The Evolving World Production Function

Robert Allen starts off his article on \”Technology and the great divergence: Global economic development since 1820\” by asking a classic question: Why have low-income countries been seemingly so slow to adopt the technologies for increased production that exist in high-income countries? The article appears in the January 2012 issue of Explorations in Economic History.  At least for now, Elsevier is allowing the article to be freely available here, but many academics will also have access through their libraries.

Some of the possible answers are that cultural factors, perhaps like Weber\’s \”Protestant work ethic,\” cause some countries rather than others to adopt new technology. Or perhaps institutional factors like a legacy of property rights and representative government make some countries likelier to develop technology. Allen argues a different view: \”This paper explores an alternative explanation of economic development based on the character of technological change itself. While the standard view assumes that technological progress benefits all countries, this paper contends that much technological
progress has been biased towards raising labor productivity by increasing capital intensity. The new technology is only worth inventing and using in high wage economies. At the same time, the new technology ultimately leads to even higher wages. The upshot is an ascending spiral of progress in rich countries, but a spiral that it is not profitable for poor countries to follow because their wages are low.\”

Simple examples of this phenomenon abound. It is cost effective to install price scanners in U.S. supermarkets, because it saves the time of cashiers, as well as purchasing and accounting workers behind the scenes. But for a low-income country with much lower wages, saving the time of workers isn\’t worth such an investment. Multiply this example all across the economy.

Using data on capital per worker and on GDP per worker across countries at different periods of time, Allen estimates a world production function. Here\’s is the evolution of the world production function for the period from 1820-1913, and from 1913 to 1920.

These production functions display some common patterns. On the far left, GDP per capita rises in a more-or-less linear way with capital per worker. On the right, at the technological frontier, GDP per capita doesn\’t rise with capital per worker. Over time, the technological frontier–where the gains from additional capital per worker don\’t add to per capita output–keeps rising. For example, the production function flattens out at about $2000 per worker in 1820, at about $4500 per worker in 1913, $17,000 per worker in 1965, and $35,000 per worker in 1990. Allen suggests that the technological leaders grow by stages, taking a generation or two to perfect the possibilities of one level of capital per worker, before then pushing further up the scale.

In this perspective, technology is quite transferable between countries with roughly similar capital to worker ratios: for example, this helps to explain the convergence in per capita GDP among high-income economies in recent decades. However, low-income countries find that the technology invented by high-income countries inappropriate for their circumstances; indeed, less capital-intensive technology from 50 or 100 years ago often seems more appropriate for them. This perspective also helps to explain why a ultra-high savings rate has often been so important as a precursor to rapid growth in places like Japan in mid-twentieth-century, and then to the East Asian \”tiger\” economies, and then to China. High savings creates a high capital to worker ratio, and thus makes it much more possible to leapfrog forward by adopting technologies closer to the frontier.

Looking ahead, an intriguing question is whether rapidly emerging economies around the world can become their own source of innovation: that is, can they take their high savings rates and draw upon world technological expertise to create a new kind of cutting-edge innovation aimed at their own home market. Can the emerging countries forge their own technological path? The Economist magazine has been predicting for the last couple of years that this process is now underway. For example, the April 15, 2010 issue had a lengthy \”Special Report\” called \”The new masters of management: Developing countries are competing on creativity as well as cost. That will change business everywhere.\” Here\’s a flavor of the argument:

\”Thirty years ago the bosses of America’s car industry were shocked to learn that Japan had overtaken America to become the world’s leading car producer. They were even more shocked when they visited Japan to find out what was going on. They found that the secret of Japan’s success did not lie in cheap labour or government subsidies (their preferred explanations) but in what was rapidly dubbed “lean manufacturing”. While Detroit slept, Japan had transformed itself from a low-wage economy into a hotbed of business innovation. Soon every factory around the world was lean—or a ruin. …

\”Now something comparable is taking place in the developing world…. Emerging countries are no longer content to be sources of cheap hands and low-cost brains. Instead they too are becoming hotbeds of innovation, producing breakthroughs in everything from telecoms to carmaking to health care. They are redesigning products to reduce costs not just by 10%, but by up to 90%. They are redesigning entire business processes to do things better and faster than their rivals in the West.

\”As our special report argues, the rich world is losing its leadership in the sort of breakthrough ideas that transform industries. This is partly because rich-world companies are doing more research and development in emerging markets. Fortune 500 companies now have 98 R&D facilities in China and 63 in India. IBM employs more people in developing countries than in America….

\”Even more striking is the emerging world’s growing ability to make established products for dramatically lower costs: no-frills $3,000 cars and $300 laptops may not seem as exciting as a new iPad but they promise to change far more people’s lives. This sort of advance—dubbed “frugal innovation” by some—is not just a matter of exploiting cheap labour (though cheap labour helps). It is a matter of redesigning products and processes to cut out unnecessary costs. In India Tata created the world’s cheapest car, the Nano, by combining dozens of cost-saving tricks.\”

This scenario suggests that in the future, technological change may not just disseminate gradually from the advanced countries to the rest of the world, as countries build up their capital/labor ratios. Instead, technological change and its effects may also be disseminating from the huge emerging markets back to consumers and firms in high-income countries.


Added note:

Louis Johnston writes from the College of St. Benedict at St. John\’s University to tell me that Robert Allen\’s article is also Chapter 4 of  Allen\’s recent book Global Economic History: A Very Short Introduction (

The U.S. and Europe: Productivity Puzzles and Information Technology

From the 1970s into the 1990s, productivity levels in Europe, as measured by output per hour, was converging with the United States. But since the mid-1990s, the U.S. productivity lead has been expanding.

