macroresilience

resilience, not stability

The Great Stagnation and Special Interests

with 8 comments

In the last couple of months, I wrote three posts [1,2,3] that tried to explain our recent economic experience as a consequence of the increased rent-seeking that goes along with a prolonged period of stabilisation. My analysis was restricted to the post-2008 period which has thrown up some anomalous patterns that cannot be explained by conventional macroeconomic theory (Keynesian or Monetarist). In particular, I focused on two patterns:  the disconnect between corporate profitability and unemployment (highlighted by the rapid rise in labour productivity), and the fact that this increased profitability has so far only led to increased corporate cash balances and not to increased investment. Both these patterns, although unique, still possess an ancestral lineage that can be traced back to the Great Moderation. Recoveries have been becoming increasingly jobless since 1991 and the “corporate savings glut” has been a common feature since atleast the 90s in the United States, Europe and Japan. To some commentators (notably Michael Mandel and Peter Thiel) our current problems are the result of a prolonged innovation deficit, a view that has been expanded upon by Tyler Cowen in his excellent new book ‘The Great Stagnation’. In my opinion, this innovation deficit is atleast partly driven by increased Olsonian rent-seeking.

It’s difficult to prove that innovation has fallen due to increased rent-seeking. How can we measure the innovation that could have been in the absence of special interests? One approach is to look for industries where the developed economies of the United States, Europe and Japan are not at the forefront of innovation. Tyler Cowen correctly notes that much of the growth in developing economies comes from “catch-up” growth but this is not always the case. As the Economist notes, some of the best innovation in frugal healthcare is now coming out of China and India and much of this innovation has been slow to make its way into the developed economies. The Economist identifies the price-insensitivity of developed markets and regulatory red tape as reasons but this is an incomplete explanation. The same dynamic is visible in financial services where almost all the genuine innovation is taking place in developing economies (e.g. mobile banking in Africa and India), and although financial services has its share of regulatory red tape, it is certainly not price-insensitive.

A hint as to the real problem can be found in the unusually honest comment from a GE executive in the Economist article who admits that “the sales and distribution systems at firms like his, set up to sell $100,000 scanners, are ill-suited to sell versions at a tenth of that price”. As [amazon_link id=”0060521996″ target=”_blank” ]Clayton Christensen[/amazon_link] and James Utterback identified long ago, incumbent firms are almost never responsible for disruptive product innovations. These are inevitably originated by new entrants into the industry. As Christensen noted, disruptive innovations often result in worse product quality in the short term and drastically reduced profit margins that cannot sustain the incumbents’ cost structure. To expect an incumbent in this situation to take a leap on an uncertain innovation that at best will result in dramatically reduced profits is unrealistic. This highlights the damage done by the pervasive presence of special interests in any industry. Rent-seeking becomes the dominant niche that outcompetes all exploratory innovation by new entrants.

Despite this rather gloomy analysis, there is a silver lining. In the long run as the disruptive innovation becomes established, it is inevitable that the technology will spread even to the most rent-infested economies. This highlights the benefits of nation-level diversity in the global economy and the folly of pursuing homogeneity in global regulatory regimes. As Kenneth Boulding said: “If you have only one system, then if anything goes wrong, everything goes wrong.” As long as the “Olsonian cycles” of the major economies are not perfectly synchronised, the global economy may be able to maintain a healthy pace of innovation albeit in a stop-start manner.

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Written by Ashwin Parameswaran

January 31st, 2011 at 4:49 pm

Posted in Cronyism

8 Responses to 'The Great Stagnation and Special Interests'

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  1. David Hume examined China and Europe and wondered why China had fallen so far behind. As the only check on Olsonian plunder, he offered up the fragmentary status of Europe: “The divisions into small states are favorable to learning, by stopping the progress of authority as well as that of power.”

    Mike Gibson

    31 Jan 11 at 5:31 pm

  2. Mike – In my opinion, there’s an element of the Olsonian story to the falling behind of many of the Asian societies – India after 600 AD, the Islamic empires and China post-Renaissance. And the exploration-exploitation tradeoff is relevant here – what shuts down first is disruptive innovation which can displace the incumbents. Too many people look at the trade and production numbers and conclude that China did not fall behind till the 18th century but the process of ossification started long before that.

    Also highlights the folly of European political integration.

    Ashwin

    31 Jan 11 at 6:01 pm

  3. Hi Ashwin,

    Our intuitions are remarkably aligned. For some time I’ve taken it as axiomatic that the single greatest cost from regulatory rent-seeking comes from the fact that it thwarts innovation. Only recently have I realized just how difficult it is to prove such a notion empirically to those (most intellectuals) to whom it is not obvious.

    I’ve tried to make the case that, for instance, that various innovations could easily have been thwarted by regulatory rent-seeking in order to provide skeptics with a sense of the scale of the problem. For instance, consider what would have happened had Ebay not been allowed to operate due to regulations? Or what if IBM had been in a position to define licensing standards for all engineers in the IT industry from 1960 to the present? Or going back farther, what if Edison had been thwarted due to regulatory obstacles?

    To me, these notions adequately illustrate the scale of damage that regulatory rent-seeking can have (and, of course, almost all regulation sooner or later incorporates a rent-seeking aspect to it). And yet, curiously, very few seem to internalize the obvious lessons. May your examples be more effective.

