Wednesday, January 05, 2011

A Theory of Growth

Business cycles and the essence of long-run economic growth are distinct issues. Preventing recessions is not the key to growth, as these are regrettable but unavoidable companions to an economy directed by a capital allocation process that is susceptible to systematic failure. Preventing the last failure is pretty irrelevant, because the next systematic failure will be different. Last I checked, only the US government is offering low-down payment loans, and no one offers no-documentation loans, so our government is not really helping here. As for creating growth via something new, if centralized governments could do that, the Soviet Union would still be around.

That decentralized, self-interested, people can collectively make such large errors seems irrational or corrupt to many, but they should remember that growing economies require people to be making things better, which means, new ways of doing things. New ideas are often wrong. Economics has gone onto intellectual cul-de-sacs many times (socialism, Keynesian macro models, input-output models, Hilbert spaces in finance, Arbitrage Pricing Theory, Kalman-filter macroeconomic models, etc.). Other scientific disciplines have their own mistakes, and political mistakes--stupid wars--are also common. These are rarely conspiracies, but rather, smart people making mistakes because the ideas that are true, important, and new, are really hard to discern, and tempting ones are alluring when lots of other seemingly successful people are doing them.

My Batesian Mimicry Theory posits that recessions happen because certain activities become full of mimics, entrepreneurs without any real alpha who got money from investors looking in their rear-view window of what worked and focusing on correlated but insufficient statistics. For example, people assumed a nationally diversified housing prices would not fall significantly in nominal terms, because they had not for generations; people assumed anything related to the internet would make them rich in the internet bubble, conglomerates would be robust to recession in 1970, that the 'nifty fifty' top US companies had Galbraithian power to withstand recessions in 1973, that cotton prices would not fall in 1837, etc.

As in ecological niches, there is no stable equilibrium when mimics arise to gain the advantages of those with a real, unique and costly, comparative advantage. Every so often there are too many mimic Viceroy butterflies, not enough real poisonous Monarch ones, and a massive cataclysm occurs as predators ignore the unpleasant after-effects and start chomping on all of them. The Viceroy population grows until this devastating event occurs, a species recession. Next time, it won't happen in butterflies, but rather, among frogs or snakes. They key is, some ecological niche is always heading towards its own Mayan collapse (distinct from the 2012 Mayan apocolypse).

The key to wealth creation is doing more with less--destroying jobs at the micro level and creating jobs at the macro level by reallocating capital and labor to more valuable pursuits. The computer got rid of things from typesetters, secretaries, to engineers working with slide-rules, but these people didn't stay unemployed, they did something else, making the economic pie bigger. This is antithetical to government and unions who think creating a permanent 'job' creates productivity--stability at the micro level and stagnation at the macro level. Wealth is created by having decentralized decision-makers focused on simple goal of making money, which means, they oversee transactions where revenues collected are greater than expenses paid. If externalities are properly priced (I know, most liberal think this never happens), this implies value is created. The continual improvements in method (ie, productivity, wealth creation) merely maintain profits in a competitive environment; to do nothing would see their profits eaten away by competitors would could easily copy what they did and just undercut their prices.

The key to this is having managers who keep their workers focused. A good example is a story I heard second-hand about a football player for Minnesota Vikings in the 1970s. Coach Bud Grant called this marginal player into a meeting, and said, 'Here's what I need you to do...'. The player, an articulate fellow quite confident in himself, interrupted with an explanation of why he wasn't doing better and suggestions about how to correct it, mainly focused what others were doing wrong. Grant cut him off: 'You don't understand. This isn't a negotiation. Do what I'm telling you, and you have a role here. Otherwise, you don't.' Hierarchies only work well when people have clearly defined goals, and managers who manage their direct reports singlemindedly.

Private firms can do this much more quickly and often than government, and are rewarded with investment and retained earnings to the degree they do it well. When the government wants to do something, like build a light-rail system, it instead satisfies all its stakeholders who have no financial downside, only veto power, and so the cost/benefit calculus is almost irrelevant. The probability that benefits will outweigh costs when not prioritized is negligible, as highlighted by the fact that companies have to work very hard to make this positive when all those other considerations are ignored.

Thus, Minneapolis's light rail, at the cost of $1.1B for 12 miles of track, takes me longer to go downtown than a car because it stops 19 times at places no one wants to go because these 'hubs' were then sold as development opportunities, and an unusual number of ex-city councilmen are part owners of coffee shops and stores near these stops. Ridership does not even cover their marginal costs. It could have worked if they had an express train that went non-stop from end to end, but doesn't because it was not designed with the goal of making money, only the hope.

Good companies like Facebook, Apple and Google, have this sense of really understanding their users. Lots of simple things that making going to their sites and getting what you want. Their inferior competitors are relatively ugly, cluttered, and clunky. These generally weren't genius ideas like the ideas needed to create the first transistor, or Cantor's diagonal argument, in that their competitors had similar raw competence in these field, but it did take people looking to do things better than others, and decisive people who could empathize with their customers created really great things.

Robin Hanson had a neat article about the Myth of Creativity, where he criticizes Richard Florida's vision of bohemian lead productivity:
This is a Star Wars vision of innovation: "Feel the force, Luke; let go of your conscious self and act on instinct." And it is just as much a fantasy as that celluloid serial. Innovation is no more about releasing your inner bohemian than it is about holding hands, singing Kumbaya, and believing in innovation.

In truth, we don't need more suggestion boxes or more street mimes to fill people with a spirit of creativity. We instead need to better manage the flood of ideas we already have and to reward managers for actually executing them.