Why? Nicholas Bloom, Raffaella Sadun, and John Van Reenen try to answer that question in \”Americans Do IT Better: US Multinationals and the Productivity Miracle,\” which appears in the February 2012 issue of the American Economic Review. The article isn\’t freely available on-line, although many in academia will have access through a library subscription. Part of the answer is that the resurgence of U.S. productivity since about 1995 has been driven by industries that either make or use information and communications technology. As measured by the total stock of information technology capital divided by hours worked, the U.S. economy has opened a larger lead over Europe.

These patterns are fairly well-known in the economics literature on determinants of economic growth. For example, in the Winter 2008 issue of my own Journal of Economic Perspectives, which is freely available on-line courtesy of the American Economic Association, Dale W. Jorgenson, Mun S. Ho, and Kevin J. Stiroh offer \”A Retrospective Look at the U.S. Productivity Growth Resurgence,\” which discusses how the resurgence in U.S. productivity growth in the mid-1990s was first led by productivity increases in the information-technology-producing sector, and then was led by productivity increases in industries that made intensive use of information technology. In that same issue, Bart van Ark, Mary O’Mahony, and Marcel P. Timmer discuss \”The Productivity Gap Between Europe and the United States: Trends and Causes.\” They discuss how European productivity was converging with U.S. levels, until it started diverging, and point to a possible role for information technology, along with issues related to the role of information technology and differences in labor and product market regulation.

In their just-published article, Bloom, Sadun, and  Van Reenen pose the question, and their answer, this way (footnotes omitted):

\”Given the common availability of IT throughout the world at broadly similar prices, it is a major puzzle why these IT related productivity effects have not been more widespread in Europe. There are at least two broad classes of explanation for this puzzle. First, there may be some “natural advantage” to being located in the United States, enabling firms to make better use of the opportunity that comes from rapidly falling IT prices. These natural advantages could be tougher product market competition, lower regulation, better access to risk capital, more educated or younger workers, larger market size, greater geographical space, or a host of other factors. A second class of explanations stresses that it is not the US environment per se that matters but rather the way that US firms
are managed that enables better exploitation of IT (“the US management hypothesis”). These explanations are not mutually exclusive. …\”

\”Nevertheless, one straightforward way to test whether the US management hypothesis has any validity is to examine the IT performance of US owned organizations in a European environment. If US multinationals partially transfer their business models to their overseas affiliates—and a walk into McDonald’s or Starbucks anywhere in Europe suggests that this is not an unreasonable assumption—then analyzing the IT performance of US multinational establishments in Europe should be informative. Finding a systematically better use of IT by American firms outside the United States suggests that we should take the US management hypothesis seriously. …

We report that foreign affiliates of US multinationals appear to obtain higher productivity than non-US multinationals (and domestic firms) from their IT capital and are also more IT intensive. This is true in both the UK establishment-level dataset and the European firm-level dataset. … Using our new international management practices dataset, we then show that American firms have higher scores on “people management” practices defined in terms of promotions, rewards, hiring, and firing. This holds true for both domestically based US firms as well as US multinationals operating in Europe. Using our European firm-level panel, we find these management practices account for most of the higher output elasticity of IT of US firms. This appears to be because people management
practices enable US firms to better exploit IT.\”

They carefully add in a footnote: \”It is plausible that higher scores reflect “better” management, but we do not assume this. All we claim is that American firms have different people management practices than European firms, and these are complementary with IT.\”

This work is part of a longer-term project of these authors, which seeks to spell out what is meant by \”good management,\” and then to use survey data to figure out where \”good management is being practiced. In a Winter 2010 article in my own journal,  Bloom and Van Reenen offer a useful overview of this work in \”Why Do Management Practices Differ across Firms and Countries?\”

They describe how they try to measure good management, using 18 different categories \”which focuses on aspects of management like systematic performance monitoring, setting appropriate targets, and providing incentives for good performance.\” Their group conducts interviews with middle-level corporate managers, and ranks firms on a scale of 1-5 in each of these 18 categories. One of their findings is that average management scores for U.S. firms are the highest in the world.

It sometimes seems to me, reading the news, that American firms are managed by time-serving functionaries who run the gamut from myopic to venal. But like most Americans, my direct experience with companies operating in the rest of the world is almost nonexistent. By international standards, managers of U.S. firms as a group may well be among the best in the world.

The Remarkable Consistency of Long-Run U.S. Economic Growth

President Obama\’s proposed budget for FY 2013 came out yesterday, and I did what I usually do: Skip the details of the budget proposals, and in particular skip the projections for years off in the future , which are under every president a mix of political calculations and feigned optimism about what will be enacted into legislation. Instead, head for the volumes labelled \”Analytical Perspectives\” and \”Historical Tables.\”

For example, the \”Analytical Perspectives\” volume of the proposed FY 2013 budget has some discussion of whether the U.S. economy will eventually bounce back all the way from the Great Recession to its earlier trendline of growth, or whether the Great Recession will cause a drop of the economy to a lower growth path. A figure illustrates that from 1890 to the present, the U.S. economy has followed a very consistent growth path.

The vertical axis of the graph shows per capita GDP measured by it natural logarithm. For those eyeballing the graph, the natural log of $40,000 is 10.6–roughly the present level of per capita GDP. The natural log of $5,000 is 8.5–roughly the level of real per capita GDP back in 1890. A straight line on a log graph means that the variable is growing at a constant percentage rate: in this case, at about 1.8% per year.

