was often a policy recommendation that the government might need to bolster investment in some way. Here are some thoughts that John Maynard Keynes had related to this subject in a little essay on \”The Long-Term Problem of Full Employment,\” dated May 25, 1943. It\’s available in volume 27 of The Collected Writings of John Maynard Keynes edited by Donald Moggridge, pp. 320-325.

Keynes begins by stating: \”It seems to be agreed to-day that the maintenance of a satisfactory level of employment depends on keeping total expenditure (consumption plus investment) at the optimum figure … The problem of maintaining full employment is, therefore, the problem of ensuring that the scale of investment should be equal to the saving which may be expected to emerge ….\”

Writing in 1943, Keynes then predicted \”three phases\” that would appear after the end of World War II. In the first phase after the war, there would be an investment boom, which in his view the government should act to tamp down:

\”It is, however, safe to say that in the earliest years investment urgently necessary will be in excess of the indicated level of savings. … In the first phase, however, equilibrium will have to be brought about by limiting on one hand the volume of investment by suitable controls, and on the other hand the volume of consumption by rationing and the like.\”

In the second phase, after a period which \”might last five years,\” then those controls could be ended. At that point, Keynes\’ prescription was that government would influence a large share of investment and steer it to the right level so that it would stabilize the economy. He wrote:

\”If two-thirds or three-quarters of total investment is carried out or can be influenced by public or semi-public bodies, a long-term programme of a stable character should be capable of reducinjg the potential range of fluctuation to much narrower limits than formerly, when a smaller volume of investment was under public control and when even this part tended to follow, rather than correct, fluctuations of investment in the strictly private sector of the economy.\”

Keynes predicts that the second state \”might … last another five or ten years.\” The third section is then what Keynes calls the \”golden age.\” In this stage, not as much investment will be desirable or needed. The goal will only be to have enough investment to replace capital equipment as it depreciates. Rather than pumping up investment, the goal of government should be to reduce savings and encourage people to spend on leisure activities. Keynes writes:

\”It becomes necessary to encourage wise consumption and discourage saving,–and to absorb some part of the unwanted surplus by increased leisure, more holidays (which are a wonderfully good way of getting rid of money) and shorter hours. … The object will be slowly to change social practices and habits to reduce the indicated level of saving. Eventually depreciation funds should be almost sufficient to provide all the gross investment that is required.\” 

In this third stage, if there is a need for countercyclical fiscal policy, Keynes suggests that it might be carried out by \”varying social security contributions according to the state of employment.\”

From a modern perspective, Keynes\’ arguments are remarkable in a number of ways. For example, they presume a very high level of activist macroeconomic policy. When investment is high, government should tamp it down. When investment is medium, government should control \”two-thirds or three-quarters\” of it to limit economic fluctuations.\” When investment inevitably becomes low, then to avoid the problem of secular stagnation, government will need to boost consumption and leisure.

I suppose that one can theoretically imagine a situation in which all these government controls are general in nature–that is, government wouldn\’t be favoring or disfavoring specific industries or sectors, and would not be interfering in specific investment or consumption decisions,  Keynes approvingly quotes another writer on the merits of how the state might \”fill the vacant  post of entrepreneur-in-chief, while not interfering with the ownership or management of particular businesses, or rather only doing so on the merits of the case and not at the behests of dogma.\” Of course, in the real world of politics, this kind of beneficent neutral interventionism that operates \”n the merits of the case and not at the behests of dogma\” seems rather unlikely.

Finally, the \”golden age\” imagined by Keynes sounds like a time of economic stasis, what old-time 19th century economists used to call the \”stationary state.\” The notion that the leading economies of the world were about to reach that stationary state back in the 1950s or 1960s doesn\’t seem like one of Keynes\’s best predictions. But the notion that such a view was widespread perhaps helps to explain why Great Britain made a series of business and policy decisions at about this time that helped bring about slower growth for a few decades.