Sure, it's good to punish fraudsters, and be wary of the stupid ideas that were passed off as brilliant in the prior cycle (eg, Angelo Mozilo winning the American Banker's Lifetime Achievement Award in 2006, celebrated by politicians on the right and left, prized by Fannie Mae, and Harvard, is now an example of the 'unregulated predatory private sector'). But this is like learning not to put one's hand on a hot stove--good to know, but old news to most. Our priority at the top level should be to get out of the way, and so government should focus on its essential but limited perennial tasks as opposed to creating some new engine of growth. Leave that for the millions of people making sure millions of small changes are constantly made to daily procedures. Such changes do not require vision from politicians, subsidies, or tax breaks, but are rather the natural by product of people trying to make a buck. It's the standard Hayek/Friedman view of macroeconomics, and it's still the best description of how the complex adaptive system of our economy works.


Anonymous said...

Why did you start using the most user unfriendly format? Negative type is terrible.

Dave said...

This new format is hard on the eyes, Eric. I'm not against change, but you can find much more attractive and readable themes out there than this.

dmfdmf said...

I'm with anon and Dave... the white on black is harsh.

Eric Falkenstein said...

It was negative before! I soften the white text a bit.

Eric said...

I think it reads much better than the old one. For those that want to read these pages really well, try: using Readability, available as firefox and chrome addon, or standalone at

Back to the post itself, I think you have point in that government should focus on its essentials. However, even if everyone in the government is taking that stance, it still isn't really an equilibrium situation I think.

You start with a government that wants to do at least the army/police parts, and taxes and laws and so forth. You inevitably end up with a continuously growing government, it's just the rate that is variable. I would love to hear your take on this.

Eric Falkenstein said...

Well, what about the Soviet Union, China, Vietnam, or other previous totalitarian states. Eventually the central group cedes control, because they know they don't really have it anyway.

I agree we seem to vacillate, and have not reached an equilibrium. As people are regrettably much more egalitarian than libertarians would like, I'm not sure there will ever be a stable equilibrium.

Anonymous said...

So how can this system work properly when two of the most important price signals in the world - US short-term rates and CNY-USD - are set by beurocrats?

Eric Falkenstein said...

I've read all the Austrian business cycle literature, and I don't think the key is the short term rate because if so excess investment would be a function of roundaboutness, but instead it just is focused in different industries independent of their capital/labor ratios. Surely, this screws things up, just like proping up housing prices (FHA now does 90+% of mortgages <$300k) in this recession is screwing things up.

Anonymous said...

The old type was bad, this one is worse. Why put your readers through the pain. We already have to cope with your mild dyslexia, surely that's enough.

Eric Falkenstein said...

hmm. It works for me, but I am mildly dsylexic(!) as you note, so perhaps I'm not the best judge. the problem is people not bothered by it tend not to comment, so I'm rather unsure if I need to change to the standard positive contrast.

Brian Peters said...

Eric, you may be interested in this paper, which aligns with your mimicry theory.

Epidemics of Rules, Information Aggregation Failure and Market Crashes

AnonJr said...

<< I'm rather unsure if I need to change to the standard positive contrast>> about you apply some of your advanced economics training to the problem: do you reckon the inverse type attracts or annoy the marginal reader? If it's the latter--a recurring theme of your blog-- stick with inverse type.

Anonymous said...

Re ugly font:
It may improve absorption and retention.

Michael Meyers said...

Eric.... maybe your eyes are better than mine, but this new format is VERY HARD to read... I love you blog, but don't make me struggle so hard to read it.

Unknown said...

Great post!

I'll read it no matter what, but this is harder on my eyes also.

jmm5491 said...

This was a brilliant mini-essay! It seems to obvious that government control of the economy isn't the way to wealth creation. The fact that everyone doesn't (or refuses to) understand it is a testament to the minor role that rationality plays in human choices.

Re the new format: the softened white characters appear kind of muddy against the black bg.

Michael Meyers said...

Eric... THANKS, much easier to read!

Dave said...


Much easier on the eyes now, thanks.

As to the substance of your post, a lot of wealth creation today seems to come from labor arbitrage -- outsourcing production to cheaper countries, or bringing in immigrants from poor countries willing to work here for less. That doesn't create net jobs here, and that's a political as well as an economic problem for this country.

More broadly, laissez faire would leave a lot of Americans behind. That's not necessarily an argument in support of the government's current policies, but it is an argument against the government doing nothing but the bare libertarian minimum (police power, enforcing contracts, etc.).

In a way, we seem to have the worst of both worlds today. Our government leans toward laissez faire when it comes to labor arbitrage, which lowers wages and increases unemployment for American workers. And our government leans toward activism/statism when it attempts to compensate for lower wages by subsidizing home ownership, education, and health care, subsidies which apparently raise the cost of all three.

Eric Falkenstein said...

"laissez faire would leave a lot of Americans behind"...I don't know what you mean by that. Relatively, or in absolute terms? I don't think it's true in absolute terms. Further, one could provide poor relief much differently, so that people 1) don't starve or suffer when poor and 2) they don't see this as a free lunch. That is, if you want free room and board, you have to live in a poor house, which has work rules and drug tests. No-strings-attached charity is no good for the recipient, as much as they might prefer it.

Dave said...

I meant in absolute terms: abject poverty.

I agree that there are better ways to aid the poor, including ones where aid is contingent on constructive behaviors on their part. But what I was thinking of above wasn't so much aid to the poor, as policies designed to prevent more people from becoming poor in the first place.