Here\’s how the budget discusses the question of whether the economy will eventually return to trend:

\”Recent recoveries have been somewhat weaker than average, but the last two expansions were preceded by mild recessions with relatively little pent-up demand when conditions improved. Because of the depth of the recent recession, there is much more room for a rebound in spending and production than was true either in 1991 or 2001. On the other hand, lingering effects from the credit crisis and other special factors have limited the pace of the recovery until now. Thus, the Administration is forecasting a slower than normal recovery, but one that eventually restores GDP to near the level of potential that would have prevailed in the absence of a downturn. Some international economic organizations have argued that a financial recession permanently scars an economy, and this view is also shared by some American forecasters. On that view, there is no reason to expect a full recovery to the previous trend of real GDP. The statistical evidence for permanent scarring comes mostly from the experiences of developing countries and its relevance to the current situation in the United States is debatable. Historically, economic growth in the United States economy has shown considerable stability over time as displayed in Chart 2-7. Since the late 19th century, following every recession, the economy has returned to the long-term trend in per capita real GDP. This was true even following the only previous recession in which the United States experienced a disastrous financial crisis – 1929-1933 …\”

Of course, past performance is no guarantee of future results, as the investment adviser are quick to remind you. Still, those who believe that the Great Recession will move the U.S. economy to a permanently lower growth path are making a prediction that flies in the face of the last 120 years of U.S. economic experience.

McKinsey on Reducing Debt and the Pathway to Economic Health

 The McKinsey Global Institute has just published \”Debt and deleveraging: Uneven progress on the
path to growth.\” The report uses the cases of Sweden and Finland in the 1990s as a map for how recovery from too much debt, asset bubbles, and financial crisis might proceed.  MGI writes:
\”The examples of deleveraging in Sweden and Finland during the 1990s have particular relevance today. Both nations experienced credit bubbles that led to asset bubbles and, ultimately, financial crises. But both also moved decisively to bolster their banking systems and deal with debt overhang. And—after painful recessions—both nations went on to enjoy more than a decade of strong GDP
growth.  The experiences of the two Nordic economies illustrate that deleveraging often proceeds in two stages. In the first, households, the financial sector, and nonfinancial corporations reduce debt, while economic growth remains very weak or negative. During this time, government debt typically rises as a result of higher social costs and depressed tax receipts. In the second phase, economic growth rebounds and then the longer process of gradually reducing government debt begins.\”

With this pathway to eventual recovery in mind, MGI makes an argument that the U.S. economy is actually further down the road to recovery than most other high-income countries:

\”Since the end of 2008, all categories of US private-sector debt have fallen relative to GDP. Financial-sector debt has declined from $8 trillion to $6.1 trillion and stands at 40 percent of GDP, the same as in 2000. Nonfinancial corporations have also reduced their debt relative to GDP, and US household debt has fallen by $584 billion, or a 15 percentage-point reduction relative to disposable income. Two-thirds of household debt reduction is due to defaults on home loans and consumer debt. With $254 billion of mortgages still in the foreclosure pipeline, the United States could see several more percentage points of household deleveraging in the months and years ahead as the foreclosure process

Historical precedent suggests that US households could be as much as halfway through the deleveraging process. If we define household deleveraging to sustainable levels as a return to the pre-bubble trend for the ratio of household debt to disposable income, then at the current pace of debt reduction, US households would complete their deleveraging by mid-2013. …\”

Here\’s a figure showing the rapid increase in U.S debt by sector, and the recent change. In contrast to this U.S. pattern, MGI notes that in Japan private-sector debt levels didn\’t start falling until eight years after the bursting of the bubble.

 What steps should we be seeing along the way in the next year or two that would reassure us that the U.S. economy is returning to health? The MGI report offers six \”markers.\” Here, I\’ll focus on how the U.S. economy measures up on these markers, although the report offers many intriguing comparisons to other countries, especially the United Kingdom and Spain.

\”Marker 1. Is the banking system stable?\”
The U.S. economy does seem to have stabilized the banking system (at some cost!). \”Net new mortgage lending only recently turned positive in the United States.\”

\”Marker 2. Is there a credible plan for long-term fiscal sustainability?\”
In terms of what Congress has enacted and President Obama has signed into law, the answer is clearly \”no.\”

\”Marker 3. Are structural reforms in place to unleash private-sector growth?\”
\”The United States should encourage business expansion by speeding up regulatory approvals for business investment, particularly by foreign companies, and by simplifying the corporate tax code and lowering marginal tax rates in a revenue-neutral way. Business leaders also say that the United States can improve infrastructure and the skills of its workforce and do more to encourage innovation.\”

\”Marker 4. Are the conditions set for strong export growth?\”
This step was especially important for Sweden and Finland, as small open economies. It\’s less crucial for the U.S., with its huge internal market and, by world standards, relatively low trade-to-GDP ratio. Still, the U.S. economy should be recognizing that the most rapid growth in the world economy in the next few decades is going to be happening outside our borders, and we need to be thinking about how we can tap into this growth, with everything from building connections for exporters to encouraging tourism.

\”Marker 5. Is private investment rising?\”
\”Today, annual private investment in the United States and the United Kingdom is equal to roughly 12 percent of GDP, approximately 5 percentage points below pre-crisis peaks. Both business investment and residential real estate investment declined sharply during the credit crisis and the ensuing recession. While private business investment has been rising in recent quarters, total investment remains low because of slow housing starts.\” My own expectation is that real estate investment isn\’t going to be driving the U.S. economy forward in the next few years–at best, we can hope that it won\’t be a drag. So the key to U.S. investment is business investment levels.

