Tyler Cowen’s Best Business Aphorism

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From an interview with Nick Beckstead on the topic of existential risk, meaning fundamental threats to the human race.

In his view, uploads are just an idea that some people came up with, most ideas don’t work, and most institutions are dysfunctional. Those truths seem more important for thinking about the distant future than any complicated arguments for the feasibility and importance of uploads.

Emphasis added to highlight the phrase that grabbed me.

Another aphoristic excerpt from the interview:

People in rural areas care most about things like fights with local villages over watermelon patches. And that’s how we are, but we’re living in a fog about it.

Scott Sumner on the German Jobs Miracle

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He writes,

So what’s the real explanation for the German success? That’s pretty obvious; the Hartz reforms of 2003 sharply reduced the incentive to not work, and sharply increased the incentive to take low wage jobs. As a result, today Germany has lots of very low wage jobs of the type that would be illegal in France or California. (Germany has no minimum wage.)

Noah Smith on Solar Power

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He writes,

Solar is a libertarian dream. The utility companies that states like Oklahoma are scrambling to protect are cozy government-protected monopolies (though eventually they too will survive by switching to solar). Rooftop solar offers a chance for independent homeowners to free themselves from reliance on a collectivist system. And solar is a triumph of human ingenuity, the kind of advance that Julian Simon believed would always save us from “limits to growth” – in the long run, oil and coal and gas will run out, but cheap solar will sustain capitalism.

Pointer from Mark Thoma. I agree that as innovations continue to bring about reductions in the relative cost of solar power, many benefits will ensue. Still, I believe that the Department of Energy’s loan guarantees to solar companies (and others) were not good policy, and certainly not libertarian in spirit. I am interested in engaging with those who would criticize such a belief. I am not interested in engaging the theory that conservatives, because of their evil nature, are opponents of solar power.

By the way, as I read the table in Timothy Taylor’s post, solar power does not come across as particularly inexpensive in the near future. And you should also read this earlier Timothy Taylor post:

When a technological standard is required, then firms which could have reduced pollution more cheaply are not allowed to gain a competitive advantage from doing so–because all must follow the prescribed standard.

Read the whole post, which describes the tendency for environmental regulation to become less about reducing pollution and more about restricting competition.

I propose that we try to eliminate from discussions of public policy related to solar and nuclear energy any arguments that are based on sentiment, wishful thinking, or rent-seeking. Everybody police their own side.

What’s Wrong With the Neoclassical Production Function

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The NPF makes sense in a simple context. Suppose you are an entrepreneur with a fruit orchard. You can pay to have fruit trees planted. That is your capital. After a while the fruit trees mature, and you hire workers to pick and sell the fruit. That is your labor. The function Y = f(K,L), which says that output is a function of capital and labor, is a reasonable model that can help to predict your decisions and the share of income that goes to your workers.

Economists from Ricardo to Piketty have wanted to describe the relationship between economic growth and income distribution in terms of simple laws. For the past fifty years or so, the NPF has been the go-to tool for economists trying to do this. Mathematically, it is very elegant for that purpose.

But thinking of the economy in terms of an aggregate NPF has many problems, including the following:

1. Capital aggregation. There is a huge, huge literature on this (see “Cambridge capital controversies”). The result was that the economists who claimed that you cannot construct a meaningful aggregate out of different types of capital equipment won the theoretical battle but lost the practical war. That is, those who use capital aggregation admit that it is bogus, but they go ahead and do it anyway. It’s a matter of “I need the eggs.”

2. Solow residual. The NPF can account for only a small fraction of changes in economic growth over time or differences in productivity across countries. The unexplained differences are known as the Solow residual. Again, there is a huge literature devoted to this issue.

3. Labor heterogeneity. In the NPF, there is one wage rate, which is what is needed to induce you to give up an hour of leisure. In the real world, there are many different salaries paid to different people.

4. Capital proliferation. Over the past fifty years, economists have conceptualized many types of capital. We now have human capital, social capital, organizational capital, institutional capital, environmental capital, network capital, consumer capital, cultural capital, knowledge capital, innovation capital, and so on. Some forms of capital help with understanding labor heterogeneity. Other types help with the Solow residual. But these multiple forms of capital mess with the simple NPF and with the correspondence between theoretical concepts and real world data.

5. Knightian uncertainty. Unlike our theoretical orchard-owner, real-world entrepreneurs must cope with the fact that the return on a particular investment is unknown ex ante. The distribution of income among capitalists is affected by differences in ex post returns. Moreover, since so much of “labor” income is an accrual to human capital, all of us are capitalists, and hence most “labor” income is subject to differences in ex post returns.

