Paul Krugman and Tyler Cowen, annotated

When I recommended this conversation between economists Paul Krugman and Tyler Cowen, I said that if I were using it as a teaching tool I would insert my own explanations. Some of my readers responded by asking me to offer my annotations, so here they are. I will discuss concepts in the order in which they came up during the conversation. Note that this essay does not cover the conversation itself. Instead, it tries to help non-economists watch the conversation by clarifying some of the jargon that got used.

Concept: Aggregate demand and aggregate supply

Context: How can we explain the sluggish economic growth in the decade following the financial crisis?

Textbook background: Think of the economy as one big factory. Aggregate supply is the capacity of that factory if it is fully utilized. Aggregate demand is the extent to which the capacity is utilized.

Another term for aggregate supply is “potential GDP.” Tyler and Paul both allude to the fact that estimates of potential GDP have fallen over the past decade. But Paul says that the shortfall in productive capacity is in fact a response to a long period of low aggregate demand.

My take: I personally have abandoned use of the concepts of aggregate demand and supply. I think that overall economic outcomes instead reflect the fact that we do not work in one big factory. Instead, we have individual skills and backgrounds, and we need the market to act as a sort of “shop foreman” telling us where to work and what to do. Sometimes, the shop foreman gets flustered and cannot figure out what to do with all of us. Until the shop foreman figures things out, the result is high unemployment and disappointing growth.

Further reading: The drop in potential GDP; Specialization and Trade

Concept: Transaction costs

Context: What will be the ultimate economic significance of Bitcoin and other applications of blockchain technology?

Textbook background: Markets allow strangers to trade with one another. The chain of transactions needed to allow you to obtain goods and services in a modern economy is staggeringly complex. Money simplifies this transaction process. Imagine instead what it would be like if goods always had to be traded for one another, without a common medium of exchange.

We use money even though it has no intrinsic value. You cannot eat a $20 bill or make nice jewelry out of it. In general, money is worth what people believe it is worth.

My take: My understanding of blockchain is that it is a technique for creating trustworthy records. The more traditional techniques make use of government. Contracts, such as real estate sales, are recorded and enforced by government. Money is backed by government (if nothing else, the government says that you can pay taxes in money). Can blockchain provide an alternative to government backing? Well, some governments are too weak or corrupt to enforce contracts, and perhaps blockchain can help there. And there are some contracts that governments won’t enforce, because the contracts involve drugs, gambling, or prostitution. But otherwise, I believe that blockchain will not reduce the cost of enforcing contracts.

Further reading: my blog posts on blockchain

Concept: increasing returns

Context: This year, the Nobel Prize in economics went to Paul Romer and William Nordhaus, both of whom contributed to our understanding of economic growth. What facilitated the large increase in living standards in recent centuries, and what explains the large differences in living standards across countries?

Textbook background: Economists speak of the “law of diminishing returns.” Suppose that you want to increase wheat production, and you try to grow more on the same ground. At first, the additional seeds yield a lot more wheat, but at some point doubling the number of seeds will yield less than twice as much additional wheat. That is what is meant by diminishing returns.

If instead when you doubled the number of seeds on one piece of ground you could get more than double the wheat, that would be increasing returns. With increasing returns, you could feed the entire planet using one flower pot.

Because of diminishing returns, over 200 years ago Thomas Malthus predicted that living standards would stagnate. As population increased, we would not be able to feed the larger population.

But economic progress has been much better than Malthus would have predicted. Starting around the time when he was writing, we began to see steady increases in productivity in the developed world that have cumulated into dramatic increases in living standards.

If diminishing returns put a constraint on economic well-being, and yet economic well-being has improved dramatically, then there must be increasing returns somewhere. Economists have adopted the explanation that the increasing returns come from ideas and innovation. Ideas can be spread without “using them up.” And ideas can be combined to provide new ideas.

In the 1980s, Krugman used the idea of increasing returns to explain some patterns of production and trade. For example, why did we see concentrated locations for some industries, including automobiles in Detroit, movies in Hollywood, and computers in Silicon Valley? Apparently there are increasing returns that come from having many people with relevant skills working close to one another, even if they are different firms.

My take: In the video, Paul and Tyler point out some problems with the narrative of ideas and increasing returns. It seems to imply that economic growth will just get faster and faster, as we have more people combining more ideas. But measured economic growth, while still positive, appears to have slowed in recent decades. Also, since ideas can be used without being used up, why are some countries so backward in their use of ideas?

The answers to these sorts of questions take us out of the realm of typical economic factors. At one point, Paul quotes Robert Solow as saying that these discussions end up in a “blaze of amateur sociology.”

