[amazon text=Invisible Wealth: The Hidden Story of How Markets Work&asin=159403527X]
by Arnold Kling, Nick Schulz, published 2011
Recently I found myself rooting around the in archives of sites like Let A Thousand Nations Bloom and Distributed Republic and I selected a few recommended titles about the frontier of economics, politics and soft institutions (culture, legal norms, etc.) looking for answers to these questions mentioned in an earlier post:
- Why do political borders and different legal systems seem to have such disparate impacts on economic development?
- Which follows which, the culture/political system or the economy?
- How sound is the idea of “competition amongst governments” and why don’t we see more countries’ policies moving toward a “developed” mean?
Invisible Wealth proved helpful in thinking more deeply about the first two questions, but it really didn’t offer any insights on the third question. The book is a mixture of introductory lessons on concepts from “Economics 2.0” intermixed with interviews from numerous academic economists who have done research in the field of the interplay between economic development and social institutions. The strongest parts of the book are the interviews with the economists. The introductory lessons suffer from too many mixed metaphors (hardware/software layer, Malthusian meadow/food court, innovation as the heart of the economy) and the insistence on delineating economic ideas as part of 1.0 or 2.0 thinking seems contrived and forced, not only because there is no existing group of economic thinkers who so identify themselves as adhering to one system of ideas or the other, but also because there is an entire school of thought, the Austrian school of economics, which recognized the importance of both 1.0 and 2.0 concepts and successfully integrated them decades ago, but which gets no spotlight aside from the consistent mentions amongst the interviews of the importance of the work of FA Hayek as an exemplar.
Briefly, Economics 1.0 is supposedly Classical Economics, which sees all economic issues in terms of the three basic inputs of land (original, unprocessed resources), labor (the effort and ingenuity of human beings interacting with those resources) and capital (the factors of production generated by mixing land and labor for future production). E1.0 is obsessed with equilibrium and static economic models, which are amenable to mathematical and statistical analysis. In contrast, Economics 2.0 acknowledges the important role of entrepreneurs in managing change and dynamism in the economy. Sadly, the authors neglect the ultra-important dimension of TIME and the role this plays in production and the coordinating activities of entrepreneurs… which is why the Austrian school again seems incredibly advanced compared to this offering and might be categorized as Economics 3.0. But even ignoring time, E2.0 is a big advance on E1.0 in acknowledging change as not only a real phenomenon of economic systems that is neglected by E1.0, but also the central element of economic development and growth. For development to take place, change must occur, and for change to occur, there must be actors with an interest and incentive in causing the change.
This shifts the analysis from studying the mineral resources or accumulated capital of a community, to studying the existence and behavior of entrepreneurs as innovators improving economic outcomes for everyone. The question begged then is, “Why do some economies have a lot of entrepreneurs, or very talented ones, while others have none or poor ones (or corrupt ones who get wealthy making people worse off)?” And for an answer to that question, one must explore the role of institutions.
With institutions, whether we’re talking E2.0 or E3.0, it’s clear that the science is still developing on which institutions are important for development, what role they play and how they can be successfully built (a significant meta-problem, because often there is feedback between a poor economy and difficulty building strong institutions and so on). There are also so many potential institutions to consider that the analysis can quickly get complicated, for example:
- Property rights (how to define, how to enforce, what can/can’t be owned and by whom)
- Legal norms (ie, tendency to rule a certain way in a certain type of case)
- Legislation (ie, “the law” that will be enforced, including civil, criminal and regulatory policies)
- “Culture” (accepted behaviors, social expectations, traditions, ideals, even aesthetics)
- History (this is an odd one because it is so intangible and uncontrollable, but the history that each community comes from has a real effect on shaping other institutions and thus economic outcomes)
- IQ (more on summary findings from [amazon text=Hive Mind&asin=0804785961] below)
- The family
I think this is why the interview portions of the book really shine. It is here that we get a lot of competing theories of development and which institutional factors are most important and why. They not only highlight how unsettled this part of economic or social science is, but also they provide outstanding examples of how critical each of these factors can be. And there is a clear distribution of insight and intelligence demonstrated by these interviews as well– while almost all of the interviewees have earned numerous awards and accolades, including Noble Prizes, for their economic work, several stand out as innovative giants while others seem to trade in the same, tired old statist fallacies of yore. What follows are some of the quotes I thought were most fascinating.