I have little confidence in the kind of activist macroeconomic policy and government control over investment and consumption that Keynes describes here, and no confidence at all that the high income economies of the world are near a stationary state. However, the problem that when the economy is already slow, firms have little incentive to invest, and so the economy stays slow for longer, seems like a real one to me. While I have no particular disagreement with the need for more  investment in fixing roads and bridges, the real prosperity of the future isn\’t going to depend mainly on fewer potholes and more multi-lane roads. I fear that we settle on fixing roads and bridges as a motherhood-and-apple-pie solution for investment shortfalls because we have a hard time agreeing on how to encourage or even to allow other kinds of investment, like pipelines for oil and gas, new intercity rail tracks, or more resilient grids for electricity and communications. We also seem to have a hard time boosting research and development, or raising the skills of workers, which provides the ideas and the employees for new business investment to take place. We seem to have a hard time talking about whether its possible to shape all the rules and regulations and laws that affect business investment and expansion in a way that still accomplishes desired public goals, but with a reduced disincentive for firms to invest and expand.

China\’s Stock Market Performance: A 25-Year View

The recent decline in China\’s stock market is big global economic news, and it deserves to be. China is close to overtaking the US economy as the biggest of any country in the world, and large movements in its stock prices have both economic and political implications. That said, how about just a little dose of perspective on the level of China\’s stock prices?

Here\’s a figure (from Yahoo Finance) showing the level of the SSE Composite Index–that is the benchmark Shanghai Stock Exchange Composite Index–going back to 1990. Clearly, the recent spike and fall in stock prices is real and severe. Also clearly, the current spike and fall are dwarfed by what happened before and after the previous peak in October 2007. In fact, even with the recent decline, China\’s benchmark stock index is still well above its level at the start of 2015. The stock market losses that are now being suffered are just offsetting a portion of the upward price spike from a few months ago.

China has some real difficulties in its financial system. It\’s level of credit relative to GDP has risen very sharply in the last few years (for some background, see the posts here and here). At a deeper level, China\’s economy has had a hard time rebalancing itself as it has grown so rapidly, with one of the most prominent signs being that its level of consumption as a share of GDP had fallen to only about 35%, roughly half the level that\’s common in advanced economies (for discussion, see here and here). In China, this economic pattern was sometimes criticized as the \”nation rich, people poor\” policy. China is trying to increase consumption–thus, allowing and encouraging higher levels of credit and debt–but a lot of that buying power seems to be flowing into the stock market–thus, making frothy bubbles of price spikes and declines more likely.  

Peak Farmland, Peak Timber, Peak Car Travel, Peak Child

Every now and again, it\’s bracing to read a bold essay that makes strong pronouncements with a minimum of hedging. If you\’d like an environmentalist essay along these lines, I recommend \”Nature Rebounds,\” by Jesse H. Ausubel, written for a January 2015 seminar presentation.

Here\’s Ausubel\’s overall perspective:

\”[A]bout 1970 a great reversal began in America’s use of resources. Contrary to the expectations of many professors and preachers, America began to spare more resources for the rest of nature, first in relative and more recently in absolute amounts. A series of decouplings is occurring, so that our economy no longer advances in tandem with exploitation of land, forests, water, and minerals. American use of almost everything except information seems to be peaking, not because the resources are exhausted, but because consumers changed consumption and producers changed production. Changes in behavior and technology liberate the environment.\”

Ausubel on peak farmland (references to figures omitted):

\”Then, in America, in about 1940 acreage and yield decoupled. Since about 1940 American farmers have quintupled corn while using the same or even less land. Corn matters because it towers over other crops, totaling more tons than wheat, soy, rice, and potatoes together. Crucially, rising yields have not required more tons of fertilizer or other inputs. The inputs to agriculture have plateaued and then fallen, not just cropland but nitrogen, phosphates, potash, and even water. … The story is precision agriculture, in which we use more bits, not more kilowatts or gallons. Importantly, the average yield of American farmers is nowhere near a ceiling. …

\”Steadily, the conversion of crops, mostly corn, to meat, has also decoupled, because the meat game is also one in which efficiency matters. From humanity’s point of view, cattle, pigs, and chickens are machines to make meat. A steer gets about 12 miles per gallon, a pig 40, and a chicken 60. Statistics for America and the world show that poultry, land’s efficient meat machines, are winning.

