Cowen's Great Stagnation, von Mises's Great Solution

Tyler Cowen recently wrote a $4 e-book, The Great Stagnation, a book enjoyed by Reihan Salam on the right and Matthew Yglesias on the left. Alas, missives with such broad appeal are like David Broder or board games that are ‘fun for the whole family’: lots of praise, mainly due to ulterior motives. In this case, his even-handed criticism of the right and left allows anyone with a little nuance to claim a well-know objective economist agrees with his particular spin, always useful for pundit who has a daily word quota.

The book is motivated by our current slump, and as von Mises noted in Human Action (p441):

Nothing has harmed the cause of liberalism more than the almost regular return of feverish booms and of the lingering slumps.

That is, most observers focus on the recessions, and try to play these into broader themes. Their magnitudes pale in comparison to the secular growth rates that over generations differentiate us from Ghana and other impoverished countries. They are as relevant to our nation’s long-term growth as a flu is to the growth of a child. They breed counterproductive remedies like the National Industrial Recovery Act of 1933, or the endless extensions of unemployment insurance. The cumulative effect of our remedies is to increase the scope of government in every dimension of the economy and is probably the main reason for our productivity slowdown.

Here’s Cowen’s theme: we live in an unusual era of lower productivity, and the financial crisis was merely a symptom of this broad trend we are just now realizing. Here’s the key graph:

In a figurative sense, the American economy has enjoyed lots of low-hanging fruit since at least the seventeenth century: free land; immigrant labor; and powerful new technologies. Yet during the last forty years, that low-hanging fruit started disappearing and we started pretending it was still there. We have failed to recognize that we are at a technological plateau and the trees are barer than we would like to think. That’s it. That is what has gone wrong.

I think the housing bubble was in many ways a singular event, though a special case of a catastrophic regime collapse as outlined in my Batesian Mimicry model of business cycles. This theory posits that recessions are always different because misallocations can only occur where they are unexpected, and by definition unexpected things are somewhat unique. The housing bubble is not very relevant to the post-1975 slowdown in productivity growth.

Despite Tyler's depressing diagnosis, he notes some good news. A lot of value is being created that isn’t priced, so maybe everyone should take comfort in that. For example, in the mid 70's productivity growth started to decline, but at the same time there started an explosion of free porn created by the VCR and the internet (not his example, but serves his point). Is that a wash? Maybe measured GDP really is rising as fast as ever, we just don’t count it well anymore because so many things are often free. Perhaps, but you could say the same thing in the past, as with pasteurization or radio.

Another bit of good news according to Cowen is that there is some low hanging fruit in those diseased fields of health care and K-12 education. For example, he mentions that:

we now see a critical mass in the American electorate favoring concrete steps to bring greater quality and accountability to K-12 education...Obama has opted for an education policy that, on the whole, the teachers union strongly dislike.

I do not see any big education changes around the corner. Obama’s weak support of merit pay is going nowhere, and would not make a difference if implemented. The only real merit pay structure that works is the one used in the private sector: decentralized, unstructured reviews by a boss who has a financial stake in the employee’s success, and there's a 5%ish chance the reviewed employee actually gets fired because of it. This would be considered unfair by teachers unions so instead we have pure seniority, or merit programs such as in Minnesota where 99.94% of all teachers garnered the carrot. My kids learn more math at their $100/month Kumon program than in public schools and I live in Money Magazine’s Best City in America, so clearly our above-average school system can do better pretty easily. The key is having a curriculum where kids move through a set of exercises that build upon each other, and only if they have mastered the previous material. This maximizes their potential, but everyone moves at different rates. That would lead to massive tracking of students by ability and the demographic inequality exposed would be politically untenable.

