Studying Growth

In the very first microeconomics course I ever took (after the Econ 101 series), I recall that the teacher opened the very first class with the observation that we don’t know how to create economic growth but we do know how to create shortages. In a piece at the Wall Street Journal David Henderson takes note of the work of David Romer and William Nordhaus who’ve just been awarded the Nobel Memorial Prize in Economics:

The winners of this year’s Nobel Memorial Prize in Economics are U.S. economists William D. Nordhaus of Yale and Paul M. Romer of New York University. Mr. Nordhaus is acknowledged for “integrating climate change into long-run macroeconomic analysis,” while Mr. Romer is credited with “integrating technological innovations into long-run macroeconomic analysis.”

What is meant by “long-run macroeconomic analysis,” the common element in both awards? Largely, the term refers to projections of economic growth. Growth isn’t the only focus of macroeconomic analysis; short-term ups and downs in the economy, known as the “business cycle,” are considered part of the same field. But growth is by far the more important factor in economic health. Consider that the anguish of the Great Depression was caused by a 30% drop in U.S. gross domestic product, but real GDP today is 14 times its level in 1929. Over periods of a decade or more, the effect of growth dominates the effect of even the most serious recessions.

For that reason, it makes sense for economists to focus on long-run growth, as Messrs. Romer and Nordhaus have done.

In the 1980s, Mr. Romer was the lead developer of endogenous-growth theory, which proposes that growth results from factors that exist within—or are “endogenous” to—a given economy. Before this breakthrough, researchers’ preferred model of growth was one developed in the 1950s by Massachusetts Institute of Technology economist Robert Solow. Though Mr. Solow acknowledged that technological progress was a key driver of economic growth, he had no way to project the pace or impact of such progress: it was “exogenous” to his model. Mr. Romer made technology endogenous. In particular, he noted that there are incentives within an economic system to come up with new ideas, and he urged policy makers to think carefully about how to structure such incentives.

Patents are an old example of an effective economic incentive. Consider the pharmaceutical industry. A 2014 Tufts study estimated that it costs an average of $2.6 billion to develop a new drug and market it successfully. Once the formula is discovered and tested, another company could copy the invention of the firm that did all the work. If that second company were allowed to sell the drug, the first one probably wouldn’t do the work in the first place. A patent gives the inventor a monopoly for a fixed number of years during which it can charge a monopoly price and earn the returns necessary to motivate it to innovate.

In a 2006 article on economic growth, Mr. Romer noted the huge difference in long-run well being that would result from raising the growth rate by a few percentage points. He cites the “rule of 72,” which holds that the length of time over which a magnitude doubles can be found by dividing the growth rate into 72. So, for example, an economy that grows 2% a year will take 36 years to double in size, while one that grows 4% a year will double in 18 years.

Mr. Nordhaus also has made multiple contributions to economic literature on growth. In the citation for his award, the Nobel committee didn’t mention his demonstration that the price of light has fallen by many orders of magnitude over the last 200 years. He showed that the price of light in 1992, adjusted for inflation, was less than 0.1% of its price in 1800. The failure of government analysts to account fully for this and similar price reductions, he argued, led them to underestimate the real growth rate of the economy and wages.

What earned Mr. Nordhaus his Nobel, though, was his work on the economics of global warming. Starting in the 1970s, he constructed increasingly comprehensive models of the interaction between the economy and additions of carbon dioxide to the atmosphere. Economists use these models, along with assumptions about the current and future magnitude of emissions, to compute the “social cost of carbon.” Mr. Nordhaus has subsequently used this cost to recommend taxes on carbon. In 2017 he computed the optimal tax to be $30 for each ton of carbon dioxide. Such a carbon tax would increase the price of gasoline by about 27 cents a gallon.

Mr. Nordhaus recently noted the large degree of uncertainty about the optimal tax. For the $30 tax above, the actual optimal tax could be as little as $6 a ton, or as much as $93.

Robert P. Murphy, an economist at Texas Tech, used Mr. Nordhaus’s work to show that setting too high a carbon tax can be worse than setting no carbon tax at all. Using Mr. Nordhaus’s 2009 calibration, Mr. Murphy calculated the present value of damages caused by carbon dioxide and abatement costs at $22.6 trillion. Mr. Nordhaus’s optimal carbon tax would have reduced damages but increased abatement costs, decreasing the impact of emissions to a total of $19.5 trillion—a relatively minor net improvement of just over $3 trillion.

Meanwhile, the Nordhaus model shows that the cost of a policy to limit the temperature increase to only 2.7 degrees Fahrenheit by 2100 would have been $37.03 trillion—$16.4 trillion more than the cost of doing nothing after accounting for the damage done by carbon emissions. Thus, Mr. Nordhaus’s work doesn’t support the recent announcement by the International Panel on Climate Change about the urgent need to limit warming to 2.7 degrees. Indeed, Paul Krugman castigated Mr. Nordhaus in 2013 for his belief that the optimal temperature increase is 4.1 degrees.

Interestingly, neither Mr. Nordhaus nor anyone else anticipated fracking, which has increased natural-gas usage at the expense of coal. The result is that the U.S. has cut its carbon-dioxide output year after year without the aid of a carbon tax.

It’s refreshing to see the Nobel Prize awarded to economists who study growth. It makes sense to worry about short-term fluctuations in GDP, but it makes even more sense to keep our eyes on what matters much more: long-term growth and the policies that favor it.

I don’t think there’s any more important topic in economics than growth and I’m glad that Drs. Romer and Nordhaus have been recognized.

4 comments… add one
  • steve

    What is nice also is that their work largely transcends ideology, though I am sure someone will turn it into a battle.

    Steve

  • Guarneri

    What do we talk about more than anything with our portfolio companies? Growth. Followed closely by management. The cost trick is interesting. Metrics interesting. And so on. Growth is hard.

    If you had a looming financing issue like medicare and SS. Wage growth issues. You would think economic growth would occupy a large portion of your time.

  • bob sykes

    On a time scale of millenia, the Earth is cooling, because the Milankovitch cycles and the resulting reduction in insolation. Virtually all of the temperature rise over the last 150 years is recovery from the Little Ice Age. And the temperature has been a very good thing in terms of human and global well-being.

    Ideally, the Earth would be warm enough so that Canada and Siberia were habitable, another 10 to 12 million square miles of living space, agriculture…

    Temperature increases occur at higher latitudes, and the tropics are more or less stabilized by the oceans.

  • Gray Shambler

    Hate to break it to ya Bob, but the IPCC has just turned in a report giving the inhabitants of earth 144 months to reverse climate change, or die. That’s 4,383 days, what did you do today? The report was backed up by consensus. President Trump thanked the IPCC for their tireless effort, said he’d look at it, but curiously, he said he want’s to know who authored it. Who? consensus, duh.

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