\”High grain and cereal yields and efficient meat machines combine to spare land for nature. In fact, we have argued that both the USA and the world are at peak farmland,not because of exhaustion of arable land, but because farmers are wildly successful in producing protein and calories. … In America alone the total amount of corn fed to cars grows on an area equal to Iowa or Alabama, as mentioned. Think of organizations like the Long Now Foundation turning all those lands that are now pasture for cars into refuges for wildlife, carbon orchards, and parks. The area is about twice the area of all the US national parks outside Alaska. \” 

Ausubel on peak forest:

\”Foresters refer to a “forest transition” when a nation goes from losing to gaining forested area. France recorded the first forest transition, about 1830. Since that time French forests have doubled while the French population has also doubled. Forest loss decoupled from population. Measured by growing stock, the USA enjoyed its forest transition around 1950,and measured by area, about 1990. In the USA, the forest transition began around 1900, hen states such as Connecticut had almost
no forest, and now encompasses dozens of states. The thick green cover of New England, Pennsylvania, and New York today would be unrecognizable to Teddy Roosevelt, who knew them as wheat fields, pastures mown by sheep, and hillsides denuded by logging.\”

Ausubel on the increase in global biomass:

\”[G]lobal greening … [is] the most important ecological trend on Earth today. The biosphere on land is getting bigger, year by year, by 2 billion tons or even more. Researchers are reporting the evidence weekly in papers ranging from arid Australia and Africa to moist Germany and the northernmost woods. Probably the most obvious reason is the increase of the greenhouse gas carbon dioxide in the atmosphere. In fact, farmers pump CO2 into greenhouses to make plants grow better. Carbon dioxide is what many plants inhale to feel good. It also enables plants to grow more while using the same or less water. Californians David Keeling and Ralph Keeling have kept superfine measurements of CO2 since 1958. The increasing size of the seasonal cycle from winter when the biosphere releases CO2 to the summer when it absorbs the gas proves there is greater growth on average each year. The increased CO2 is a global phenomenon, potentially enlarging the biosphere in many regions.\”

Ausubel on peak car travel and peak car:

\”[T]ravel in personal vehicles seems to have saturated. America may be at peak car travel. If you buy an extra car, it is probably for fashion or flexibility. You won’t spend more minutes per day driving or drive more miles. Unlike the car companies, I would not bet on selling a lot more cars either. The beginning of a plateau in the population of cars and light trucks on US roads suggests we are approaching peak car. The reason may be that drone taxis will win. The average personal vehicle motors about an hour per day, while a car shared like a Zip Car gets used eight or nine hours per day, and a taxi even more. As venture capitalists here know, driverless cars can work tirelessly and safely and accomplish the present mileage with fewer vehicles.\”

Ausubel on peak child:

\”[G]lobally it appears that Earth is passing peak child. Swedish statistician and physician Hans Rosling estimates that the absolute number of humans born reached about 130 million in 1990 and has stayed around that number since then. With fertility declining all over the world, the number of newcomers should soon fall. While momentum and greater longevity will keep the total population growing, technical progress can counter the likely mouths. A 2 percent annual gain in efficiency can dominate a growth of population at 1 percent or even less.\”

There\’s much more in this short essay, about peak commodity use, how to feed the future world population with fish farming and flavored microorganisms, and how the patterns described here are spreading around the world.

For the record, Ausubel is someone with the professional pedigree to make him worth listening to, even if you feel a need for a dollop of skepticism now and then. He is Director of the Program for the Human Environment at The Rockefeller University, and his background includes being one of the main organizers of the first UN World Climate Conference in Geneva in 1979. As his bio page says in the report: \”In the late 1990s he helped initiate and then lead the Census of Marine Life, an international observational program to assess and explain the diversity, distribution, and abundance of life in the oceans. Beginning in 2002 he helped found the Barcode of Life Initiative, which provides short DNA sequences that identify animal, plant, and fungal species. During 2006–2007 he served as the founding chair of the Encyclopedia of Life project to create a webpage for every species.\”

Homage: I ran across mention of this report at Arnold Kling\’s always interesting askblog website.

Greece and its Slow Growth Problem

I knew that Greece has not traditionally been the economic dynamo behind growth in the EU economy. I had not quite realized how far the Greek economy has lagged behind over the last several decades. Here\’s a figure from an IMF report on \”Greece: Preliminary Draft Debt Sustainability Analysis\” (June 26, 2015, Country Report 15/165).

Greece joined the European Union in 1981. The The horizontal axis shows growth of \”total factor productivity,\” or TFP, for countries of Europe from 1981 to 2014. Greece lags well behind the other countries with an annual productivity growth rate of 0.1%. The vertical axis shows growth in real GDP over time. Again, Greece lags behind with an average annual growth rate of 0.9%. Again, these are not numbers just for the last year or two, but instead are averages during a period of 33 years.