\”Marker 6. Has the housing market stabilized?\”
\”Both Macroeconomic Advisers and the National Association of Home Builders predict that new housing starts will not approach pre-crisis levels until at least 2013—coincidentally the year in which we estimate that US households may be finished deleveraging.\”

In my own view, the most important policy steps that flow from this analysis are the importance of building to an agreement on a credible middle-term plan for holding down the ongoing rise in U.S. government debt levels, and finding ways to encourage business investment.

McCloskey on the Great Fact of Economic Growth

In a characteristically ornate, well-considered, good-humored and provocative essay, Dierdre McCloskey has a lot to say about \”A Kirznerian Economic History of the Modern World.\” This essay was originally presented at the 2010 Upton Forum at Beloit College, which focused on the work of Israel Kirzner. This link is from a post by Peter Boettke at Coordination Problem. The conference proceedings will eventually be available third Annual Proceedings of the Wealth and Well-Being of Nations, although the essays don\’t seem to be posted on the Upton Forum website yet. Here\’s McCloskey:

\”What I got with a jolt around age 65 was that economic growth since 1800, the Great Fact of an increase of real income per head by a factor of anything from a factor of 16 (using the most conventional statistics in the countries that were richest at the outset) all the way to (if you properly account for improved quality) a factor of 100, had very little to do with routine, Samuelsonian/ Friedmanite/Douglass-Northian adjustment of marginal cost to marginal benefit. That is, mere supply-and-demand efficiency does not explain the modern world. …\”

\”The problem with all the economistic explanations lies deep within classical and most of subsequent economic thought: the conviction that shuffling stuff around makes us a little better off, which is true; and therefore that the shuffling makes us as rich as modern people are, which is false. Trade. Transportation. Reallocation. Information flow. Accumulation. Legal change. … Yet the path to the modern was not through shuffling and reshuffling. It was not by the growth of foreign trade or of this or that industry, here or there, nor by shifting weights of one or another social class. Nor indeed was it by reshufflings of property rights. Nor, to speak of another sort of reshuffling, was it by rich people piling up more riches by shuffling income away from their worker-victims. They had always done that. Nor was it through bosses being nasty to workers, or through strong countries being nasty to weak countries, and forcibly shuffling stuff toward the nasty and strong. They had always done that, too. Piling up bricks and money and colonies had always been routine. … The new path was not about anciently commonplace theft or accumulation or commercialization or reallocation or conquest of foreign kings or any other reshuffling. It was instead about discovery, and a creativity supported by novel words. In terms of the seven principal virtues, the routine of efficiency that Samuelsonian economists love so passionately depends only on the virtue of Prudence …  What I am claiming here is that Austrian discovery and creativity depends also on the other virtues, in particular on Courage and Hope. … As a result, previously unknown inputs were discovered (coal for steam engines; then coke for iron; then natural gas to replace the sickening coke burnt in French kitchens), fresh hierarchies of ends were articulated (in the new political economy, for example, which tended to the democratic end of general vs. privileged prosperity; in the new politics, which tended to the radical end of strict equality), new goods and services were created (black tulips, common stocks, reinforced concrete). All of it was very far from routine Prudence. …

To put it another way, economics in the style of Adam Smith, which is the mainstream of economic thinking, is about scarcity and saving and other Calvinistic notions … In the sweat of thy face shalt thou eat bread, till thou return unto the ground. We cannot have more of everything. Grow up and face scarcity. We must abstain Calvinistically from consumption today if we are to eat adequately tomorrow. Or in the modern catchphrase: There Ain’t No Such Thing as a Free Lunch (TANSTAAFL). But over time, taking the long view, modern economic growth has been a massive free lunch. Discovery, not reshuffling, was the mechanism, and the springs were the nonprudential virtues.\”

All of this and much else in the essay is very well-said, as one expects from McCloskey, but at some level, the posited separation between supply-and-demand efficiency and economic growth seems to me a bit overstated. Yes, basic supply and demand is static and one-time, and economic growth is a dynamic process over time. But at least when I teach supply and demand, I emphasize that the interaction of utility-maximizing consumers looking and profit-seeking producers is an evolving process. Producers are continually attempting to entice consumers, through combinations of new qualities and new products, along with price competition. Consumers are continually seeking a better deal. To me, at least, even the most basic models of mainstream supply-and-demand economics are built on more than penny-pinching Prudence. They are also incorporate discovery, creativity, and even creativity and hope.

I fear that in McCloskey\’s effort to emphasize this broader perspective, she draws too bright a line between supply-and-demand and the Great Fact of economic growth, and thus veers close to a reductionist or perhaps a mechanistic view that if economic models don\’t include a specific variable for Courage or Hope or Creativity or Discovery, then the models can\’t encompass those motivations.  But being reminded of the importance of such concerns and motivations is always useful, and thus McCloskey\’s bracing and entertaining essay is well worth reading.

Asian Century or Middle Income Trap?

Will Asia come to dominate the global economy during the 21st century? The Asian Development Bank published a thoughtful report on the subject in August called \”Asia 2050: Realizing the Asian Century.\” The Executive Summary is available here; the full report is available by searching the web. Despite the triumphalist-sounding title, the report actually has a cautionary focus. 