RF emphasized the role of technology in development, because as he says, “technological advance is the basis for all economic growth.”
One measure of economic development he suggested was looking at life expectancy. A rising life expectancy implies that people are able to produce sufficient resources to protect themselves from basic environmental and health risks. However, in looking at the historical data, there is an interesting trend in early industrial European societies by which rural populations maintained higher life expectancies than urban dwellers until around the turn of the 20th century. He blamed this on changes in technology, because
when you walked around in New York City, you were breathing pulverized horse manure, a much worse pollutant than the exhaust of automobiles
That idea grabbed me, both because it is vivid and disgusting, but also because it highlights that economic development is fraught with risk and even though the “ultimate” destination of economic development might be a less toxic technology like automobiles, the “path” along the way might include way points with more toxic technology (pathogen-laden pulverized horse manure) which is worse for health outcomes than taking your chances with subsistence-level existence in the countryside. A question I had which wasn’t explored in the discussion is why a.) city municipal services failed to keep the volumes of horse manure out of the streets as part of a sanitation program or b.) why market entrepreneurs didn’t collect and sell this “fertilizer” back to the countryside? It could be a technological problem within a technological problem.
Fogel also emphasized that the rate of technological change appears to be increasing in industrial economies:
it took four thousand years to go from the invention of the plow to figuring out how to hitch a plow up to a horse… it took 65 years to go from the first flight in a heavier-than-air machine to landing a man on the moon
Now, the example is cherry-picked and there are probably still a lot of technologies we’re using that are 10,000 years old (for example, if we ever primarily grow crops indoors, one could say “It took us 10,000 years to go from growing crops outdoors, to figuring out how to grow them indoors”, which seems like a really long time to figure out what will at that point be a best practice idea) but it still has impact.
He also mentioned the importance of economic development for the well-being of the aged:
you need to have a successful and rapidly growing economy in order for standards of living for the elderly to improve
I think this is true because the savings of the elderly need to earn an increasing return in real terms for their standard of living to improve without being forced to consume their capital, which puts a fixed timeline on their survival once they run out of capital entirely. And the only way their savings can earn a greater real return over time is if the entire economic pie is growing. It’s an interesting example of the connection between economic growth and and humane conditions.
RS highlighted the complexity of the problem of solving poverty in poor countries:
Without appropriate institutional infrastructure, without the right local incentives, without complementary human capital, aid and investment will be wasted… poor countries are not only poor in capital, they are poor in the factors that make for “total factor productivity”
This is a direct application of E2.0 thinking contrasted with E1.0 thinking. The E1.0 aid crowd believes that if you just redistribute enough of the world’s wealth to the poor countries, they’ll be able to escape poverty. But RS emphasizes that they’re not just poor in terms of resources but also in terms of institutions which allow them to manage and develop resources. If this is true (and I think it is), it certainly gives one pause before hitting the “Donate to Charity”-button.
PR focused on changes in technological systems and the economic impact that comes from replacing an old technology with a new one:
We didn’t get that much more light by producing hundreds of thousands of candles per person, but by switching from candles to gas
He also discussed the way technological development may improve our capacity to make further discoveries,
it may be inherent in the process of discovery that the more we learn the faster we can learn
and the impact that improvements in institutional technology have allowed us to harness those discoveries with greater efficiency:
the modern university and research system was designed not to create property rights but to lead to the rapid dispersal of new information; academics were rewarded based on the priority with which they disclosed information, so that the first person to disclose gets all the professional credit for discovering something new
what we’ve done is created better institutions over time, so that we now exploit the opportunities for discovery much more effectively than we used to
The most important insight from his interview was that growth requires change, and change creates “winners” and “losers”, and it’s easy for the losers to become a special interest group and lobby the government to arrest the change:
everyone wants growth but nobody wants change, and you’ve got to have both or you’ve got to have neither… change accompanies growth… when you have change, there will inevitably be winners and losers… we can’t let a small group of losers — either absolute losers or relative losers — stop the process of growth that will benefit most people going forward
Incidentally, this is why countries pursuing socialist policies stagnate. Socialism is a policy that preserves the status quo and tries to equalize outcomes that are created by change. Inevitably, equalizing outcomes ends up stopping the change itself and thus stagnation sets in.