The future prospects for economic growth in Greece are, if anything, worse–indeed, one plausible projection would be for negative future GDP growth for the foreseeable future. The IMF writes:

What would real GDP growth look like if TFP growth were to remain at the historical average rates since Greece joined the EU? Given the shrinking working-age population (as projected by Eurostat) and maintaining investment at its projected ratio of 19 percent of GDP from 2019 onwards (up from 11 percent currently), real GDP growth would be expected to average –0.6 percent per year in steady state. If labor force participation increased to the highest in the euro area, unemployment fell to German levels, and TFP growth reached the average in the euro area since 1980, real GDP growth would average 0.8 percent of GDP. Only if TFP growth were to reach Irish levels, that is, the best
performer in the euro area, would real GDP growth average about 2 percent in steady state. With a weakening of the reform effort, it is implausible to argue for maintaining steady state growth of 2 percent. 

I\’m sure that Greece\’s economic and debt woes have many dimensions, but it\’s a symptom of all these issues when it become plausible to project future GDP growth as negative (even with a bounceback in investment). The IMF report is mostly a detailed breakdown of Greek debt, financing costs, needs for concessional financing and extending debt maturities, and so on, and readers who want detail on the parameters if the IMF arguments can go there. Here, let me just offer a few other snapshots of the Greek economic woes.

Here\’s a figure from the IMF showing the rise in Greek public debt in the last decade. The near-doubling in debt/GDP ratio from 2004 to 2011 is remarkable, and since then the problem has been one of damage containment. (The projections for the future assume that various reforms are undertaken, so they should only be swallowed with a skeptical tablespoon of salt.) As you can see, essentially all of the debt is in euros.

Here\’s a perspective on the size of the GDP in Greece, generated by the ever-helpful FRED website run by the Federal Reserve Bank of St. Louis. In the figure, GDP for 2010 is set equal to 100. Thus, from 1981 up through the early 2000s, you can see a gradual rise in growth that seems to be taking off after about 2000–of course, fed at that time by the huge accumulation of government borrowing and spending. You can also see the Depression-sized drop in output, with the economy falling by roughly one-third in size in the last 6-7 years.

That collapse in the size of Greece\’s economy brought sky-high unemployment with it. The lower blue line shows the unemployment rate for those aged 15-64: it rises from under 10% (already a disturbingly high level) around 2008 to more than 25%. The red line shows the unemployment rate for those 15-24. One expects the unemployment rate for this group to be higher than average: still, having it spike to almost 60% is a sign of an economy in extraordinary disarray.

Earnings Inequality Between Companies

The basic fact that inequality of US earnings has been generally rising over the last several decades is well-known, but here\’s a question I haven\’t seen previously addressed: Is the rise in earnings inequality for individuals happening within individual firms? Or is it happening because the average pay between firms is also becoming more unequal?

Jae Song, David J. Price, Fatih Guvenen, and Nicholas Bloom explore this question in \”Firming Up Inequality,\” written as Discussion Paper #1354 for the Center for Economic Performance at the London School of Economics (May 2015). They use a sample of data from the Master Earnings File
(MEF), which is compiled and maintained by the U.S. Social Security Administration. Because employers need to report what you earned to the Social Security Adminstration, this data includes both individuals and employers (although any identifying traits for individuals and employers are stripped out before the data is released to researchers). Here are some of their conclusions: \”Except at the very top, the highest-paid individuals now work at higher-paying firms, but are not higher paid relative to those firms … Wage dispersion between firms is increasing, while dispersion within firms has been stable.\”

Here\’s a quotation from their findings. The first sentence makes the point that earnings have risen faster for those in the highest percentiles, which means that rise in inequality has occurred. The rest of the quotation makes the point that essentially all of the rising inequality of earnings is reflected in a rising inequality of the average amount paid by firms.

(To make sense of what follows, some readers may need bit of explanation about what is meant  \”log points\” and percentages. As an example, consider an increase from 50 to 60. This is a rise of 20%–that is, (60-50)/50. But there is alternative way to approximate this percentage change, which is to take the natural logarithm of the ratio (60/50). Punch it into a calculator, and ln(60/50)= .18232, which is sometimes referred to as \”log points.\” Notice that the log calculation is an approximation of the percentage change. I won\’t try to explain here why it\’s often useful to work in terms of log values, but as a matter of calculation, it\’s straightforward to switch back and forth between log points and percentages–so which one to emphasize in the exposition is just a choice of the author.)