\”The rapid rise of Asia over the past 4-5 decades has been one of the most successful stories of economic development in recent times. Today, as Asia leads the world out of recession, the global economy’s center of gravity is once again shifting toward the region. The transformation underway has the potential to generate per capita income levels in Asia similar to those found in Europe today. By the middle of this century, Asia could account for half of global output, trade, and investment, while also enjoying widespread affluence.

While the realization of this promising outcome—referred to as the “Asian Century”—is plausible, Asia’s rise is by no means pre-ordained. Given Asia’s diversity and complexity, this rapid rise offers both important opportunities and significant challenges. In its march towards prosperity and a region free of poverty, Asia will need to sustain high growth rates, address widening inequities, and mitigate environmental degradation in the race for resources. In addition, Asian economies must avoid the middle income trap in order to realize the Asian Century.\”

As a starting point, the report offered a useful simplification for thinking about the huge region of Asia. Seven countries in Asia have roughly three-quarters of the region\’s population, and about 90% of the region\’s GDP. So in thinking about prospects for the the Asian region, one can reasonably focus on China India, Indonesia, Japan, the Republic of Korea, Thailand and Malaysia.

In the \”Asian century\” scenario, the region of Asia will regain the position in the world economy that it last held in the 1700s–that is, the region will produce more than half of all global output.

 Much of the report is a lots of discussion of possible issues that could derail this pattern: governance, urbanization, an aging population in some countries, education, regional cooperation, energy, environment, others. Here, I will pick out just a couple of broad theme.

A primary concern for Asia is the \”Middle Income Trap.\” For an illustration, consider per capita growth of Korea compared with that of South Africa and Brazil. Korea has kept per capita income generally rising, even after terrible shocks like the 1997-98 financial crisis in east Asia. In contrast, Brazil, much of Latin America, and South Africa have been stuck at more-or-less the same place for several decades.

The report explains: \”But many middle-income countries do not follow this pattern. Instead, they have bursts of growth followed by periods of stagnation or even decline, or are stuck at low growth rates. They are caught in the Middle Income Trap—unable to compete with low-income, low-wage economies in manufactured exports and with advanced economies in high-skill innovations. Put another way, such countries cannot make a timely transition from resource-driven growth, with low-cost labor and capital, to productivity-driven growth.\”

If the rising economies of Asia go follow the pattern of Latin America over most of the last 3-4 decades, then the world economy in 2050 will not look dramatically different than it does today. Instead of the Asian region producing over half the world\’s GDP by 2050, in this scenario it would produce just 31% of global GDP by 2050– not far above current level. In this scenario, by 2050 the U.S. economy would be larger than the economies of China and India combined.

The closing words of the report are: \”Asia’s future is fundamentally in its own hands.\” That statement is a bit evasive: referring to \”its own hands\” seems to imply a more unitary identity for Asia than is actually true. A great many hands will be involved in shaping the region\’s future. However, the statement also contains a deeper truth is worth considering. U.S. and Europe will surely influence the outcomes in Asia in modest ways, but Asia is a huge region, with huge population and huge resources. While exporting to the U.S. and western economist has jump-started growth in the region, it surely the capability at this point of generating continued growth from within.  Of course, whether that capability will be realized remains to be seen.

Given that the U.S. isn\’t going to determine what happens in Asia, how should it regard the possibilities?  If Asia falls into the Middle Income Trap, the U.S. can focus less on that area, both economically and politically. I personally would hope for continued economic growth in the region, because it would improve the standard of living so dramatically for several billion people. In this Asian Century scenario, the U.S. should be striving to find a way to connect its human, managerial, technological, financial, and other resources with all that vibrant economic growth, so that we can benefit from it. If the world economy is going to be pulled ahead by an Asian locomotive, the U.S. had better start figuring out how to reserve some good seats on the train. 

For a previous post on this topic, see Will Emerging Economies Dominate the World Economy? from July 22, 2011. For posts in the last few months on China catching up to and perhaps surpassing the U.S. economy, see Will China Catch Up to the U.S. Economy? from June 27, 2011, and Is China\’s Economic Dominance in the Long Run a Sure Thing? from September 9, 2011.

Independence and Depression: Economics of the American Revolution

For at least half a century, economic historians looking at colonial America have started with 1840–when the U.S. census collected useful data about economic issues like occupations and industry–and then worked  backward. A common approach was to divide the 1840 economy into sectors, and then work backwards trying to make reasonable estimates about the number of workers in each sector and their productivity.

Peter Lindert and Jeffrey Williamson have been taking an alternative approach. They have been collecting  available archival data, like local censuses, tax lists, and occupational directories. They look for data on occupation or in some cases on social class, and then combine it with data on wages. They then extrapolate from documented localities within a region to similar undocumented localities within a region, and so on up to the national level. More broadly, instead of trying to estimate GDP from the production side of the economy, they try to estimate it from the income-earning side of the economy.  