So, should we use the NPF to guide economic policy to try to achieve the best balance among growth and the distribution of income? Some possibilities:

(1) The criticisms of the aggregate NPF are not important, so that policy conclusions are still sound.

(2) Some of the criticisms are devastating, but we need some tool to guide policy, and until something better comes along our best choice is the aggregate NPF.

(3) Some criticisms are devastating, and as a result we should be very cautious and humble about making policy pronouncements based on our understanding of the NPF.

To me, (3) makes the most sense. But that is not a popular position at the moment.

My Best Sentence?

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From my January 31st post:

Again, I have not read the book (it will be released in about 6 weeks). Does he come out in favor of privatizing Social Security? If not, then why not?

According to Arpit Gupta, Piketty understands how his analysis helps make a case for privatizing Social Security, but he says

one must bear in mind that the return on capital is in practice extremely volatile. It would be quite risky to invest all retirement contributions in global financial markets. The fact that r > g on average does not mean that it is true for each individual investment. For a person of sufficient means who can wait ten or twenty years before taking her profits, the return on capital is indeed quite attractive. But when it comes to paying for the basic necessities of an entire generation, it would be quite irrational to bet everything on a roll of the dice. The primary justification of the PAYGO system is that it is the best way to guarantee that pension benefits will be paid in a reliable and predictable manner: the rate of wage growth may be less than the rate of return on capital, but the former is 5-10 times less volatile than the latter.

What’s that, Dr. Piketty? There’s risk, you say? Capital income is 5-10 times more volatile than labor income? It is “quite irrational to bet” on capital unless you are “a person of sufficient means”? And these factors only matter in the context of Social Security privatization, but can be ignored in the main part of your book?

Joshua Gans’ Best Sentence

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In his take on Piketty, he writes,

It forced me, for one, to think about and go back and see what economists had said on this issue.

Read the whole post. It raises the possibility that Piketty’s support for his own thesis may not hold up, but the book will still make a major contribution by forcing economists to pay attention to the underlying issues.

I think that is right. For me, the interesting issue concerns the neoclassical production function. The beauty of the NPF is that it offers an integrated theory of growth and distribution, which is exactly how Piketty wants to use it. But the NPF has many known weaknesses. Some possibilities:

1. The weaknesses in the NPF are not important in practice, so it is ok to rely on it for insights, in either narrow or broad applications.
2. The weaknesses in the NPF can be addressed in narrow applications through straightforward modifications. However, for truly broad applications, such as Piketty’s, the necessary modifications are too many and complex to make it practical.
3. The NPF is always and everywhere a source of error and deception, and we need to somehow wean ourselves from it.

Over the years, (3) has been the view of the heterodox left (see Jamie Galbraith on Piketty). The response of mainstream economics to these critiques reminds me of the Woody Allen joke about the guy with a crazy relative who thinks he’s a chicken. Asked why he won’t take the relative to a psychiatrist, the guy answers, “I need the eggs.” Mainstream economists might agree that the NPF is crazy, but they need the eggs. In other words, the mainstream view is somewhere between (1) and (2).

My views are somewhere between (2) and (3), probably closer to (3). Maybe we’re due for an essay that argues (3) from an Austrian sort of viewpoint.

Tyler Cowen’s Best Sentence

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From his own review of Piketty.

In this sense, Piketty is like a modern-day Ricardo, betting too much on the significance of one asset in the long run: namely, the kind of sophisticated equity capital that the wealthy happen to hold today.

Cowen notes that Ricardo’s prediction that wealth would ultimately accrue to owners of land proved inaccurate. Read his entire review, as well as his related blog post. In the latter, I like these sentences:

Piketty converts the entrepreneur into the rentier. To the extent capital reaps high returns, it is by assuming risk (over the broad sweep of history real rates on T-Bills are hardly impressive). Yet the concept of risk hardly plays a role in the major arguments of this book. Once you introduce risk, the long-run fate of capital returns again becomes far from certain. In fact the entire book ought to be about risk but instead we get the rentier.

Regular readers will note that I have expressed concerns about this issue.

Clive Crook’s Best Sentence

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It is not in the excerpt of Crook’s review of Piketty that Tyler Cowen blogged. Instead, my favorite sentence is this:

It could also explain why the book has been greeted with such erotic intensity: It meets the need for a work of deep research and scholarly respectability which affirms that inequality, as Cassidy remarked, is “a defining issue of our era.”

I’ll get in trouble for saying this, but I will say it anyway:

Marx’s economics never stood on its merits. He got major things clearly wrong.