JM was actually one of my favorite interviews, so I will quote him extensively.
First, he talked about the reasons why humanity has gotten increasingly technologically advanced over time:
inventions are made when there is a minimum epistemic base… you cannot build a nuclear reactor by accident… but you can invent aspirin quite serendipitiously, without having the faintest clue about how it works
We invent something, and sometimes we know a little bit about how it works, sometimes we know nothing, sometimes we know quite a bit, but in all cases, as we use it more, the epistemic base gets wider.
This technological advancement requires time, and a bit of luck, because
the only way we can think about technology is in evolutionary terms… a kind of science that makes no predictions
That’s also a really interesting idea because some economists have claimed that “science is prediction” and thus any economics which does not concern itself with empiricism and making valid predictions is not scientific. But here we have two examples (evolution, and technology) of sciences where prediction is not possible. Does that mean they are not scientific?
Later, JM goes into an explanation of the way changing technology led to economic development, and the way economic development impacted institutions and social ideas, and then the way this fed back into attempts to limit technological development and, by extension, economic development:
If you look at Europe in 1650 or 1700, what you see is a very sophisticated set of economies. They have just basically finished exploring the rest of the world, and there has been great deal of commerce and trade — joint stock companies are emerging, insurance is emerging. This is a fairly sophisticated commercial economy. The problem is, there are lots of special interests trying to get exclusionary arrangements that are good for them but bad for the economy. This is a system in which property rights are well defined and enforced, as Douglass North loves to say, but also rather distortive in the sense that you have lots of exclusionary arrangements. In other words, for the economy to function well, you don’t just need good property rights, you also need what we could call, somewhat vaguely, “economic freedoms.” You need labor mobility; you need to get rid of guilds; you need to get rid of monopolies, both local and global; you need to get rid of all kind of regulations; and above all, you need free trade. And if you don’t have that, you’re going to end up in a society that will not be able to grow.
Nowadays we have a different term for this. We call it corruption. We always say, look at countries like Russia or the Central Asian nations — these countries will never have good economies because they are corrupt. But corruption is really just a special form of what we call, in economic jargon, “rent-seeking.” I argue in my book that one of the things that happens in eighteenth-century Europe is a reaction against what we today would call rent-seeking, and that this, to a great extent, is what the Enlightenment was all about. The Enlightenment wasn’t just about freedom of religion and democracy. It wasn’t to be about democracy at all, but never mind that. It was about freedom of religion, tolerance, human rights– it was about all of those things. But it was also a reaction against mercantilism, and you find that attitude in certain people who were very important in the Enlightenment. Above all, of course, the great Adam Smith.
when you look at the few places in Europe where the Enlightenment either didn’t penetrate or was fought back by existing interests, those are exactly the countries that failed economically [Spain, Russia]
This is definitely a different take on the Enlightenment than I have come across before, but it makes a lot of sense to me and seems to do a good job of integrating economic, technological and political phenomena of the time period!
nobody has held technological leadership for a very long time… technology creates vested interests, and these vested interests have a stake in trying to stop new technologies from kicking them out in the same way that they kicked out the previous generation
That is the feedback loop mentioned earlier, and why the Enlightenment might have been a reaction against a vested interest reaction.
Cardwell’s Law: the more open the world is, the more free trade, the more ideas and people can move from one country to another, the less likely it is that technological progress will come to an end
This idea gives hope that there is a case for rational optimism assuming liberal social institutions around the world.
if you change the institutions but don’t change the culture, you’re not going to change the institutions
the degree to which we hold fast to the wisdom of earlier generations is an incredibly important element in how innovative a society is, because if you think about it, every act of invention is an act of rebellion
This suggests that “conservativism” as a social policy might lead to stunted economic development, depending upon when marks the beginning of what traditions and systems one is trying to conserve. It also highlights the problem that RS mentioned, namely, that there is complex interactivity between social institutions which enable economic growth and it’s possible that a “backwards” culture could interfere with or limit the effectiveness of “progressive” social institutions as a whole, so it’s not as simple as, say, invading a country and giving them a modern political constitution (ignoring the obviously negative social impact of a war!)
And this might seem like a throwaway quote, but I thought it was interesting:
Over most of history people have not voted their pocketbooks — Marxists included.