A nice readable overview of their work is available in an essay published in July on VOX called \”America\’s Revolution: Economic disaster, development, and equality.\” Those who want to know more about how the sausage was made can look at their NBER working paper (#17211) from last July: \”American Incomes Before and After the Revolution.\” And those who want to see the actual uncooked meat inside the sausage can look at their open-source data website here. The effort is clearly a work in progress: at one point they refer to it as \”controlled conjectures\” and at another point as \”provocative initial results.\” Here are three of their findings:

During the Revolutionary War and in its aftermath, the U.S. economy contracted by Depression-level amounts. From 1774 up to about 1790, on their analysis, the U.S economy may have declined  by \”28% or even higher in per capita terms.\” They offer several plausible reasons for this decline: the destruction caused by the War itself;  the sharp decline in exports caused by the Revolutionary War, including the loss of more than half of all pre-war trade with England by 1791; and the departure of skilled and well-connected loyalists. Urbanization is typically a sign of economic development, but during this time period, the U.S. economy was de-urbanizing. They write: To identify the extent of the urban damage, one could start by noting that the combined share of Boston, New York City, Philadelphia, and Charleston in a growing national population shrank from 5.1% in 1774 to 2.7% in 1790, recovering only partially to 3.4% in 1800. There is even stronger evidence confirming an urban crisis. The share of white-collar employment was 12.7% in 1774, but it fell to 8% in 1800; the ratio of earnings per free worker in urban jobs relative to that of total free workers dropped from 3.4 to 1.5 …\” 

These economic losses seem to me an often-neglected part of the usual historical narrative of America\’s War for Independence. Those fighting for independence were sticking to their cause, even as the typical standard of living plummeted.

The American South was the region that suffered by far the most from the Revolutionary War. 
On their estimate, the New England region suffered only a modest loss in per capita GDP of -.08% per year from 1774 to 1800, and then grew at a robust annual rate of 2.1% from 1800 to 1840. The Middle Atlantic region suffered a larger annual decline in per capita GDP of 0.45% from 1774 to 1800, but bounced back with an annual growth rate in per capita  GDP of 1.45% from 1800 to 1840. However, the Southern region experienced a near-catastrophic drop of 1.57% per year in per capita GDP over the quarter-century from 1774-1800, and rebounded to a growth rate of just 0.43% from 1800 to 1840. On their numbers, the South is has by far the highest incomes of the three regions in 1774, and by far the lowest per capita GDP of the three regions by 1840. Indeed, on their estimated, real per capita GDP in the South in 1840 was about 20% below its level in 1774!

This absolute and relative decline of the South has been used as an example of how institutions can shape long-run economic development. The basic argument is that when the New World was settled, certain areas seemed well suited mining and plantation agriculture. Those areas ended up with what  Daron Acemoglu, Simon Johnson, James A. Robinson in a 2002 article referred to as \”extractive institutions, which concentrate power in the hands of a small elite and create a high risk of expropriation for the majority of the population, are likely to discourage investment and economic development. Extractive institutions, despite their adverse effects on aggregate performance, may emerge as equilibrium institutions because they increase the rents captured by the groups that hold political power.\” The alternative is areas where extractive economics won\’t work, and these areas instead receive a \”cluster of institutions ensuring secure property rights for a broad cross section of society, which we refer to as institutions of private property, are essential for investment incentives and successful economic performance.\” In their 2002 article in the Quarterly Journal of Economics, the authors apply this dynamic broadly across the settlement of the New World, and they title the article: \”Reversal of Fortune:  Geography and Institutions in the Making of the Modern World Income
Distribution.\” For a nice readable article laying out a similar theory, see \”Factor Endowments, and Paths of Development in the New World,\” by  Kenneth L. Sokoloff and Stanley L. Engerman, in the Summer 2000 issue of my own Journal of Economic Perspectives. (The JEP is publicly available, including the most recent issue and archives going back more than a decade, courtesy of the American Economic Association.)

I can\’t claim any expertise on the interaction of economic conditions and public mood in the years leading up the U.S. Civil War. But it does seem to me that seeing the U.S. South as a region where per capita GDP had for decades been struggling to recover from an enormous decline, while in relative terms falling ever farther behind other regions of the country, helps to deepen my understanding of the South\’s sense of separateness which fed into a willingness to secede.

Without the economic damage from the Revolutionary War, the U.S. economy might have started its period of more rapid economic growth several decades sooner–and perhaps been the first nation in the world to do so. Economic historians do love considering counterfactual possibilities, and this one strikes me as a good provocative one. Lindert and Williamson write: \”It seems clear that America joined Kuznets’s modern economic growth club sometime after 1790, with the North leading the way, while the South underwent a stunning reversal of fortune. And without the 1774-1790 economic disaster, it appears that America might well have recorded a modern economic growth performance even earlier, perhaps the first on the planet to do so.\”

The Natural Resources Curse

Jeffrey Frankel has a readable overview of the arguments over \”The Curse: Why Natural Resources are Not Always a Good Thing,\” in the Fourth Quarter 2011 issue of the Milken Institute Review, available (with free registration) here.  Frankel writes:

\”It is striking how often countries that are rich with oil, minerals or fertile land have failed to grow more rapidly than those without. Angola, Nigeria and Sudan are all awash in petroleum, yet most of their citizens are
bitterly poor. Meanwhile, East Asian economies, including Japan, Korea, Taiwan, Singapore and Hong Kong, have achieved Western-level standards of living despite being rocky islands (or peninsulas) with virtually no exportable natural resources. This is the phenomenon known to economists as the “natural resources curse.” The evidence for its existence is more than anecdotal. The curse shows up in econometric tests of the determinants of economic performance across a comprehensive sample of countries.
Consider the figure on page 31, which plots the relationship between nonagricultural resource exports as a portion of total goods exports and average economic growth rates over the past four decades. The usual
suspects – China, Korea, Thailand – are conspicuously high in growth and low in natural resources. Likewise, resource-rich Liberia, Venezuela and Zambia have little to show for their wealth in terms of economic development. The negative correlation is not very strong because some countries – think Chile and Saudi Arabia – have managed to have it both ways. But the data certainly suggest no positive correlation between natural resource wealth and economic growth.\”

Frankel offers a wide array of examples and evidence on the natural resources curse. Along the way, he reviews the possible reasons why natural resources might hinder economic growth: 1) Commodity prices fluctuate a lot, so an economy that depends on commodity exports will be hit by a series of shocks; 2) An economy focused on natural resources diverts land, labor, and capital from other sectors of the economy, like manufacturing; 3) Natural resource endowments can foster corruption and weak institutions, as different groups jostle for control of the income from the resources; 4) High exports of natural resources can lead to currency appreciation which then disadvantages all other exports; and 5) Natural resources can be depleted.