Solow’s name comes up in any discussion of economic growth. In the Solow model, the economic driver of productivity is savings. But there is a “residual” driver of economic growth, that Solow equates to pure advances in technology.

My own view is that intangible factors are important determinants of economic outcomes. I believe that they have become increasingly important in recent years. This limits our ability to explain economic growth on the basis of the measurable components of the Solow model.

Further reading: David Warsh, Knowledge and the Wealth of Nations; Arnold Kling and Nick Schulz, Invisible Wealth; Stephen L. Parente and Edward C. Prescott, Barriers to Riches (this is referenced by Tyler in the video); Economists wake up: it’s the 21st century

Concept: near-zero variable cost

Context: Internet companies in some ways “break the rules” of standard economics. How important is this?

Textbook background: In textbooks, we claim that the typical firm faces increasing variable cost. Think of an apple orchard. Picking fruit at the bottom quarter of the tree (the low-handing fruit, so to speak) might cost you $1 per apple. Going to the next segment of the tree, half-way up, it might cost you $2 per apple. Three-quarters of the way up it might cost you $3 per apple. Near the top, it might cost you $4 per apple.

This pattern of increasing variable cost creates a logical way to relate prices and production levels. If the market price of apples is $2, you pick the apples up to half-way up the tree. If the price is $3, you go three-quarters of the way up.

But in some industries, the variable cost is very low, and fixed cost is very high. For example, in pharmaceuticals, it might cost hundreds of millions in research and testing to bring a new drug to market. But the actual pill costs just pennies to manufacture.

An industry with low variable cost is said to be a natural monopoly. Because variable costs are unimportant, the key to success is spreading the fixed cost over the largest number of customers. The natural structure for such a business is “winner takes all.”

Internet-based services, such as web search or music streaming, have low variable cost. They are natural monopolies.

Another aspect of business models on the Internet is that sometimes there are network externalities, meaning that the value to one customer increases as more customers use the network. For example, the value of phone service to you comes from the ability to connect with other people. The value of joining Facebook comes from the ability to find other people on Facebook.

My take: I have been saying for many years that this is an important issue for economists to confront. I give credit to Paul and Tyler for bringing it up. As with other topics in the conversation, there is much more to be said.

In these sorts of industries, markets neither work nor fail. What I mean by not working is that the market cannot use variable cost to regulate consumer demand and output. This means that a lot of economic analysis of the benefits of the price system will not apply.

But markets do not fail in these industries, either, at least if we stick to the conventional notion of market failure. Ordinarily, when economists spot market failures, they identify mis-alignments of incentives that can be corrected with taxes or regulations. But there is no tax or regulation that can correct a situation in which a price based on variable cost will be far too low to recover the fixed cost of creating a service. Dealing with that problem is a matter for business strategy, not taxes or regulation.

Further reading: The Post-Industrial State; Carl Shapiro and Hal Varian, Information Rules;

Concept: economics of health care

Context: The share of the U.S. economy devoted to health care has increased dramatically over the past 50 years, now approaching 20 percent. How can we encourage efficient use of resources in that sector?

Textbook background: Medical care differs in important respects from other products and services. It is like car repair, in that you have to trust that the provider is recommending the most appropriate procedure. But unlike car repair, it may be difficult to tell afterward whether the procedure achieved the best possible outcome. More important, you do not have the option of trading in the malfunctioning body for a new one.

Health insurance markets are compromised by two possible ways that insurance can be exploited by consumers. One possibility is called asymmetric information. The consumer may know, but the insurance company may not, about a medical condition that will be costly to treat.

The other possibility is called moral hazard. Protected by insurance, consumers may engage in more risky behaviors than they would without insurance.

My take: Why is Medicare so expensive? Paul seems to think that there were some design flaws built in, and it is very difficult to correct design flaws in government programs, because consumers and service providers develop a stake in the existing system. Tyler sees Medicare as, for better or worse, fitting in with American consumer culture. I am inclined to take his side on that issue.

Further reading: Kenneth Arrow, “Uncertainty and the Welfare Economics of Medical Care” (referenced by Paul in the video); (blogger) Random Critical Analysis, “High US health care spending is quite well explained by its high material standard of living” (I assume Tyler was referring to this blog post); Crisis of Abundance;

Concept: ISLM

Context: What, specifically, caused the shortfall in aggregate demand ten years ago?

Textbook background: the abbreviation ISLM stands for investment-savings, liquidity-money. That probably doesn’t help you much. The idea is that national income (GDP) and interest rates have to balance two combinations of aggregates. Desired savings have to balance investment plus other uses of saving, notably the government budget deficit. If desired savings are too low, then in order to increase savings income must be higher or interest rates must be higher. And the demand for money has to balance the supply of money. If the demand for money is too low, then income has to be higher (so that people need more money to undertake transactions) or interest rates have to be lower (so that people become less inclined to economize on money holdings).