\”Between 1982 and 2012, the middle of the income distribution saw an increase in real wages of 18 log points (20 percent), while the top one percent saw an increase of 66 log points (94 percent). This change is roughly mirrored in their firms: individuals in the middle of the income distribution worked at firms with mean real wages 23 log points (25 percent) higher in 2012 than in 1982, but individuals in the top one percent worked at firms with mean real wages 72 log points (105 percent) higher. If we calculate the increase in individual inequality during that time period as the difference between the change at the top end with the change at the middle—a 48 log point difference—then virtually all of that increasing individual inequality is explained by the 49 log point difference between the firms of individuals at the top, versus firms of individuals in the middle. These trends are consistent across regions and industries, remain true when restricting by sex, age, and tenure, and are robust to various changes to the sample selection criteria.\”

This is the kind of result that makes you want to sit down for awhile and think about what it means. The authors suggest a couple of basic explanations for this pattern. Perhaps firms have become more specialized over time, so that some firms have become in recent decades more likely to hire a bunch of higher-earnings workers while others are more likely to hire a bunch of lower-earnings workers. Or as a complementary explanation, perhaps productivity differences between firms are rising over time, leading to greater dispersion of average wages between firms.

Of course, these kinds of explanations just raise the question of why firms might have become more specialized over time, or why productivity differences between firms are rising. As I try to sort out my thinking on these broader questions, there are a couple of other implications worth considering.

This evidence suggests that inequality of earnings within a typical workplace has not increased much in recent decades. As the authors point out, this may \”suggest an explanation for why many do not feel that there has been an increase in inequality: on average, individuals’ inequality with their coworkers has changed little over the past three decades.\”

I would add the evidence also implies that as the inequality of earnings has risen, there has also arisen a separation between those with higher levels of earnings. The old-time story of someone who starts in the mail-room and works up to the top within a current employer is in this sense becoming less possible, because someone who starts at the bottom will tend to be with an employer with lower-paying jobs, and to get near the top of the earnings distribution is more likely to need a shift to the employers who tend to have higher-paying jobs. We know that many people hear about possible jobs through co-workers past and present. The growing inequality of earnings apparently also reflects a growing disconnect between the workplace networks of those with different levels of earnings.

Fourth of July: Economics and Ruminations

For those who actually check blogs during Fourth of July weekend–a group in which readers of this blog are almost certainly overrepresented–here\’s a sampling of three past posts with close ties to America\’s Independence Day.

1) What did Adam Smith, as published in The Wealth of Nations in 1776, have to say about the England-United States relationship? 

For economists around the world, 1776 means the publication date of Adam Smith\’s classic The Wealth of Nations. Book IV, Chapter 7, is entitled \”Of Colonies.\” Smith expresses the view that Europe contributed very little to the economic success of its American colonies–except for some talented people. He also believed that while England benefited from trade with its colonies, England also had to bear the costs of defense and the costs of the monopolies on trade that it created. He painted a picture of how the American colonies might be allowed democratic representation, but viewed it as a politically unlikely outcome. He also predicted that even when a nation didn\’t benefit from having colonies, it would still be reluctant to let the colonies go peacefully. In reading Smith\’s discussion, one can almost imagine an alternative world history, in which the US colonies get full political representation in the Parliament of a greatly expanded United Kingdom. For a more detailed discussion of what Adam Smith had to say, see \”Adam Smith on the Economics of US Independence\” (originally posted July 4, 2013). 
2) What economic factors among the main causes underpinning the US Revolutionary War? 
Modern commentators often discuss the US Revolutionary War as a battle for constitutional rights, but that focus is at best incomplete. After all, the Boston Tea Party and \”no taxation without representation\” have economic as well as political motivations. Commercial disputes over whether or how the British Parliament could restrict navigation by US-based ships were one of the biggest issues in the mid-1770s.  Staughton Lynd and David Waldstreicher offer a refreshing take on the role of economic forces in the U.S. Revolution in \”Free Trade, Sovereignty, and Slavery: Toward and Economic Interpretation of American Independence,\” which appeared in the October 2011 issue of the William and Mary Quarterly. They review various explanations that historians have offered for the US Revolution and write: \”[T]he American Revolution was basically a colonial independence movement and the reasons for it were fundamentally economic.\” For an elaboration and discussion of their thesis, see \”Economic Underpinnings of the US Revolutionary War\” (originally posted January 31, 2012). 