He also discusses policies that countries can use to reduce the risk of these pitfalls.

• Hedge export proceeds on derivatives markets (in particular, options markets), as Mexico has done with oil. That way, exporting countries can plan government budgets around firm expectations of revenues and, as important, dampen shocks caused by unanticipated  changes in price.

• Denominate debt in terms of the world price of the export commodity. Exporting countries can (and, in some cases, should) borrow abroad, for example, to develop infrastructure. By writing debt contracts in which the principal is indexed to the price of their export commodity, borrowing countries can share the risk of commodity price volatility with lenders. …

• Adopt Chilean-style fiscal rules, which prescribe a structural budget surplus and use independent panels of experts to determine what future price of the export commodity – in Chile’s case, copper – should be assumed in forecasting the structural budget. Thus, when the independent experts determine that copper prices have fallen below long-term expectations, the government is authorized to offset the impact with temporary fiscal stimulus. But when copper prices are above the long term trend, and the bonanza is determined to be entirely temporary, the government must save the proceeds.

• Intervene in foreign exchange markets to dampen upward pressure on an exporter’s currency in the early stages of commodity booms, while seeking to prevent the money supply from swelling. Subsequently, allow gradual appreciation when the commodity boom has proved to be long-lived or when domestic inflation is no longer contained.

• Establish transparent sovereign wealth funds with the proceeds of commodity exports in order to assure that future generations share the bounty. Botswana’s Pula Fund, built on earnings from the sale of diamonds, is a good model. The fund, invested entirely in securities denominated in other currencies, serves both as a sinking fund to offset the depletion of diamonds and as a buffer to smooth economic fluctuations.

• Make lump-sum per capita distributions of revenues from mineral exports in order to make sure the money doesn’t end up in the bank accounts of corrupt officials.

The Vast, Automatic, Invisible Economy: W. Brian Arthur

W. Brian Arthur has written \”The Second Economy\” for the October 2011 issue of the McKinsey Quarterly. (Free registration is needed to access the article.) The subheading under the title is: \”Digitization is creating a second economy that’s vast, automatic, and invisible—thereby bringing the biggest change since the Industrial Revolution.\” As one expects from Arthur, this short essay is full of thought-provoking comments. Here are a few highlights:

What does an economic transformation look like?

 \”In 1850, a decade before the Civil War, the United States’ economy was small—it wasn’t much bigger than Italy’s. Forty years later, it was the largest economy in the world. What happened in-between was the railroads. They linked the east of the country to the west, and the interior to both. They gave access to the east’s industrial goods; they made possible economies of scale; they stimulated steel and manufacturing—and the economy was never the same.

Deep changes like this are not unusual. Every so often—every 60 years or so—a body of technology comes along and over several decades, quietly, almost unnoticeably, transforms the economy: it brings new social classes to the fore and creates a different world for business. Can such a transformation—deep and slow and silent—be happening today? …

But I want to argue that something deep is going on with information technology, something that goes well beyond the use of computers, social media, and commerce on the Internet. Business processes that once took place among human beings are now being executed electronically. They are taking place in an unseen domain that is strictly digital. On the surface, this shift doesn’t seem particularly consequential—it’s almost something we take for granted. But I believe it is causing a revolution no less important and dramatic than that of the railroads. It is quietly creating a second economy, a digital one.\” …

\”Now this second, digital economy isn’t producing anything tangible. It’s not making my bed in a hotel, or bringing me orange juice in the morning. But it is running an awful lot of the economy. It’s helping architects design buildings, it’s tracking sales and inventory, getting goods from here to there, executing trades and banking operations, controlling manufacturing equipment, making design calculations, billing clients, navigating aircraft, helping diagnose patients, and guiding laparoscopic surgeries. Such operations grow slowly and take time to form. …\”

First an economic system with muscles, and now one with nerves

\”Think of it this way. With the coming of the Industrial Revolution—roughly from the 1760s, when Watt’s steam engine appeared, through around 1850 and beyond—the economy developed a muscular system in the form of machine power. Now it is developing a neural system. This may sound grandiose, but actually I think the metaphor is valid. Around 1990, computers started seriously to talk to each other, and all these connections started to happen. The individual machines—servers—are like neurons, and the axons and synapses are the communication pathways and linkages that enable them to be in conversation with each other and to take appropriate action.

Is this the biggest change since the Industrial Revolution? Well, without sticking my neck out too much, I believe so. In fact, I think it may well be the biggest change ever in the economy. It is a deep qualitative change that is bringing intelligent, automatic response to the economy. There’s no upper limit to this, no place where it has to end. Now, I’m not interested in science fiction, or predicting the singularity, or talking about cyborgs. None of that interests me. What I am saying is that it would be easy to underestimate the degree to which this is going to make a difference.

