A Nobel for Our Grandchildren

© Nobel Media

Awarding the Nobel Prize for Economics to Romer and Nordhaus is a nod to thinking about the long term.

In 1930, John Maynard Keynes wrote an essay titled ‘The economic possibilities for our grandchildren’. In his own words, the purpose of the essay was to ‘disembarrass’ him of  ‘short views’ and ‘take wings into the future.’ He asked: “What can we reasonably expect the level of our economic life to be a hundred years hence?”

The 2018 Nobel memorial prize in the economic sciences has been awarded to Paul Romer and William Nordhaus for creating a framework for thinking about similar long-term questions. The citation for this year could have been titled ‘A prize for exploring the economic possibilities for our great-grandchildren’.

Long term macroeconomics is mostly about understanding the determinants and sustainability of economic growth. Compound growth is an extremely powerful force. The Nobel committee notes: “Even small year-to-year differences in growth rates, which may seem tiny in a short-run perspective, cumulate. If such differences are systematic over decades, they build up to significant changes in living standards.”

To understand what factors can explain persistent growth, it is important to understand factors that cannot. For example, human skills cannot explain long-term growth. Skill is something that is stored in our muscles and brain, neither of which is permanent; it cannot be accumulated. Think of a carpenter. His skills are enormously valuable. Nevertheless, it cannot be a source of the persistent growth for a simple reason: there will be a time when he must retire, bringing the growth to a halt.

Growth strategy that is based solely on the accumulation of inputs cannot be sustainable either.  This is due to a different reason: mobilizing inputs gets progressively difficult and diminishing returns set in eventually. To see this starkly, think of agriculture. One source of agricultural growth is the area under cultivation. Typically, it is relatively easy to increase area under cultivation from say 30 to 60 percent. Afterwards, it will be extremely difficult to increase it up to say 90 percent; finally, it is logically impossible to increase area under cultivation beyond 100 percent. If increasing area under cultivation were the only source of agricultural growth, it won’t last forever.

Similar reasoning applies to other factors of production too. In a 1994 essay, Paul Krugman had used similar reasoning to argue that East Asian miracle was not long-lasting. As an economic crisis broke out three years later, Krugman’s prediction was vindicated, cementing his reputation as a crystal-ball gazer.

Back to the original question: if neither skills nor accumulation of inputs can account for long-term growth trends, what does? For sustainable long-term growth, one needs a factor of production that is accumulable, yet never runs into diminishing returns.

Romer has identified precisely such a factor: ideas. Before Romer entered economics, he was a trained physicist, and his background played a key role in the development of his conceptual framework. He wrote:

We don’t really produce anything. Everything was already here, so all we can ever do is rearrange things. Think of conservation of mass. We’ve got the same amount of stuff we’ve always had, but the world is a nicer place to live in because we’ve rearranged it.

If so, the process of economic growth is about finding new ideas. To use an analogy from cooking, sustainable economic growth comes not from increasing the ingredients, but from discovering better and better recipes.

This way of looking at the economic growth has many drastic and unconventional implications. For example, key determinants of our long-term growth turn out to be the incentives that govern production and dissemination of ideas, and not the ones governing the production and distribution of ordinary goods and services.

From the microeconomic point of view, the distinguishing feature of an idea is that it is ‘non-rival’. If you consume an apple, another person can not consume that apple. But if you learn an idea, say, a multiplication table, you don’t prevent other person from learning it.

While exact details vary in different papers, Romer has received his Nobel by synthesizing the microeconomics of the production of non-rival goods (ideas) with the macroeconomics of the growth process. In fact, one of his papers begins with the following declaration which is the best non-technical summary of his research:

The central claim of this paper is that the difference between the economics of ideas and the economics of objects is important for our understanding of growth and development.

William Nordhaus has been awarded his prize for ‘integrating climate change in the long-run macroeconomic analysis.’ His work deals with the four-way interaction between economic activities, carbon emission, carbon concentration and climate change. Given the level of carbon intensity, economic activities contribute to the carbon emission; carbon emission alters the climate by changing the heat budget; finally, climate change has a damaging effect on the GDP, completing the feedback loop.

In Nordhaus’s model, the agents making choices are forward-looking and altruistic (they care about their offsprings); still, carbon emission is sub-optimally high. This result is based on a standard externality argument: In making decisions, people worry about the personal costs and benefits and neglect the cost it imposes on others. Because the cost of carbon emission is dispersed globally, no one has any incentive to reduce carbon emission or undertake mitigation efforts.

Of course, Nordhaus’s model goes far beyond this standard argument. It combines the economics of climate change with the physical constraints imposed by carbon flow. It can be used to understand the effect of policies on the dynamics of climate change; to compute the optimal tax for correcting externality; and to estimate the tentative cost of mitigation policies.

There are some potential critiques however. First, his model is sensitive to the choice of parameters, so even a minor change can affect optimal policies drastically. Second, a topic like climate change has strong normative dimensions. Because costs and benefits of climate change mitigation efforts are borne by different generations, optimal policy will be contingent on the normative weights attached to well-being of different generations. Economic models can not make ethical choices, but they can clarify the trade-offs involved and sharpen the debate. Nordhaus’s model does precisely that.

In this age of social media, outrage cycles based on immediate problems crowd out long-term issues. If this year’s Nobel prize can focus attention on the issues which are critical for our progress and survival, it will have served its purpose.

About the author

Avinash M Tripathi

Avinash M. Tripathi is an Associate Research Fellow (Economics) at the Takshashila Institution. His research interests include competition policy and financial risk management. He prefers a profound answer to a silly question rather than the other way around.