    Michael Strong

    31 Jan 11 at 7:18 pm

  4. Hi Michael

    Trying to prove that innovation did not happen due to rent-seeking is difficult as you say. It’s made even more difficult by the fact that people measure innovation simply by measured productivity which can go up in the short run even when exploratory innovation is suppressed. This is exactly what we’re seeing right now – dominant incumbents become more efficient by reducing headcount.

    Ashwin

    1 Feb 11 at 2:37 am

  5. Mobile banking hasn’t been developed in the U.S. and Europe because it solves problems we’d already solved.

    We can securely transfer money, through cash, or checks or electronically. My debit/credit card is accepted at 99% of establishments I use.

    I can transfer money between accounts using a telephone automated teller, any one of 1000s of atm, my laptop, or my iphone.

    We can carry large sums of cash securely on our persons, but don’t need to make payments because again we can pay with checks or cards already.

    So I think this is not a great example of stagnation, but a wonderful example of local innovation to local conditions. Problems we’d largely solved already in the developed world.

    Peter Noordijk

    1 Feb 11 at 4:31 pm

  6. Peter – Thanks for the comment.

    I don’t claim that mobile banking solves an unsolved problem. But just like frugal innovation in medicine in China and India, it makes a similar service available at a price point that is far below the current offering. Compare this to the swipe fees that Visa and Mastercard charge, or how banks are making it harder to get a free checking account with low balances and it’s hard to claim that there are no oligopolistic rents being charged here.

    Ashwin

    2 Feb 11 at 3:36 am

  7. There’s a danger in using a moral compass, just like there’s a risk of misdirection attached to using a magnetic compass. The moral meanings and functional system might line up much of the time, just as the axis of rotation and the magnetic axis line up. But, you want to analyze the functional system, just to make sure.

    “How many” innovations is the wrong question, here. It leads, as you note, into a dead-end of counterfactual speculation.

    Rather than try at the outset to distinguish “genuine” innovations (by some morally meaningful criteria), it might be better to observe that innovations (changes to the functional structures of the economy and its managerial and technical organization of production and distribution) occur everywhere. It takes “innovation” — changes in structure — to make a rent-seeker’s paradise just that.

    If you want to use an evolutionary perspective, with experimental variation (innovation) and selection, that works, too. Just be morally neutral about identifying “innovation” long enough to recognize that the rent-seeker’s paradise will be selecting “successful” innovations in an overall pernicious way.

    You’ve got the right idea in the MRI example: the “direction” of (selected) innovation in the rent-seeker’s paradise will be different, and it will show up in the effect of productivity increases on factor incomes.

    In a healthy economy — invisible hand and all that — innovation yields transitory profits, but is, in a profound sense, self-defeating for the innovator, even as it rewards the society as a whole. The cost of final product declines, the cost of factor inputs goes up and profit (and to *some* extent, rent) is competed away. In an abundance of caution, let me remind you that some very large organizations can become dynamic engines of continuous “innovation” over fairly long periods of time, as the logic of an innovative architecture (petroleum extraction and refining, assembly line, copper-wire switched-network telephones, microprocessors, operating system programs, container shipping) plays out, experience accumulates and technology-embedding capital investment are made. (Big is suspicious, but not necessarily entirely the enemy; mixed picture is the rule with Standard Oil, General Motors, Microsoft, Wal-Mart, etc.)

    The “direction” of innovation’s effects on final product price, and factor incomes, gives us the key interpretative clues. In U.S. medical insurance and care, we see the advancing technical possibilities being turned into increasingly costly insurance and care. The Baumol effect explains why we might want to devote more resources to health care, but not why we let health care capture more income, and more consumer surplus.

    In the financial sector, it is even more exaggerated: the rents earned are reflected in skyrocketing executive compensation and rising final product prices (credit card interchange fees, credit card interest rates, the cost of foreclosure to consumers, etc.)

    Recognizing the role of rent-seeking in mis-shaping the economy’s performance on several dimensions, is a little like the insight that the earth is a sphere in space. At first, it seems counter-intuitive, a contradiction of the hypothesis of a Euclidean flat-earth, but gradually one recognizes the evidence everywhere, from the receding horizon to the phases of the moon to the tides to the passage of day into night, to the progress of the stars in the night sky, to the angle of sun against the horizon. That’s my experience reading your best essays. It’s heady stuff.

    “Rent-seeking” doesn’t necessarily affect the pace of innovations, in the sense of change in response to the advance of technical possibility, but it does heavily restrict the extent to which consumer surplus is captured and producer surplus remains uneroded by competitive allocation of resources.

    I suppose lots of people think innovation is rewarded, but, really, it is not. Or, it “shouldn’t be”. In an economy, in which productivity is rising, the sectors where innovation is doing what we want it to do — driving down product prices, input factor incomes are likely to stagnate or fall. It’s the lawyers, landlords, barbers and real estate agents, not the engineers, who profit most reliably in the Silicon Valleys of this world.

    Bruce Wilder

    3 Feb 11 at 5:49 pm

  8. Might our recoveries be increasingly jobless precisely because we are following Keynesian policies of bailouts and stimulus packages?

    http://zatavu.blogspot.com/2011/02/why-government-stimulus-packages-cannot.html

    Troy Camplin

    6 Mar 11 at 7:04 am

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