3) Melting Pot, Salad Bowl, or Chocolate Fondue? 

The Great Seal of the United States famously includes the motto, E pluribus unum, or \”Out of many, one.\” For much of the 20th century, the predominant metaphor for that process was the US as a \”melting pot,\” an image tracing back to sentimental and very popular play of that name by an immigrant named Israel Zangwill that opened in Washington in 1908. In recent decades, a more common metaphor has been the \”salad bowl,\” an image popularized back in the 1950s by historian Carl Degler, and his popular text His book “Out of Our Past: The Forces that Shaped Modern America,” which was in widespread use from the 1950s up through the 1980s. I point out some shortcomings of these metaphors for the distinctively American process of \”out of many, one,\” and suggest my own metaphor: chocolate fondue. For a short essay on this subject, see my essay on \”Melting Pot, Salad Bowl, or Chocolate Fondue?\” (posted on this blog on July 5, 2014).

Interview with Al Roth: Market Design When Prices Aren\’t Sufficient

Douglas Clement offers another characteristically excellent interview in The Region magazine published by the Federal Reserve Bank of Minneapolis, this one with Al Roth (June 2015 issue, pp. 14-25). Roth, of course, was a co-winner of the 2012 Nobel prize in economics (with Lloyd S. Shapley) for his work on market design. The interview ranges over Roth\’s work in many areas, including programs run by cities in which parents chose schools for their children, matching medical residents and hospitals, and matching kidney donors and recipients. The whole interview is very readable, but here are a few comments that jumped out at me.

On what makes a matching market different from a market where price is sufficient for buyers and sellers to agree to a transaction:

God makes wheat, but the Chicago Board of Trade makes #2 hard red winter wheat. It has a lot less variance than wheat. You know what you’re going to get and, therefore, you don’t have to care who you’re buying it from. You don’t have to inspect it. But before wheat was commodified, you had to have someone look at the wheat to see what you were buying. Similarly, before coffee was commodified in Ethiopia, you needed a man in Addis Ababa tasting the coffee; now you don’t.

In those markets, you can make an offer to the entire market. I want #2 hard red winter wheat from whomever; it doesn’t matter who I get it from.

But, of course, labor markets aren’t like that, and many other markets aren’t like that—because you care not just about the price, but also about who you’re dealing with. What that means is, if everyone has a different price—if dealing with you is so nice that I’m willing to pay a higher price rather than deal with someone else—there’s no longer a small-dimensional vector of prices that organizes the market, like a price for each kind of wheat.

Instead, it’s personalized prices, maybe doubly personalized prices. How much will Google pay me to work for them? How much would I need to take their offer, rather than a different salary from Facebook?

The space of prices is larger, so even if you tried to organize the market entirely through prices, you would need to see many, many more prices than you do in the market for coal, where you only need a price per ton for each grade of coal.

There isn’t a sharp line between matching markets and commodity markets. I think there is sort of a continuum. There are markets where price does all the work: the New York Stock Exchange, for instance. Its job is to define at any moment the price at which supply equals demand for each of a bunch of financial commodities. The labor market is very personal, but price also matters a lot, so it’s somewhere in the middle of the continuum. For school choice and kidney exchange, we don’t let prices work at all. And lots of markets fall somewhere between kidney exchange and the market for wheat.

What used to happen in matching medical residents to hospitals before a formal process was set up–and how matching market can unravel: 

In 1900, when you graduated from medical school, you looked for a job. We’re talking about graduating in June and looking for a job that starts around July. By 1930, those jobs were being filled by Christmastime (before graduation) rather than June. Medical journals from the 1930s say, “We’re now hiring our new interns without knowing their class rank and other important information we might get by waiting until they graduate. We can live with that, but let’s not go any earlier.”