There is only one combination of interest rates and income that balances everything. Because of this, changes in the budget deficit or the money supply can be used to manipulate income and interest rates.

My take: Paul mentions the ISLM story, and the particular variation he has in mind is one in which the demand for money is very high and interest rates are at a lower bound of zero (the liquidity trap). In that case, if we are in a recession, the only way out is for the government to run a bigger deficit. Tyler probably does not want to commit to the liquidity trap story, so he just offers a general hand-waving story about aggregate demand.

Paul’s emphasis on the loss of household wealth resulting from the collapse of the home price bubble is probably the explanation for the deep recession that is mostly widely shared by economists. But as noted above, I am not a fan of the aggregate demand and aggregate supply concepts.

Further reading: Atif R. Mian, Kamelesh Rao, and Amir Sufi, “Household Balance Sheets, Consumption, and the Economic Slump”; Memoirs of a would-be macroeconomist.

Concept: Bank Regulation

Context: After the financial crisis of 2008, Congress enacted Dodd-Frank legislation intended to prevent a recurrence. Will it work?

Textbook background: Beliefs about the soundness of companies are partially self-fulfilling in all cases. If we believe that a business is in good shape, then we will be willing to lend to it at a low interest rate, and the low cost of borrowing will help the condition of the business.

In the case of banks, beliefs are particularly important. If people doubt the soundness of a bank, they may race with one another to withdraw money while the bank is still in business. This “run” on the bank can cause a bank to fail, even if its assets actually have adequate value.

Since the 1930s, the U.S. has used deposit insurance to prevent bank runs. But two problems remain. One is that the risk of banks’ reckless lending has been transferred to taxpayers, who now have to be protected by regulators at agencies like the Federal Deposit Insurance Corporation. The other problem is that regulated banks may look for ways to offload risks to uninsured financial institutions (“shadow banks”), and those institutions may then be subject to runs. Many economists see the crisis of 2008 as a run on shadow banks.

My take: Paul thinks that Dodd-Frank gave regulators the tools to prevent a crisis, but he think it depends on having agency personnel who are highly skilled and properly motivated. Tyler is more skeptical. I share Tyler’s skepticism.

A crisis is hard to spot in advance. Paul alludes to the fact that there are people who are very good at warning about crises. But as he points out, the problem is that many of these anticipated crises do not occur. At any one time, including the present, there are several plausible indications of financial fragility, but which of these, if any, needs to be addressed in order to avert a crisis?

My own view is that we are not going to create a financial system that is impossible to break. Policies that might seem to reduce risk instead tend to shift it elsewhere. For example, as Tyler points out, requiring banks to have higher capital ratios might reduce the risk of bank failures, but it will likely lead to more creative and extensive use of shadow banking.

Instead, I think that it would be better to orient policy efforts toward making the financial system easy to fix. Paul talks about “resolution authority,” which means the ability of regulators (or courts) to quickly divide up the assets of a failed financial institution, reducing the uncertainty that a failure currently entails.

If it were up to me as a regulator, I would prevent financial institutions from becoming huge and complex in the first place. People who disagree with me will argue that banks need to be large and complex in order to better meet the needs of global businesses. I would be willing to sacrifice some of the alleged benefits of large-scale banking in order to make individual bank failures less catastrophic.

Further reading: Not What They Had in Mind; The Chess Game of Financial Regulation.

Concept: Rent-seeking

Context: Tyler says, “Alibaba is not just a rent-seeking company.” This is near the end, when he and Paul are discussing various sorts of international threats to prosperity. For example, on trade, Paul points out that Brexit could be more costly than a tariff war, because if Britain exits the European free trade area and has to re-install customs inspections for goods coming from the continent, this will act like a tax that yields no revenue, only costs.

Textbook background: Rent-seeking is a term used by economists to describe profits that are earned by manipulating government policies. A company that enjoys government subsidies is a rent-seeker.

When a company makes profits without rent-seeking, then it is likely that it is improving social welfare. When consumers voluntarily buy products, we think of the profits as deserved.

Rent-seeking means lobbying for special favors. These favors benefit the recipients, but they cause harm elsewhere. Consider an industry protected by a tariff. Consumers pay higher prices than they would without the tariff. The resources that the industry spends lobbying for the tariff are wasted from a consumer standpoint.

For this final segment of the discussion, I have nothing to add and no further reading to suggest.