Thankfully! Because if they did, or do, then it will be truly hopeless to expect any kind of reform ideology to take place in the face of billions of people who could “vote their pocketbook” and keep instituting handout systems that impoverish everyone.
WE focused on the appropriateness of specific institutions to solving specific problems, namely, the planner-mentality to solving poverty. He looks at poverty as a circumstance created by a lack of innovation, and he identifies planning as a practice which is anti-thetical to innovation. Thus, planning can not solve poverty:
Planners think that the end of poverty requires a comprehensive, administrative solution. They’re trying to do something that’s a lot like central planning in the old, Soviet-style economies, in the context of poverty reduction.
It’s as if central planning has been totally, mercifully extinguished everywhere else except [in the areas with] the world’s desperate, poorest people, who can least afford such a dysfunctional solution to their problems — [areas] where it would be much better to imitate the mentality of free markets, which are all about giving financial incentives and motivating people to meet consumer needs.
corporate planning is just about scaling up a solution after you find something that works… you can’t use planning to find what works
WL, like JM, emphasizes the way that institutions can be used to enable and unleash innovative forces, or to restrict and restrain them. He also talks about attitudes of people in the industrialized West who are trying to create panacea solutions for people in poor countries:
Just because people are not educated does not mean that they are incapable, which is a mistake educated people in the West often make.
He points out that if the opposite were true, poverty would be a necessary part of the social landscape for much of the world for at least the next 50 years while several generations of people are being educated. But this wasn’t the pattern of development in the industrial countries before they obtained their industrial development and he doesn’t think it’s a good assumption for the remaining non-industrial countries as well.
No producer – no producer – has ever asked for more competition. So these domestic producers are really the secret enemies of globalization and they are exerting a lot of influence against it.
There’s that feedback loop! And it gives us an insight into the truth of protectionist policies, which don’t enable development but rather enable special interest groups to profit patriotically.
[Gordon] Wood showed that at the time of the Revolution, consumerism exploded in the United States. And consumerism was associated with fundamental notions of individual rights. Prior to that, at least in the feudal societies of Europe, consumption was viewed as a luxury to which only the land-owning class was entitled.
I’ve got a Gordon Wood book on my stack right now so I am excited to explore this idea further, this is another example of integrating economic and political ideas holistically and applying them to the analysis of a historical period to yield an interesting result.
And of course, the way you make a plan happen is by having a plan for production, not for consumption. There is no way you can plan or affect the individual choices that people make as individuals when they buy things, but you certainly can affect strongly what they have to buy through production planning. So this whole producer orientation was aided and abetted in modern times by the planning idea. It’s easy to see where the idea came from in feudal times– basically, the landowners and the people who owned the capital could control what happens. They were the only ones who had the ability to do anything. This whole battle for individual rights, for the political philosophies based on individual rights, and for what immediately comes from those political philosophies — namely, the idea of consumer rights — has expanded around the world to a relatively small degree.
Earlier I had mentioned [amazon text=Hive Mind&asin=0804785961]. Here are some “institutional” effects of High IQ societies, according to the author.
- Correlated with higher savings, which means more capital which raises the productivity of all labor
- Correlated with more cooperation, which means less corrupt government and more productive businesses
- Correlated with social market orientation, a form of social organization key to widespread prosperity
- Better at using “weakest link” team-based technology
So one challenging idea from Invisible Wealth and some of these interviews is that poor countries, in so far as they demonstrate low average IQs, as well, may have a more difficult time creating the institutional arrangements necessary to allow for sustained economic development. That has many ramifications for social policy if it’s true!
I noticed also that this idea about the importance of institutions is exactly what Hernando de Soto was discussing in his [amazon text=The Mystery of Capital&asin=0465016154], which I read last year. His approach was to emphasize property rights and formal versus informal economies. His argument was that poor countries tend to have major urban areas centered around the political capital where the elites in power and their cronies have the benefit of property rights enforcement and thus are able to build and accumulate capital, whereas the squatters and poor folk in the outlying communities not only have no property rights but are actively prevented from developing them or having them recognized by the formal legal system. The result is an estimate of trillions of dollars of capital “frozen” in informal structures which limit their exchangeability and thus their value, usefulness and ability to be improved or accumulated over time.
[amazon asin=159403527X&template=iframe image2] [amazon asin=0465016154&template=iframe image2] [amazon asin=0804785961&template=iframe image2]