I think that for the rest of this century, barring wars and pestilence, a lot of the story will be the building out of this second economy, an unseen underground economy that basically is giving us intelligent reactions to what we do above the ground. For example, if I’m driving in Los Angeles in 15 years’ time, likely it’ll be a driverless car in a flow of traffic where my car’s in a conversation with the cars around it that are in conversation with general traffic and with my car. The second economy is creating for us—slowly, quietly, and steadily—a different world. …\”

Will this second economy change the nature of jobs and how economic production is distributed?

\”The second economy will produce wealth no matter what we do; distributing that wealth has become the main problem. For centuries, wealth has traditionally been apportioned in the West through jobs, and jobs have always been forthcoming. When farm jobs disappeared, we still had manufacturing jobs, and when these disappeared we migrated to service jobs. With this digital transformation, this last repository of jobs is shrinking—fewer of us in the future may have white-collar business process jobs—and we face a problem.

The system will adjust of course, though I can’t yet say exactly how. Perhaps some new part of the economy will come forward and generate a whole new set of jobs. Perhaps we will have short workweeks and long vacations so there will be more jobs to go around. Perhaps we will have to subsidize job creation. Perhaps the very idea of a job and of being productive will change over the next two or three decades. The problem is by no means insoluble. The good news is that if we do solve it we may at last have the freedom to invest our energies in creative acts.\”

Global Equality and the Lucas Horse Race

It is possible that although inequality within many countries is rising, global inequality is actually falling. After all, a number of countries with lower levels of per capita income, like China and India, have been experiencing rapid growth. Perhaps from a global viewpoint, the gap between high and low incomes is diminishing even though within countries, that gap has been rising.

In the Winter 2000 issue of my own Journal of Economic Perspectives, Robert E. Lucas 
contributed \”Some Macroeconomics for the 21st Century.\”  He offers a horse-racing metaphor that I have found useful in explaining the rise in global inequality over the last couple of centuries–and he predicts that the 21st century will be one of greater global equality. Here\’s Lucas:

\”We consider real production per capita, in a world of many countries evolving through time. For modelling simplicity, take these countries to have equal populations. Think of all of these economies at some initial date, prior to the onset of the industrial revolution. Just to be specific, I will take this date to be 1800. Prior to this date, I assume, no economy has enjoyed any growth in per capita income—in living standards—and all have the same constant income level. I will take this pre-industrial income level to be $600 in 1985 U.S. dollars, which is about the income level in the poorest countries in the world today and is consistent with what we know about living standards around the world prior to the industrial revolution. We begin, then, with an image of the world economy of 1800 as consisting of a number of very poor, stagnant economies, equal in population and in income.

\”Now imagine all of these economies lined up in a row, each behind the kind of mechanical starting gate used at the race track. In the race to industrialize that I am about to describe, though, the gates do not open all at once, the way they do at the track. Instead, at any date t a few of the gates that have not yet opened are selected by some random device. When the bell rings, these gates open and some of the economies that had been stagnant are released and begin to grow. The rest must wait their chances at the next date, t + 1. In any year after 1800, then, the world economy consists of those countries that have not begun to grow, stagnating at the $600 income level, and those countries that began to grow at some date in the past and have been growing every since.

The first is that the first economy to begin to industrialize—think of the United Kingdom, where the industrial revolution began—simply grew at the constant rate a from 1800 on. I chose the value α = .02 which, as one can see from the top curve on the figure, implies a per capita income for the United Kingdom of $33,000 (in 1985 U.S. dollars) by the year 2000. …

So much for the leading economy. The second assumption … is that an economy that begins to grow at any date after 1800 grows at a rate equal to a α = .02, the growth rate of the leader, plus a term that is proportional to the percentage income gap between itself and the leader. The later a country starts to grow, the larger is this initial income gap, so a later start implies faster initial growth. But a country growing faster than the leader closes the income gap, which by my assumption reduces its growth rate toward .02. Thus, a late entrant to the industrial revolution will eventually have essentially the same income level as the leader, but will never surpass the leader’s level. …

\”Ideas can be imitated and resources can and do flow to places where they earn the highest returns. Until perhaps 200 years ago, these forces sufficed to maintain a rough equality of incomes across societies (not, of course, within societies) around the world. The industrial revolution overrode these forces for equality for an amazing two centuries: That is why we call it a “revolution.” But they have reasserted themselves in last half of the 20th century, and I think the restoration of inter-society income equality will be one of the major economic events of the century to come.\”

What is the evidence on global inequality? Branko Milanovic offers a useful figure, where inequality is measured by the Gini coefficient. For those not familiar with this term, the quick intuition is that it is a measure of inequality where 0 represents complete equality of income and 100 represents complete inequality (one person has all the resources). Here is a figure showing Gini coefficients for relatively equal Sweden, the less equal U.S. economy, the still-less-equal Brazilian economy, and the world economy.

Milanovic writes: \”Global inequality seems to have declined from its high plateau of about 70 Gini points in 1990–2005 to about 67–68 points today. This is still much higher than inequality in any single country, and much higher than global inequality was 50 or 100 years ago. But the likely downward kink in 2008—it is probably too early to speak of a slide—is an extremely welcome sign. If sustained (and much will depend on China’s future rate of growth), this would be the first decline in global inequality since the mid-19th century and the Industrial Revolution.

One could thus regard the Industrial Revolution as a “Big Bang” that set some countries on a path to higher income, and left others at very low income levels. But as the two giants—India and China—move far above their past income levels, the mean income of the world increases and global inequality begins to decline.\”