As per health care, it is already highly regulated, and becoming more so. Highly regulated sectors are rarely set free again, rather, it’s the whack-a-mole strategy of fixing a problem created by the last fix which then creates a new problem. In Santiago Chile the bus system worked, but it was a private system that operated for profit, and there were the typical problems that seemed wasteful. The solution seemed like a simple two-fer: run it for public interest (lowering cost by getting rid of profit), and regulate it to make it safer and less polluting. The result has been a nightmare, as the average commute immediately goes from 40 minutes to an hour and 40 minutes. Yet there is no general call to go back to privatized busing, rather, rearrange management or add ‘better’ regulations. Similarly, our health care system will be not be improved by adding more mandates and regulations, but we aren’t going back to 1950 when 90% of our health care expenditure was out of pocket and decentralized consumers disciplined providers.

There are lots of little independent comments in the book. For example, there’s Cowen's call to 'raise the social status of scientists,’ presumably, because that leads to more truths, and with more truths, everyone can act in a more consistent fashion. You can’t exogenously raise a profession’s status. It’s like trying to make your kids more popular, at best ineffective. If scientists continue to produce the twaddle like Marxist sociologists, economists who can't agree on whether the minimum wage is a good idea, and our best physicists spend their time elaborating a theory that has no foreseeable testable implications, they get what they deserve.

But back to his theme, that previous higher growth rates were based on low hanging fruit. What were these in our past?

1) Free Land. Great, but, we have same productivity as Liechtenstein, Hong Kong, Japan, Singapore, Iceland, and they didn’t have much land. Free Land would explain the growth rates only if US productivity growth was unique, and it is not.

2) Technologic breakthroughs. Electric lights, the internal combustion engine, the typewriter, radio, fertilizer, transistor, were all big boosts to productivity. No more. Now all we have are Teflon and Tang. Life, he says, is not much different than in 1953. Well, reading Plato, life hasn’t changed all that much since Ancient Greece, but forget the semantics. I would say my job is incomprehensible to someone 30 years ago. Further, while I used to play with plastic army men and play new-fangled 45 records, my 3-year old uses my wife’s iPad to decorate princesses and play music. Her childhood is probably as different to me as me to my dad, and my dad to his dad, etc.

3) Smart uneducated kids. In the past, lots of smart kids did not go to college, and as they did, we generated easy returns to their education. Now, almost everyone smart enough goes to college, so there’s no more easy gain there. I’d say this one is perhaps true, but if you look at its affect on growth, I would say it has been small. Most economic historians start the Industrial Revolution as starting around 1750, for the next century we had this massive, unprecedented rise is productivity without a big, broad increase in formal schooling. Formal education mainly produces imitation and routine, not innovation and growth, when not engaging in pure blather.

Cowen’s way of thinking is rather common, that growth emanates from some limited resource, and like ‘peak oil’ goes through a natural cycle of growth and decline. The Physiocrats in the eighteenth century believed that the wealth of nations was derived solely from the value of things from soil like minerals and agriculture, all the rest—advertising, management, finance—just parasitic. Such thinking influenced Malthus’s idea that we are all doomed by a finite amount of land, which will ultimately constrain our population via starvation. Later the labor theory of value tried to make labor the source of all wealth, where capital was disembodied labor. This too is mistaken, and while no one promotes these theories anymore, their intuition lives on.

I remember working for a broker in the summer of 1989, and the principal of the firm was writing a 'big idea' piece for his clients. He noted that unlike the past, we had no engine of growth like the automobile, so times would be tough--unaware he was at the cusp of the computer revolution, highlighting that it is difficult to see major trends without the benefit of hindsight.


It is important to recognize the essential drivers of economic growth, and much of the following is based on the works of Ludwig von Mises and Frank Knight. Economics is not about mainly about technology or resources, but about people and their actions. The market economy is a social system in which individuals are constantly trying to better their situation. The most enterprising individuals are driven to earn profit by doing something new and different. Most innovation is unplanned, and people outside the industry, especially users, make the majority of significant innovations by revealing their preferences, and this is a theme of Amar Bhide's work on entrepreneurial consumers.