But, of course, it’s hard to stop people from competing simply by asking them not to do so. By 1940, hospitals were hiring people two years before graduation. That was very inefficient. Everyone understood it was very inefficient. Hospitals couldn’t tell who the good students were two years before graduation, and the students couldn’t really know what jobs they wanted. They didn’t yet have much experience with different medical specialties. … 

Around 1945, the medical schools intervened and managed to control the dates at which contracts were signed for post-graduation employment. The medical schools are a third party: They’re not the doctors, they’re not the hospitals, so they weren’t suffering from the competitive self-control problem that kept forcing hiring earlier. By not releasing transcripts, not releasing letters of reference, they managed to get control of the date and move it back into the senior year of medical school. That prevented unraveling, but then they had terrible exploding offer problems—job offers that were retracted if not accepted quickly. …

Fortunately, that problem has now been solved in the medical residency market, but it’s happening right now with law clerks. So this isn’t an ancient problem; it’s still very present in other markets. … Federal judges have tried over and over again, maybe a dozen times in the last 30 years, to deal with unraveling in the market for law clerks. They develop rules that they then cheat on. Right now, they’re in a period of no rules. They just abandoned their most recent set of rules because everyone was cheating. So they’re back to making very early exploding offers. If you’re a law student who is going to get an offer of a clerkship, it will come sometime well before you graduate, and it will be earlier this year than it was last year. …

[I]t’ll probably be in your second year. Some judge will make you an offer, and you will most often accept it on the spot because that’s part of the deal for getting the interview. So you won’t get to consider a lot of offers. … This unraveling process, this process of making offers earlier and earlier, turns out to be common to many markets.

On what made the University of Pittsburgh, as well as other departments, a supportive place for a researcher: 

The mathematician Alfréd Rényi is said to have said that a mathematician is a machine for turning coffee into theorems. Maybe economists turn decaf into models.

There were lots of people to talk to at Pittsburgh. It was a fruitful time. And it was a very good department. I think a lot of what makes a department a good place to work is that when you’re onto something you’re excited about and you walk out the door of your office and tell one of your colleagues about it, he’s excited to hear about it, too. He says “That’s great. Let’s go have a cup of coffee, and you can tell me about it.” So there’s the positive reinforcement you get just from having people think, “Isn’t that great you’re excited about something. You’re thinking about something interesting.” It makes places fun to work.

Here at Stanford, I try to organize regular coffees—I did this at Harvard and I do it here—regular coffees with students interested in different things. We have a Tuesday morning coffee for experimental economics and a Thursday morning coffee for market design. I think that a lot of intellectual interaction arises out of social interaction. You have to be talking to people before you’re talking about work.

Puerto Rico: Echoes from Greece

The situation of Puerto Rico as a territory of the United States is of course fundamentally different than the situation of Greece as one of the sovereign countries that are part of the European Union. But the announcement earlier this week by by Puerto Rico\’s governor, Alejandro García Padilla, that it will not be able to repay its $72 billion or so in debt, has some echoes of the situation in Greece. Anne O. Krueger, Ranjit Teja, and Andrew Wolfe provide a dose of useful perspective in \”Puerto Rico: The Way Forward,\” written for the Government Development Bank for Puerto Rico and released June 29.

The basic starting point is that the ratio of government/debt GDP has been climbing in Puerto Rico for the last 15 years, while the economy has been contracting for 10. The market is now recognizing that this combination is not sustainable. The first figure shows the debt/GDP ratio. General government debt is the large gray portion at the bottom of each bar. The colored slices on top are debt accumulated by government-owned enterprises, with the biggest being PREPA, the Puerto Rico Electric Power Authority which is basically in the business of importing oil and using it to generate electricity.  Krueger et al. argue for various reasons that this debt/GDP ratio probably understates the actual level; for example, it doesn\’t include the liabilities of various government pension funds. Indeed, the New York Times reported that on a per capita basis, Puerto Rico has more municipal bond debt than any US state.

The second figure shows the inflation-adjusted GDP of Puerto Rico, peaking in 2005 and falling since then.

When markets perceive that debt more risky and less likely to be paid off, then anyone who buys that debt will demand a higher rate of return. Here\’s the rising rate of return for the PREPA debt and for general government debt. 

Like Greece, Puerto Rico does not have the option to address its economic woes by depreciating its currency. Greece is locked into the euro (at least for awhile longer), and Puerto Rico is locked into the US dollar.

Like Greece, labor markets in Puerto Rico are a mess, exhibiting very low levels of employment. Krueger, Teja, and Wolfe write:

The single most telling statistic in Puerto Rico is that only 40% of the adult population – versus 63% on the US mainland – is employed or looking for work; the rest are economically idle or working in the grey economy. In an economy with an abundance of unskilled labor, the reasons boil down to two. o Employers are disinclined to hire workers because (a) the US federal minimum wage is very high relative to the local average (full–‐time employment at the minimum wage is equivalent to 77% of per capita income, versus 28% on the mainland) and a more binding constraint on employment (28% of hourly workers in Puerto Rico earn $8.50 or less versus only 3% on the mainland); and (b) local regulations pertaining to overtime, paid vacation, and dismissal are costly and more onerous than on the US mainland. Workers are disinclined to take up jobs because the welfare system provides generous benefits that often exceed what minimum wage employment yields; one estimate shows that a household of three eligible for food stamps, AFDC, Medicaid and utilities subsidies could receive $1,743 per month–as compared to a minimum wage earner’s take‐home earnings of $1,159.