Keynes’ economics was never proven right or wrong, but by the same token no one has ever been able to pin down the answer to the question, “What did Keynes really mean?” Who else has spawned such a voluminous and inconclusive literature dedicated to seeking the “correct” interpretation? You don’t see economists floundering over the issue of “What did Coase really mean?” or “What did Samuelson really mean?” But with Keynes, that remains the overriding reason to read The General Theory–to try to figure out what the heck the guy really meant. I would say that after more than 75 years of attempts to clarify Keynes, one must either conclude that he was a clear thinker whose ideas are so brilliant that they have eluded the understanding of all subsequent economists–or that perhaps he was not such a clear thinker.

Galbraith’s The New Industrial State was the best-seller that was greeted with erotic intensity in the late 1960s, but on its merits it fell short as well. One of its central themes was that entrepreneurialism was dead, replaced by Soviet-style planning at American industrial giants. As Deirdre McCloskey tartly observed, “Eight years after the first publication of The New Industrial State, Bill Gates founded Microsoft.”

So before we pronounce Piketty’s book a masterpiece, I suggest waiting to see how the economic arguments shake out.

Robert Solow on Piketty

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Solow writes,

if the economy is growing at g percent per year, and if it saves s percent of its national income each year, the self-reproducing capital-income ratio is s / g (10 / 2 in the example). Piketty suggests that global growth of output will slow in the coming century from 3 percent to 1.5 percent annually. (This is the sum of the growth rates of population and productivity, both of which he expects to diminish.) He puts the world saving / investment rate at about 10 percent. So he expects the capital-income ratio to climb eventually to something near 7 (or 10 / 1.5). This is a big deal, as will emerge. He is quite aware that the underlying assumptions could turn out to be wrong; no one can see a century ahead. But it could plausibly go this way.

…The labor share of national income is arithmetically the same thing as the real wage divided by the productivity of labor. Would you rather live in a society in which the real wage was rising rapidly but the labor share was falling (because productivity was increasing even faster), or one in which the real wage was stagnating, along with productivity, so the labor share was unchanging? The first is surely better on narrowly economic grounds: you eat your wage, not your share of national income. But there could be political and social advantages to the second option. If a small class of owners of wealth—and it is small—comes to collect a growing share of the national income, it is likely to dominate the society in other ways as well. This dichotomy need not arise, but it is good to be clear.

Both Tyler Cowen and Solow make the same point about wages, but they do so subtly. Let me be blunt: Piketty’s nightmare scenario, in which capital accumulates and has a high return, is a terrific scenario for wages in absolute terms. If workers care about what they can consume, as opposed to the ratio of their net worth to that of the capital owners, they would hate to see any policy that might interfere with the high rates of investment that Piketty is envisioning. Note, however, that I personally would not concede that the distinction between workers and capital-owners is as clear-cut as it is in the Solow growth model.

The tone of Solow’s review is generally laudatory. It also is by far the clearest explanation of Piketty’s argument that I have read. It reflects Solow’s command of the logic of economic growth as well as his abilities as a teacher.

I think that Solow arrives at a higher evaluation of the book than I would for two reasons. First, Solow gives Piketty the benefit of the doubt on nearly every uncertain issue. For example, on the crucial assumption that Piketty makes that the rate of return on capital remains steady even as the capital-income ratio creeps ever higher, Solow writes,

Maybe a little skepticism is in order. For instance, the historically fairly stable long-run rate of return has been the balanced outcome of a tension between diminishing returns and technological progress; perhaps a slower rate of growth in the future will pull the rate of return down drastically. Perhaps. But suppose that Piketty is on the whole right.

On another issue, the fact that inequality is high between different workers, not just between workers and capitalists, Solow offers a hand-waving defense of Piketty. Solow writes,

Another possibility, tempting but still rather vague, is that top management compensation, at least some of it, does not really belong in the category of labor income, but represents instead a sort of adjunct to capital, and should be treated in part as a way of sharing in income from capital…

it is pretty clear that the class of supermanagers belongs socially and politically with the rentiers, not with the larger body of salaried and independent professionals and middle managers

To this, I would say: why draw the line at supermanagers? Why not say that the salaries of college professors that are paid out of university endowments are “a way of sharing income from capital”? The way I look at it, the amount of income that does not represent “a sort of adjunct to capital” (including human capital) is miniscule, perhaps less than 1 percent of GDP.

My second disagreement with Solow is that he, like Piketty, omits any discussion of risk as a component of “r.” In that regard, Tyler Cowen’s skeptical review better accords with my own thinking.

The way I see it, Piketty and Solow work with models that incorporate homogeneous workers (with no differences in human capital) and homogeneous capital (with no differences in ex ante risk or ex post returns). The real world is so far removed from those models that I simply cannot buy into the undertaking.