Before the first industrial revolution around 1750, economic life in Europe was unprogressive, and its organization collectivist. The arbitrary administration of rules was not conducive to large-scale accumulation of capital prior to the first industrial revolution. Pre-industrial revolution business was imbued with the inherited spirit of privilege and exclusive monopoly, its philosophy was restriction and the prohibition of competition both foreign and domestic. The establishment of individualism was the result of the desire for improvement, even though it was not a conscious choice of political leaders.

Growth is merely the effect of free people continually improving their situation by finding better ways to solve problems, in the process creating profits, which are then used as capital to invest in greater efficiency. When profits direct economic activity, growth naturally occurs. When we instead try to service needs without regard to profit metrics or consumer preferences--as in pre-college education today in the US--we get stagnation.

Profits appear only in an economy in which the masses standard of living improves, because it is the result of taking inputs and creating products and services more valuable than their inputs. Profits are wealth creation by definition, and they only measure the producer surplus, not the consumer surplus, so they understate value created for society. To forgo them is to reduce aggregate wealth. Aggregate growth is not a result of having an awesome endowment, but rather the incessant urge of individuals towards improving their situation. One only has to look at the oil states (Nigeria?) vs. those economies in Asia without basically any raw materials. The most enterprising entrepreneurs are driven to innovate to earn profits by readjusting again and again the arrangement of productive activities so as to fill in the best possible way the needs of the consumer.

The state does not create much wealth directly--exceptions being public goods like roads and dams--but acting as the agreed-upon social apparatus of compulsion and coercion is essential for codifying and enforcing rules. When it becomes more advantageous for businessmen to rely upon the aid of those in political office than upon the best satisfaction of the needs of consumers, profits are no longer sustainable and productive, but rather their source is the compulsive redistribution of the state. Ethanol mandates and sugar quotas create profits, but only because they coerce consumer choices, as opposed to creating products and services that people actually prefer.

A big problem with modern macroeconomics is the fallacy that underlies the ‘fallacy of composition’, that is, the idea that saving hurts the aggregate savings via the multiplier. This is the hare-brained idea that if we spend 1 billionth of our GDP on bobble-head dolls, then via equilibrium reasoning, if we create $1 dollar in bobble head dolls, this creates $1 billion. As government spending is basically an investment in our future, government equals investment (G=I) to many, and instead of bobble head dolls we use investment (which is the same as government spending, remember), so you have to keep increasing G to avoid a meltdown whenever we are below full employment (which has been ‘always’ in my adult life). Funny how things worked better, in terms of growth rates economists pine for, back in the 19th century when the tools of fiscal policy were imperceptible and monetary policy absent.

Think about the distinction between paying someone welfare, and paying them to dig holes and fill them up. In terms of creating wealth for consumer, they are identical. A Keynesian (eg, Romer-Bernstein 2009) model assumes that a 1% increase in government spending—on just about anything—leads to a permanent 1.5ish percent change in GDP, which makes sense only via the magic of the multiplier, plus the faith that marginal government spending is actually creates wealth if you measured all the spillovers. Most government work does not produce benefits above their cost, and often, in the form of preventing people from freely contracting, destroys wealth (eg, financial regulators encouraged the decline in mortgage underwriting standards via their consistency with Fannie Mae’s ubiquitous underwriting software, and the Community Reinvestment Act’s mandate of lending to historically underserved communities, etc. The whole mass of financial regulators--OTS, OFFHEO, Fed, FDIC, OCC, SEC, CFPA--could surf the internet all day and no one would notice).

The system should be optimized for the whole and for long run, not the parts and the fluctuations. Microstability should be sacrificed for macrostability. The stability of the whole depends on the instability, and resultant resiliency, of the parts. When industries are protected from recessions, the system does not grow as quickly, and the productivity of the whole is sacrificed. The path back to long-run growth rates of the past is a government that was as intrusive as back then. In 1900 it was 3%, in 1950 it was 23%; now it is around 40%. The number of pages added to the Federal Register, which lists all new regulations, reached an all-time high of 82,590 in 2010, up from 9,562 in 1950. These rules create hidden costs often far beyond their direct costs, in the way that medical malpractice lawsuits are insignificant by themselves (1% of health care expenditures), though they significantly affect medical protocols (eg, my wife had Caesarians for each of our three children).