There are lots of reasons for Puerto Rico\’s slow growth and high debt. Certain federal tax provisions for manufacturing in Puerto Rico expired in 2005. The housing price bubble was large in Puerto Rico, and the corresponding fall in the local construction industry–and the injury it did to local banks–was large as well. The sharp rise in oil prices after 2005 hurt Puerto Rico, because it depends almost entirely on imported oil for electricity. (Of course, a more innovative electricity provider would be finding ways for Puerto Rico to branch into alternative energy sources like wind, solar, perhaps even ocean thermal gradients.)

The government of Puerto Rico has been unwilling to lay off worker. The Krueger et al team report: \”Puerto Rico currently has 40% fewer students but 10% more teachers than a decade ago. Teacher-student ratios are high, higher than in the mainland …\” A Wall Street Journal op-ed notes that government workers in Puerto Rico have not faced layoffs (unlike in Greece) and are typically paid about twice the average salary.

The resolution to situations like this involves some sort of deal. Any such deal tarts with a recognition by those who currently own the debt have already experienced large losses–although they not yet have recognized the fact in an accounting sense. Imagine someone you bought bonds issued by Puerto Rico that promised to pay 4-5% five years ago (as in the figure above). But now, no one will buy that bond from you at face value, because the 4-5% return isn\’t enough to compensate for the current risks of default. Instead, you would have to sell the bond at less than face value. It\’s essentially similar to buying stock, and then watching the price of the stock go down: even if you haven\’t yet sold the stock, it\’s actual value is now less–and whether you choose to admit it or not, you have in fact already lost money.

In a debt-reduction deal, those who hold the debt agree to accept some of the losses that in fact have already occurred, but hope to move to a situation where those losses will be limited. At a minimum, the lenders agree to be repaid more slowly. In exchange, the borrower offers a set of economic reforms, so that the reduced borrowing or stretched-out loans are more likely to be repaid. Of course, cutting such a deal is never easy. In the case of Puerto Rico, some of the needed reforms–like those affecting the minimum wage and the level of welfare payments–are determined by the US federal government. But the alternative of outright default won\’t be pretty, either.

Without economic growth, Puerto Rico\’s debt problems will only worsen. As Krueger et al. write:

The key to turning around Puerto Rico’s situation is a revival of growth. The island has many problems but they all result in the same outcome – a lack of growth. Structural rigidities have compromised competitiveness and yielded stagnation. Weak fiscal discipline has resulted in uncertainty that is further depressing economic activity and employment. Low growth feeds back to strains on revenue and spending. It is a vicious circle.

The good news, if you are the sort of person who can overlook the risk of screaming economic disaster in the short run and instead raise your eyes to the long-term and the big picture, is that Puerto Rico does have some notable advantages. 

Puerto Rico has many advantages to build on but also important disadvantages, some within its power to tackle and some requiring federal help. Among the advantages are its natural gifts as a tropical island, the size of its college–‐educated and bilingual population, its sizable manufacturing base, its situation as an integral part of the United States, with all the attendant benefits in terms of currency stability, legal system, property rights, and federal backing of welfare, education, defense, and banking. That is a lot. At the same time, there are numerous policy failures that raise input costs and stifle growth. While some of these are within the Commonwealth’s power to fix (such as local labor regulations), others lie in the remit of the federal government and the US Congress (the minimum wage and welfare rules, the Jones Act, and Chapter 9 bankruptcy eligibility). If these could be overcome, there is no reason why Puerto Rico could not grow in new directions – likely ones like tourism, possible ones like serving as a financial/services hub between North and South America, and entirely unpredictable ones because that is how reforms have played out elsewhere. Reducing input costs for labor, energy and transport is key to regaining competitiveness, so that production can be geared to more buoyant external markets.

In the meantime, however, the population of Puerto Rico is shrinking, as people move to other parts of the United States.