High unemployment is the result of a misallocation exposed, which happens often quite suddenly as in the 2008 housing debacle. It is not a paradox that wisdom of crowds, like the wisdom of individuals, is subject to error, as you can find people with very different purposes pre-2007 thinking that no-money-down housing is just and profitable--even Robert Shiller only could muster the prediction in 2005 that housing in some areas might decline, consistent with the erroneous assumption that a broadly diversified portfolio of mortgages had infinitesimal risk. We invested too much in housing, so that misallocation must be rectified, meaning, lots of people need to get different jobs, and the first step in this process is losing their old jobs. They need a market shove. It's regrettable, but recessions are inevitable given human fallibility (this is a deviation from von Mises).

The economy that grows best has the most freedom, and is built as a by-product of profits. As freedom and wealth are all good things, there must be a catch, and it is a big one: inequality. People hate inequality more than they love wealth, which is why people would prefer to be above average in a poorer world rather than below average in a richer world. Profits accrue to a minority of individuals via their ownership of capital, and the distribution of these profits among demographic groups is highly auto-correlated year after year. Most people are not in this fortunate minority, do not like it, and in a democracy their preferences determine policy. Sure, the German, Irish, Italian, and Jewish immigrants were once relatively poor in the US, and now not, but that took a long time. People want equality now, which means redistribution and patronage jobs (as Shirley Sherrod of the USDA said, ‘Have you heard of anybody in the federal government losing their job?’).

Most politicians see profits as a vice, not a virtue. The idea that profits primarily reflect an unfair system, as opposed to growth, leads us to hinder the source of our growth. Profits are often seen as symptoms of either thievery, or an irrelevance to what really matters, things like global warming or social justice. Recessions and poor growth are correlated with low profits--the 30's and 70's were bad for profits and asset prices--yet solutions often center on having the 'rich sacrifice', as if taxing the source of our productivity improves things. This only makes sense if you see profits not as the source of productivity, but the result of powerful people taking from an exogenous source of income.

Freedom and equal outcomes are incompatible, yet as the socialist economies showed, restricting freedom does not eliminate or even decrease inequality, it merely makes it less conspicuous and more onerous. That John Paulson made billions of dollars last year only bothers someone if 1) they are feeling petty envy or 2) they think this was merely taken from others. Most do not admit to the former, and rationalize using latter. People I do not know who truly annoy me use the force of law, as when they tell me where I can send my kid to school, tell me I am unqualified to invest in hedge funds, determine who can cut my hair, and what my medical insurance must provide.

The economy is like an ecosystem, a complex adaptive system, and the key to sustained growth is letting people with the requisite information and incentives engage in activities that are appreciated so broadly, his service or product will be needed again and again, a sustainable pattern of specialization and trade (see Kling). It is impossible to predict what fields in an economy, or species in an ecosystem, will prosper, but it is a sure bet that it will find its most sustainable, consistent equilibrium if one merely leaves it alone. No one thinks you can improve a rain forest via top-down Federal programs, but those same people find it obvious that more Federal regulations and purchases will improve a market economy, though it is just as complex and natural.

When people interact freely, they are directed by profits, and this creates something out of nothing, productivity. It does not take any specific technological or material endowment, merely liberty. There is a lot of low hanging fruit because leaving people alone is eminently feasible, but it is highly unlikely because our democracy does not trust the market to produce trickle down results sufficiently fast or fairly distributed. 'Trickle down' is referred to derisively, as if advocates are disingenuous about this patently absurd theory. This very nonintuitive idea--the invisible hand, that individual freedom maximizes growth--hatched the field of economics, which unfortunately has lost its way, lured by the hope of becoming a dentist to the economic patient with a cavity; instead, macroeconomists, by focusing on federal stimulus plans, are like modern-day bloodletters, counterproductive. Hopefully, such delusional expert folly won’t last as long.